The amount of an income tax deduction for the fair market value (FMV) of a charitable contribution of a privately held asset often prompts a disagreement between the taxpayer and the Internal Revenue Service. While arguing may not be unusual when it comes to the topic of FMV, the irony of a charitable contribution is that each side finds itself advocating an opposite position to which it’s accustomed in an estate and gift tax context: What’s the appropriate percentage for a discount for lack of control, lack of marketability or lack of voting rights?1 While higher discounts (resulting in a lower FMV) generally benefit taxpayers making gifts, lower discounts (resulting in a higher FMV) generally benefit taxpayers making charitable contributions.

One type of asset that may have become more suitable for a charitable contribution is an intra-family note with its interest rate set at a low applicable federal rate (AFR). Since the 2008 recession, the Federal Reserve’s decision to implement policies to push government interest rates to historically low levels, and the widening of the gap between AFRs and commercial interest rates, AFR-based promissory notes have become an increasingly desirable freeze-planning technique.

Intra-family notes with an AFR interest have also caused the IRS some consternation. Under the tax law’s long-standing standard of value in an exchange between a willing buyer and a willing seller, the FMV of any debt instrument is less than its face value when its stated interest rate is below that of market-based rates for debt with similar risk characteristics and term to maturity. Thus, the potential exists to create an AFR note at face value and then subsequently transfer the same note by gift at FMV, at a discount from face value, based on its below-market interest rate.

To combat this technique, the IRS has taken the position that the differential between commercial market interest rates and AFRs shouldn’t be considered for the transfer value of such notes. Only a significant change in the supporting collateral for the note provides a basis for discounting the note on its subsequent transfer. While this may not be an ideal position for taxpayers wishing to make a gift, it may provide an attractive opportunity for taxpayers wishing to make a charitable contribution of an intra-family promissory note with a low AFR; thus, establishing the deductible value of the note without regard to its below-market interest rate. A regulation proposed long ago—but never finalized—by the IRS regarding the FMV of intra-family notes,2 may give taxpayers the needed support to maximize the deductible amount.



The IRS establishes a presumption that the FMV of a promissory note is, effectively, its face value, unless the taxpayer proves otherwise:


The FMV of notes, secured or unsecured, is presumed to be the amount of unpaid principal, plus accrued interest to the date of gift, unless the donor establishes a lower value.  Unless returned at face value, plus accrued interest, it must be shown by satisfactory evidence that the note is worth less than the unpaid amount (because of interest rate, or date of maturity, or other cause), or that the note is uncollectible in part (by reason of the insolvency of the party or parties liable, or for other cause), and that the property, if any, pledged or mortgaged as security is insufficient to satisfy it.3


Humorist Mark Twain offered sage financial advice when he said, “I am more concerned about the return of my money than the return on my money.” Repayment and collectability of the principal of a note is an essential factor in assessing its FMV. But, so is the appropriate interest rate that should attach to a note with similar risk, maturity, liquidity and collateral.

The method used to value a loan is dependent on the borrower’s financial condition. One of three general scenarios is likely: (1) the loan will be repaid on time; (2) the loan will be repaid eventually; and (3) there’s significant doubt that the loan can or will ever be repaid. If there’s a reasonable expectation that the debtor will be able to meet the financial obligations of the loan, then the value of the loan is equal to the present value of the future loan payments discounted at a rate of return commensurate with the risk associated with the loan payments. Alternatively, if the debtor is unable to pay, or if there’s uncertainty whether the debtor will be able to meet the terms and conditions of the loan, then consideration is given to the present value of the expected proceeds to be received through a liquidation or bankruptcy of the debtor or other liquidity event. The proceeds are also discounted at a rate of return applicable to the risk associated with receiving payment.  

