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Discounts Applied to Determine Fair Market Value of Promissory Notes

Promissory Note Discounts for Estate and Gift Taxes

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—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…

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