Unit 1 - Types and Characteristics of Equity Securities

Incentive stock options

A stock option that gives an employee the opportunity to buy the employer corporation's stock at a fixed price for a certain period of time, and that offers favorable tax treatment if certain conditions are met. If stock purchases through exercise of an ISO and held for at least 2 years after date of the grant and one year after exercise any profits are reported as long-term capital gains. When ISO is exercised the difference between MV and SP is a preference item used in AMT

Why include preferred stock in a client's portfolio?

- fixed income from dividends -prior claim ahead of common stock -convertible preferred sacrifices income in exchange for potential appreciation

Why include common stock in a client's portfolio?

1. Potential capital appreciation 2. Income from dividends 3. Hedge against inflation

The residual right of common stockholders refers to their right to A) claim company assets in bankruptcy after wages, taxes, creditors, and preferred shareholders have been paid. B) examine the corporation's annual reports and other reports, and take legal action if irregularities are found. C) vote in elections for the board of directors and in other important business decisions, such as changes to the charter. D) receive all announced dividends in accordance with the number of shares held.

A. The residual right of common shareholders refers to their position in the event of bankruptcy. LO 1.b

All of the following statements regarding incentive stock options (ISOs) are correct except A) upon the exercise of an ISO, income for AMT purposes is created B) the favorable tax treatment associated with ISOs is lost if the shares acquired through the ISO exercise are sold before 1 year from the date of grant or 2 years from the date of exercise C) the exercise of ISOs does not create taxable income D) if the holding period is satisfied, the gain upon the sale of ISO shares will be a long-term capital gain

B. The favorable tax treatment is lost if the shares acquired through the ISO exercise are sold before 1 year from the date of exercise or 2 years from the date of grant. You are not taxed upon exercise, only upon sale, but the incentive portion of the option could be considered a preference item for purposes of AMT. LO 1.d

An employee wishing to obtain long-term capital gain treatment would prefer the employer to offer A) portable stock options. B) incentive stock options. C) nonqualified stock options. D) listed stock options.

B. Assuming the time limit conditions are met, exercise of an ISO can result in long-term capital gains while nonqualified options are always treated as ordinary income. LO 1.d

Rule 144 applies to the sale of all of the following except A) unregistered securities by an officer of the issuer. B) registered securities by an officer of the issuer. C) registered securities by a nonaffiliated shareholder of the issuer. D) unregistered securities by a nonaffiliated shareholder of the issuer.

C. Rule 144 applies to the sale of unregistered securities owned by affiliates or nonaffiliates and the sale of control stock. It does not apply to the sale of registered securities by nonaffiliated persons. LO 1.e

One of the rights of being a common stockholder is the ability to vote on important corporate matters, such as the election of members to the board of directors. The date that determines which shareholders are eligible to vote is A) the last day of the company's fiscal year. B) the election date. C) the record date. D) the ex-dividend date.

C. The record date is a date announced by the company as the official date you must be an owner on the company's records in order to participate in the annual meeting and corporate election. A fact not tested is there is no standard regarding how far in advance of the voting date this should be other than it must be at least the normal settlement period, currently two business days. LO 1.b

One way in which incentive stock options (ISOs) differ from nonqualified stock options (NQSOs) is that A) there is a maximum five-year limit for exercise on the ISO, while the time limit on the NQSO is 10 years. B) gains on an ISO are always short term, while those on an NQSO are long term. C) the bargain element of the ISO is reported as wages on the tax returns of the employer and the employee. D) the bargain element of the ISO is an AMT preference item.

D. The only true statement here is that the bargain element (the difference between the current market price at the time of exercise and the strike price) of the ISO (but not the NQSO) is one of the preference items for the alternative minimum tax. It is the bargain element of the NQSO that is reported as wages and it is possible, although difficult, to have long-term capital gains on both. Only the ISO has a maximum time limit and it is 10 years, not five.

Prefered stock

Equity security that acts like a bond as it has a fixed dividend payment and is price sensitive to Interest rate changes.

Capital appreciation

an increase in the market price of securities

Security

an investment that represents an ownership stake or debt stake becomes owner by buying shares of company's stock. Debt stake by buying issuers bonds

Preferred stock risks

market risk possible loss of purchasing power interest rate (money rate) risk Business difficulties leading to possible reduction or elimination of the dividend and even bankruptcy leading to loss of principal

Common stock risks

market risk (stock will decline in price) business risk (eliminating dividends or loss of principal) low priority at dissolution

Income

paying regular quarterly cash dividends to stockholders can be a large source of income for investors.

Nonqualified Stock options (NSOs)

when exercised the difference between current market price at time and the strike price (bargain element) is reported as wages. Instead of being capital gains employee is taxed for ordinary income and the company receives a tax deduction