In a willing-buyer, willing-seller world, an investor would accept a rate of return no lower than that available from other investments with equivalent risk and marketability and would value the investment accordingly. Hence, the valuation analyst looks to the market of publicly traded debt to determine an equivalent market-derived rate of return, or yield, applicable to the privately held loan and its underlying collateral. An appropriate yield represents the risk inherent in the collateral, as well as differences in the level of marketability between publicly traded debt and a privately held note.  

The appropriate quantification of risk attributable to a specific debt requires consideration of a number of market, industry and company-specific factors. Market-based yield to maturity is estimated through an analysis that includes the timing of payments, the stated interest rate, the risk of the debt and the interest rates for comparable publicly traded securities.    

In general, a required rate of return is comprised of three components: (1) a time-value of money component; (2) a risk premium component; and (3) a marketability or liquidity component. The first component, time-value of money, represents the rate of return that one could obtain in an investment with little or no risk of losing the interest or principal on the note. This is often called a “risk-free” rate of return. U.S. Treasury obligations are usually considered to have no default risk because they’re backed by the full faith of the federal government. As a result, a U.S. government obligation is often used as a benchmark for a risk-free investment and is considered a proxy for the time-value of money.

The second component, risk premium, is comprised of many specific types of risks. For example, a portion of the risk premium represents compensation for interest-rate risk. As interest rates rise (fall), the price of a debt instrument will fall (rise). Maturity is a major determinant of interest-rate risk. Interest-rate risk is by far the most significant risk faced by an investor of debt instruments in the public marketplace. Additionally, investors face the variability in returns from their reinvestments due to changes in market rates (that is, reinvestment risk) or, potentially, the loss of a portion or the entire investment if the debtor declares bankruptcy of fails to make payments (that is, default risk). Risk premiums can be directly observed by analyzing market yields of publicly traded corporate and high-yield debt in excess of the risk-free rate.

The third component represents the marketability of the investment and reflects how quickly one can obtain liquidity from an investment. Factors that affect marketability include restrictions on transfer of the security, the pool of possible investors, the size of the security and the amount of available information related to the issuer. The more obstacles to finding a potential buyer, the more illiquid the investment, and accordingly, the higher the rate of return one would require.

In Technical Advice Memorandum (TAM) 8229001, the IRS provided guidance on the relevant factors to consider in determining the FMV of a note:


presence of or lack of protective covenants in the note;

nature of the default provisions and default risk;

market for purchase and resale of the note;

financial strength of the issuer;

value of the security (that is, the collateral);

interest rate and term of the note;

comparable market yields;

payment history; and

size of the note.


Interest-Free Loans and the AFR

Prior to 1984, taxpayers used interest-free loans to take advantage of the IRS’ inability to convince courts that interest-free loans should be income and/or gift taxable transfers. After more than 20 years of challenging interest-free loans, the IRS achieved success when the U.S. Supreme Court held, in Dickman v. Commissioner,4 that the right to receive interest was a property right and such foregone interest was a taxable gift. To address the uncertainty involving interest rates on loans after Dickman, Congress responded with a legislative fix,which defines a below-market loan as one on which the interest rate is less than the appropriate AFR. Only a below-market loan results in a gift of foregone interest. Internal Revenue Code Section 7872 specifically addresses gift loans and replaced the traditional FMV methodology of the nine factors of TAM 8229001 in valuing below-market loans with a new standard. Thus, IRC Section 7872 sanctioned AFRs on loans as a safe harbor against what otherwise would result in an FMV analysis of a gift loan.

It’s important to note what the statute doesn’t provide: the FMV of a loan with an AFR interest. It merely provides a statutory definition that a loan with an interest rate that’s not less than the appropriate AFR doesn’t transfer a gift of foregone interest.  


Market Rates vs. AFRs

Because the AFR is based on interest rates for risk-free U.S. government obligations, it’s necessarily a below-market rate for notes possessing some or high risk of non-payment. “Market Interest Rates,” p. 75, illustrates that market investors demand a significant increase in the required yield (that is, interest rate) as maturities lengthen and a greater risk of repayment is accepted from less creditworthy (that is, more risky) debtors. For terms of five, seven and 10 years, the market requires a yield spread of approximately three percentage points between risk-free Treasuries and industrial bonds. For bond ratings from risk-free Treasuries to BB grade industrial bonds, the market requires a yield spread of approximately two to three percentage points. 

