Lending to Heirs – Valuation of Notes Receivable for Estate Planning Purposes

In general, the idea of lending money to our children can bring mixed emotions. Just the idea of putting our dollars into their hands can cause angst. Will the kids use the money wisely? Will they repay the loan as promised? What are the impacts to our own finances? These are all valid concerns under normal circumstances – assuming the children need the money. However, there are reasons to lend to our children that have little to do with their needs. Lending to our heirs is an estate planning tool that works, and the valuation implications can be significant.

The estate planning reason to lend to our heirs is fairly simple. A parent can lend at a very low, IRS-established interest rate and the borrower (the child) can invest the funds to receive a higher return, sometimes significantly higher. The difference in the investment return and the interest rate is wealth accrued to the borrower (the child). Only the interest that goes to the lender will end up as an eventual estate asset. The parent avoids increasing their estate by much, the children receive the investment proceeds, and no gift has been made. Simple.

The added benefit of this strategy is that it is possible, and even likely, that a note which bears the IRS-established interest rate will not be worth its original face value when using the Fair Market Value (“FMV”) standard.

U.S. Treasury Regulation §20.2031-1(b) defines fair market value for estate tax purposes in general, as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

U.S. Treasury Regulation §20.2031-4 states: “The fair market value of notes, secured or unsecured, is presumed to be the amount of unpaid principal, plus interest accrued to the date of death, unless the executor establishes that the value is lower or that the notes are worthless…If not returned at face value, plus accrued interest, satisfactory evidence must be submitted that the note is worth less than the unpaid amount (because of the interest rate, date of maturity, or other cause), or that the note is uncollectible, either in whole or in part (by reason of the insolvency of the party or parties liable, or for other cause), and that any property pledged or mortgaged as security is insufficient to satisfy the obligation.”

Because notes of this nature tend to be written at the low IRS interest rates, they do not reflect the “market” rate of return that a hypothetical willing buyer would require. Because the rate is below market, the only way for a buyer to receive an appropriate return would be to reduce the price to be paid for the note so that the interest due under the terms of the note plus the additional principal received at maturity would generate the market rate of return- this is the same as bond-pricing theory.

In order to properly determine the value of the note and submit “satisfactory evidence,” an analyst must consider all of the terms of the note, its collectability, the security for the note, and the history of payments. In addition, the analyst must be able to match the note to market evidence of similar instruments. The key to this type of valuation is be sure that all of the facts and circumstances have been considered and the market data has been applied properly. If performed correctly, the note itself can become the subject of a gift transfer, perhaps at a significant discount to its face-value. In these instances, not only is the parent/lender able to affect a non-gift transfer strategy, detailed above, but may also be able to affect discounted-gift transfer strategy using the same instrument.

If you have comments or questions about this article, or would like more information on this subject matter, please contact us.
Tracy Lamb

Valuation
tlamb@pcecompanies.com
Orlando Office

407-621-2100 (main)
407-621-2118 (direct)
407-621-2199 (fax)