Discount Applied to Promissory Notes
Posted on 14 September 2012 | By Lawrence Tepper
Discounts Applied to Determine Fair Market Value
Fair Market Value Compared to Book Value
Customarily we think of the value of investments as their cost in our books and records—“book value”. If we paid $40,000.00 for a promissory note paying 6.5% interest we normally feel its “value” is $40,000.00. But, the IRS’s definition may cause the investment to be valued for tax purposes at a very different figure. Book value is not always the same as IRS Fair Market Value.
What is Fair Market Value?
The definition of “fair market value” used by the IRS is the controlling value in areas of taxation, including gift tax and estate tax. For all taxation purposes, “fair market value” of a promissory note is based on the traditional standard of a “willing buyer and willing seller”. The fair market value of a note is “the price at which the note would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.” IRS Publication 561 defines fair market value. Treasury Regulation 20.2031-1(b)
Determining Fair Market Value is not an exact science; it is an educated estimate; it is estimated because there is usually no identifiable market for private promissory notes. It requires an experienced, independent appraiser who is actively involved with the valuation of promissory notes.
What is the Purpose of Applying Discount to Determine Fair Market Value: The purpose of applying discounts is to adjust the yield of the note to reflect its risk. All investments have risks. Their yields (income) reflect that risk. A high risk investment carries a high yield—a low risk investment carries a low yield. The reason for the use of discounts is to adjust the note’s yield (income) to reflect the risks inherent in the note. The interest rate printed on the note cannot be changed. But, by lowering its value (price), its yield can be adjusted upward to compensate for risks.
What Risks Cause Discounts to be Applied?
Lack of Marketability: One of the main risks of a private promissory note is not being able to convert it into cash quickly and at a reasonable price. The reason for this difficulty is the lack of an active, open, transparent note market. This is called a lack of marketability. Lack of marketability causes financial uncertainty; financial uncertainty is a risk. If the holder of a note wishes to raise cash by selling a note, or is forced to sell, the amount of cash that will be received is uncertain; and there is an uncertainty as to how long it will take to complete the sale and receive the cash. The amount to be received and when it will be received is uncertain.
Lack of Adequate Collateral Security: A promissory note can be “secured” or “unsecured”. An unsecured note is backed by only the signature (promise to repay) of the borrower. A secured note is back by the borrower’s signature, plus additional collateral security. The additional collateral security can be the guarantee of another individual or entity—a co-borrower or guarantor; it can be the pledge of real property, personal property, or a combination of property and guarantees.
The function of additional collateral security is to reduce the risk of loss if the borrower defaults. The more collateral security provided the lower the risk of loss. To assure the safety of the loan, the collateral security should be worth more than the note. It should also be liquid—easily converted into cash.
Fair Market Value, as defined by the IRS, is the required value to use for most tax related situations. To determine Fair Market Value of a promissory note, discounts must be applied to reflect the inherent risk. An experienced, independent, professional appraiser is required to apply the discounts and value the note. Lack of marketability and lack of collateral security are the main causes of discounts.