For the past few years, Bruce Johnson (Munroe, Park & Johnson Inc.) has been using data from business development corporations (BDCs) to develop a base rate of interest for small (under $10 million) privately held promissory notes, he explained during a recent webinar. These notes often carry a small IRS-approved interest rate (AFR rates), and corporate bonds from large public companies, which yield around 4% to 6%, are not comparable. BDCs are publicly traded entities that make loans to small and medium-sized, privately held businesses. Average yields for debt-focused BDCs have been around 10% (although they have spiked higher recently due to COVID-19), so that yield is used as the base rate to which you would adjust for specific risk factors related to the note, such as payment history, presence of collateral, net worth of the issuer, and more. He gave several real-world examples of building up to a market rate of interest that would be used to calculate the net present value of the note.
Any challenges? A question from the audience asked whether this methodology has passed muster with the IRS. Johnson says that he has been using this methodology for several years for estate and gift purposes and has not had any returns audited or challenged yet. In fact, the IRS is using this methodology to value notes. Johnson reports that an IRS agent called him and wanted to make sure he was using it correctly. If challenged, Johnson feels confident it would stand up to scrutiny as it is simply the same methodology bond investors use, i.e., finding the closest comparable interest rate or guideline data to value the bond.
A recording of the webinar is available if you click here. (Purchase is required, but BVR’s webinar archive is available to holders of BVR Training Passports and transcripts of the webinar are available to subscribers of the BVResearch Pro platform.)
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