Can You Apply a Discount to a Promissory Note?

Hoffman v. Commissioner: Tax Court Accepts 12.5% Discount Rate

Treasury Regulation 20.2031-4 states that the fair market value of promissory notes, secured or unsecured, is presumed to be the amount of unpaid principal, plus accrued interest at the date of valuation, unless the taxpayer provides sufficient evidence to the Internal Revenue Service which supports a lower value.

In the Estate of Marcia P. Hoffman v. Commissioner, T.C. Mem. 2001-109; Mark Mitchell was retained by the Internal Revenue Service to value two unsecured promissory notes. In order to quantify a discount rate to apply to the future cash flows of each note, Mr. Mitchell took the following interest rates, or yields, into consideration when contemplating a rate of return that would be acceptable to a hypothetical buyer of the debt instruments:

1.  Interest rates of various debt securities;
2.  Corporate bonds of various ratings;
3.  Interest rates for conventional mortgages; and
4.  Venture capital returns.

After analyzing the risk attributes associated with each of the four types of interest rate proxies, Mitchell formed an initial opinion of the rate of return expected by a hypothetical buyer of the promissory notes and then made adjustments to his rate based on specific criteria such as the:

1.  Creditworthiness of the borrower;
2.  The payment history of the borrower;
3.  The absence of security provisions in the notes such as covenants related to late and prepayment penalties;
4.  The omission of collateral assignments should the borrower default; and
5.  The lack of marketability for the notes attributable to the fact that a formal secondary market is nonexistent for private debt.

Mr. Mitchell determined that discount rates ranging from 10% to 15% would adequately account for the level of risk associated with the promissory notes and concluded that 12.5% was a reasonable rate to apply to both notes’ future cash flows in order to calculate their present (fair market) values.

The Court was not persuaded by the report and testimony of the Estate’s expert, rejected his value conclusion, and concluded that a discount rate of 12.5% appropriately reflected a hypothetical buyer’s anticipated internal rate of return between the date of death and the maturity dates of the notes.

By Gary Ringel, CGREA