Private Notes: What to Look for When Assessing Fair Market Value

Estate planning using note instruments has been a popular strategy for many years. Fueled by historically low interest rates, increased exemption amounts allowed under the Trump administration, and the threat of the planning window closing under the Biden administration, note planning has only risen in popularity.

Tax code Section 1274 sets forth the determination of the issue price for notes using the applicable federal rate (AFR) that allows planners to structure a transaction using a private note and not impute any gift tax. However, the AFR rate represents the “lowest” allowable rate and may not equal the fair market rate that would be used to value the note for any subsequent planning or the potential inclusion of the note in an estate. We provide a brief overview of how to determine the fair market rate of a private note instrument for estate and gift tax purposes.

The definition of fair market value for estate and gift tax purposes is the price at which property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts (Treasury Regulations Sections 20.2031-1(b) and 25.2512-1). More specifically as it relates to notes, Treas. Reg. Sections 20.2031-4 and 25.2512-4 state:

“The Fair Market Value of notes, secured or unsecured, is presumed to be the amount of unpaid principal, plus accrued interest to the date of gift, unless the donor establishes a lower value. Unless returned at face value, plus accrued interest, it must be shown by satisfactory evidence that the note is worth less than the unpaid amount (because of interest rate, or date of maturity, or other cause), or that the note is uncollectible in part (by reason of the insolvency of the party or parties liable, or for other cause), and that the property, if any, pledged or mortgaged as security is insufficient to satisfy it.”

A discounted cash flow (DCF) method is the general approach to assess that the note has a “lower value” than the unpaid principal plus accrued interest. The DCF approach measures the value of an asset by the present value of its future economic benefits. When applied to debt instruments, value indications are developed by discounting expected cash flows to their present value at a rate of return that incorporates the risks associated with the particular debt instrument.

The discount rate selected is generally based on rates of return available from alternative investments of similar type and quality. Given that private note transactions are usually not disclosed or publicly available, the initial discount rate search will be sourced from the public markets. The public debt data can be searched by comparable duration and matched up with comparable credit ratings. However, given the inherent differences between the comparable public debt and private notes, several additional factors have to be considered in the determination of the fair market discount rate. The Internal Revenue Service provides guidance for these considerations in Technical Advice Memorandum 8229001 and historical U.S. Tax Court case law. Considerations should include:

• presence of protective covenants or lack thereof,
• nature of the default provisions and the default risk,
• financial strength of the issuer,
• value and type of security (i.e. the collateral),
• interest rate and terms of the note,
• payment history,
• size of the note, and
• market for purchase and resale of the note.

Below are brief descriptions of the key considerations for the above outlined points.

The Presence or Lack of Protective Covenants

Covenants represent the principal means by which a creditor can monitor and assure the continuing safety of an investment. The more onerous the restrictions placed on a borrower by way of the covenants, the lower the risk for the lender.

The Nature of the Default Provisions and the Default Risk

Failure on the part of a borrower to make timely payments of interest and principal may result in a lender making claims against the assets of such borrower. The more stringent the default provisions, the lower the risk to the lender.

The Financial Strength of the Issuer

A strong financial profile of a borrower will result in lower risk for a lender and a lower required rate of return.

The Value and Type of Security

Collateral is required to serve as protection for a lender against a borrower’s failing to pay the principal and interest under the terms of the note.

The Interest Rate and Term of the Subject Notes

The greatest risk to most note investors is the risk that market interest rates will change during the holding period. The longer the term of the note, the more exposed the investor is to changes in interest rates and the higher the required rate of return.

The Payment History of the Subject Notes

If payments are current and have been made in a timely manner, especially if there is a long history of timely payments, the risk for the lender is decreased along with the required rate of return.

The Size of the Subject Notes

In most cases, well-documented protective covenants, excellent financials, and good collateralization are associated with larger companies. Accordingly, all else being equal, the size of the note will have an inverse relationship to the required discount rate.

The Market for Purchase and Resale of the Subject Notes

In many instances, the market for the purchase and resale of the note may have the most dramatic impact on the value, given that most private notes that require valuation for estate and gift tax purposes have a very limited market. There may a small pool of private note brokers, but it has been our experience that this market will demand very steep discounts to the outstanding principal amount to account for the inherent risk and illiquidity of private debt. The adjustment for lack of a liquid market can be incorporated into the fair market discount rate or determined as a separate discount using various studies of illiquid securities such as restricted stock studies.

The above analysis will provide the best support for determining the fair market value of a private note instrument and thereby also provide the best protection against a possible estate and gift tax audit.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Carsten Hoffmann is a managing director and Trust & Estate Valuation practice co-leader at Stout.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.