Thus, far less creditworthy borrowers are permitted to piggyback on the federal government’s credit rating and pay a below-market interest rate.  


Charitable Contribution at FMV

A promissory note paying appropriate AFR interest (to avoid creating a taxable gift issue with respect to imputed interest) isn’t a “below-market” loan by statutory definition. However, compared to observable market rates for publicly traded debt of similar investment risk, the AFR is below market.  

A charitable contribution of an AFR-based note is valued at its FMV on the date of contribution. A conundrum arises for the taxpayer because an AFR-based note has a below-market interest rate; therefore, its FMV is less than its face value—this relationship between the AFR and market rates exists at the creation of the note. Assuming no change in collectability, there’s a gap between the market rate of interest and the AFR. However, at the creation of the note, the taxpayer had no imputed interest income or gift tax consequences with the AFR note. The presumption that the FMV of a note is its face value plus accrued interest is rebuttable by the taxpayer on the basis of a change in interest rates or collectability. Can the taxpayer take a charitable income tax deduction of the face value of an AFR-based note when the then-existing market interest rate is significantly higher and such note would be discounted from face value in a willing-buyer, willing- seller transfer? Or, must one be resigned to discounting the note to its FMV?


Proposed Regulation

Shortly after Section 7872 was enacted, and pursuant to authority in the statute, the IRS issued a proposed regulation6 addressing the valuation of AFR notes. Concerned that for estate tax purposes, the FMV of an AFR-based loan could be discounted from its unpaid principal plus accrued interest, the proposed regulation suggests that no discount would be allowed simply because the AFR is at a below-market interest rate. This is a consistency argument that, at inception of the note when the AFR was used, no discount was applied; therefore, a taxpayer may not later switch to valuing the note at a then-higher market rate of interest. Or, more succinctly, if you’re in at the AFR, you’re out at the AFR. The proposed regulation recognized that a discount may be allowed if the facts concerning collectability of the loan have changed significantly since the time the loan was made. Accordingly, the proposed regulation indicated that interest-rate risk should be disregarded in the fair market valuation of an AFR-based note, but a change in default risk provided a basis for discounting the transfer value.  


Attractive Opportunity

Although both the IRS and taxpayers are known to switch arguments when the matter at hand moves from estate and gift tax to charitable income tax deductions, the presumption that the FMV of a note is its unpaid principal plus accrued interest is reasonably firm ground for a taxpayer who contributes an AFR-based note to a charity, presuming the collectability of the note hasn’t significantly deteriorated since issuance. As interest rates have edged higher during 2013 and past AFRs have fallen further below existing commercial rates, the opportunity to obtain a charitable deduction equal to the full amount of unpaid principal of an AFR note may provide an attractive opportunity to fulfill charitable objectives at a value favorable to the taxpayer, when compared to liquidating the note in a third-party sale.  



1. Bradley J. Bergquist, et al. v. Commissioner, 131 T.C. 2 (July 22, 2008). In this charitable contribution case, based on testimony from the Internal Revenue Service expert witness, the court found that it was appropriate to apply a 35 percent lack of control discount, a 45 percent lack of marketability discount and a 5 percent lack of voting rights discount to the net equity value of the corporation to determine the fair market value of the charitable contribution.

2. Proposed Regulations Section 20.7872-1-14, issued in August 1985.

3. Treasury Regulations Section 25.2512-4.

4. Dickman v. Comm’r, 465 U.S. 330 (1984).

5. Internal Revenue Code Section 1274 was enacted in connection with imputed interest income, and IRC Section 7872 was enacted in connection with gift loans.

6. Supra note 2.