The Valuation of Promissory Notes

When it comes to promissory notes, the IRS treads heavy but carries a small stick for want of contradicting itself. In the income tax sphere, where the deduction to income resulting from the forgiveness of a loan balance to a not-for-profit entity is at issue, the IRS wants a low value. In the estate and gift tax sphere, the IRS wants a high value. 

26 CRF § 20.2031-4 states the following: “The fair market value of notes, secured or unsecured, is presumed to be the amount of unpaid principal, plus interest accrued to the date of death, unless the executor establishes that the value is lower or that the notes are worthless.” In other words, the burden is on you to show that the note’s face value as of the valuation date is not reflective of its fair market value.

For estate and gift tax, the primary issue is whether it is a bona fide note or a gift masquerading as a note. An unsecured promissory note at the AFR with interest only payments issued to a son will look suspicious to the IRS, and their suspicion is probably justified. On the other hand, a secured note at a market interest rate with principal and interest payments due monthly, this one made to the ill-favored son, appears bona fide. 

Case Law 

Though the cases are few the details are rich. I won’t get too into the weeds here; the interested can read the cases for themselves. What follows is a high-level summary of salient points from our esteemed judges. 

In Miller v. Commissioner T.C. Memo. 1996-3, the Court provided nine factors to consider when determining whether a note is bona fide:

1. Whether there was a promissory note or other evidence of indebtedness. 

2. Whether interest was charged.

3. Whether there was any security or collateral. 

4. Whether there was a fixed maturity date. 

5. Whether a demand for repayment was made.

6. Whether any actual repayment was made. 

7. Whether the transferee had the ability to repay.

8. Whether any records maintained by the transferor and/or the transferee reflected the transaction as a loan; and

9. Whether the manner in which the transaction was reported for federal tax purposes is consistent with a loan.

The note at issue in Miller was an unsecured, non-interest-bearing demand note to a son. The Court called this a gift, saying that a promise to pay made in return for a promise not to enforce payment doesn’t constitute a bona fide promissory note.

As for the actual valuation of promissory notes, the Smith v. U.S. 923 F.Supp. 896 (1996) provides a good example. At issue was the fair market value of a promissory note. Mercer Capital opined on the fair market value of the note. Mercer’s opinion endured trial and was accepted by the Court. “As discussed in more detail below, Mercer's approach to valuing the note was to first determine the future cash flows from the note, which remained on April 28, 1988 (date of death), and to discount them at an appropriate yield to maturity date. A discount rate was described as a capitalization rate—a note used to convert a stream of payments into a value.” (Smith, p. 898.)   

Valuation Process

The value of a promissory note, as with any financial instrument producing a stream of cash flow, is the present value of the anticipated benefits. The present value is ascertained by applying a risk rate commensurate with the risks associated with the instrument. Ultimately, what we’re talking about is simply the allocation of a scarce resource – money. Investors have many alternative investments options: stocks, bonds, mutual funds, index funds, Bitcoin, NFTs, that sketchy friend’s new dispensary, promissory notes, and an overwhelming number of others. The investor’s goal is to pick the investment with the lowest risk relative to return. 

With that concept in mind, we approach the value of a promissory note. The contract promises a payment stream at a stated interest rate. The interest rate serves as the yield (rate of return) on the outstanding principal balance of the note. If you purchase a promissory note at a price equal to the outstanding principal balance, you will receive a rate of return equal to the interest rate on the note. If the purchase price is less than the principal balance, i.e., a “discount” is applied, the rate of return increases. The point of the “discount” is to set the rate of return equal to that of investment options with comparable risk. 

Let’s look at an example. Say we have a note with the following facts:

Let’s say this note is subject to a 706 valuation where the date of death was January 1, 2024. All payments are up to date, such that the outstanding principal and interest balance is $1 million. 

As noted in Smith, the two components of a note valuation are the anticipated cash flows and the discount rate. Arriving at the cash flows is simple enough; you just amortize the note payments through maturity, as shown below. The interest and principal payments reflect your anticipated cash flows through maturity.

The second component, which is the hard one, is the discount rate. The discount rate consists of a “base” rate and premiums added thereto for the additional risks associated with the subject note not captured in the base rate, if any.

The base rate is selected from market rates prevailing as of the valuation date. The selected market rate should reflect the nature of the note you are valuing. For example, the note in our example is secured by real estate, making returns on real estate investment trusts (REITs) a good candidate. The dividend yield for all REITs in 2023 was 4.25%.  Analysts may also refer to corporate bond rates, mortgage rates, “risk free” rates, the prime rate, and many others. 

To this base rate, we made upward adjustments for the risks associated with the note not contemplated by the underlying investment. By way of example, here are some premiums to consider for our note:

Although these adjustments have a basis in economic reality, their quantification is subjective, and the appraiser must use common sense and professional judgment in deciding the magnitude of each. In this case, we have landed on a premium of three percent, which brings our discount rate to 7.25%. 

The fair market value of the note can be ascertained by discounted the anticipated payment stream to the present value using our discount rate. 

On these assumptions, the fair market value of the note is a rounded $822,600. 

For illustrative purposes, let’s look at one more example using the same note but assuming that principal and interest payments are made monthly. Amortizing the note out from inception results in the following:

The payments highlighted in blue reflect the anticipated cash flows from the valuation date up to maturity. The present value of these payments, using the same discount rate ascertained above, is the following:

Of note here is the lower discount rate resulting from changing the terms of principal payments. (Note that the discount rate is calculated on the principal balance outstanding as of the valuation date.) 

Conclusion

A promissory note valuation is easy in a technical sense. What makes these valuations difficult is the burden of showing that the note is bona fide and that its fair market value is indeed lower than the outstanding principal and accrued, but unpaid, interest as of the valuation date. The latter can be shown by review of its interest rate, payment terms, collateralization, and payment history. If the interest rate on the note appears too low in comparison to other investment opportunities, the fair market value of the note would indeed be less than the outstanding principal and accrued but unpaid interest.