When A Promissory Note May Be Worth Less Than Face Value

Families and their family holding companies may hold assets in the form of promissory notes, including a note from a related business entity, a loan to a family member, or a seller-financed balance from a past transaction. Many times, these related party promissory notes carry interest at or near the AFR rate from the day they were written. It then sits on the balance sheet at face value. For gift and estate tax reporting purposes, face value is not necessarily fair market value. A promissory note may have a fair market value below the face value, but the taxpayer must substantiate that lower value through the note’s terms, borrower circumstances, and valuation-date market evidence.

Treasury Regulation sections 25.2512-4 (gift tax) and 20.2031-4 (estate tax) provide guidance for the valuation of promissory notes. The fair market value of a note is generally presumed to be the unpaid principal plus accrued interest. However, the taxpayer may establish a lower value on satisfactory evidence that the note is worth less than the unpaid amount “because of the interest rate, or date of maturity, or other cause.” This provision can lead to an estate planning opportunity, especially for promissory notes that have little to no security provisions and/or are under collateralized.

What This Looks Like in Practice

Eide Bailly was recently engaged to value nonvoting membership units in a family limited liability company formed as part of a gifting program. One of the company's more significant assets was a cognovit promissory note with a principal balance of $5 million bearing interest at nearly 4%.

The note was unsecured, uncollateralized, had no covenants, no financial reporting requirements, and no stated payment priority. No payments[DH4.1][JB4.2] had yet been made, with the first annual installment not due for over two years.

Our analysis followed the framework the IRS outlines in its Technical Advice Memorandum 8229001: start from an observable benchmark yield and adjust for the specific ways the instrument differs from investment-grade debt. The benchmark was the 10-year Treasury at 4.33 percent. Adjustments were added for subordination, lack of covenants, lack of collateral, debt priority, uncertainty regarding the borrower and its security, the payment schedule, and lack of divisibility. The resulting required yield is closer to 10%. The contractual payments — principal and interest, year by year — were then discounted at that rate.

The result: a note with a $5 million face amount carried a fair market value of $3.75 million, a discount of 25% from the stated face value of the note. An additional layer of discounts for lack of control and lack of marketability inherent in the nonvoting membership units that were gifted was also applied.

The overall effective discount for the nonvoting membership units gifted was nearly 50%. The note discount and the entity discounts stack because they answer different questions: what is the promissory note worth and what is the gifted nonvoting slice of the company holding it worth.

Turn Low-Interest-Loans Notes into an Estate Planning Opportunity

Fixed interest rate notes issued during the last 10 years likely have an enhanced discounting opportunity. The reason is that market interest rates, while historically low over the last few decades, have begun to increase . On March 15, 2020, the prime rate fell to 3.25%, where it stayed until March 16, 2022, and has since climbed to 7%, representing a more than 100% increase.

Every promissory note issued during the 2020-2022 trough and still outstanding carries a stated rate a hypothetical buyer would no longer accept, and the gap between that stated rate and today's required yield is the estate planning opportunity discount.

A gift reported on a return that satisfies the adequate disclosure requirements starts the three-year limitations period running, and a qualified appraisal is one of the routes to satisfying them.

That is exactly as true of a discounted note as of an equity interest — arguably more so, since a note reported below face value is a position that invites the question. Without adequate disclosure, a promissory note value discounted from its face value is open to revaluation indefinitely.

Eide Bailly Can Help

If your clients hold promissory notes written during the lower-rate years — intrafamily loans, seller paper, related-entity obligations — those instruments are very likely worth less than their face amount, and the difference is transferable value.

We value promissory notes for gift and estate tax purposes and can assess quickly whether a given note is a good candidate for a meaningful discount, before the transfer is documented, rather than after.