UNIT #21: Tax Considerations

A high net worth individual wishes to know when a gift can be made this year without being obligated to pay gift tax. You would respond that there is no gift tax when the gift is made to A) the American Red Cross. B) a sibling of the donor. C) a non-citizen spouse. D) a grandchild of the donor.

A *Gifts to recognized 501(c)(3) charities, such as the American Red Cross, are never subject to the gift tax. If the spouse is a non-citizen, there is a limit ($152,000 in 2018) and anything in excess of $15,000 to a grandchild or sibling is taxable unless the donor elects to use the excess against the lifetime exclusion ($11.2 million in 2018).

An estate planning tool that may be used to take advantage of the lifetime estate tax exclusion is the A) complex trust B) bypass trust C) testamentary trust D) living trust

B *The bypass trust is most commonly used to maximize estate tax savings by having the first to die of a married couple leave the lifetime exclusion ($11.4 million for 2019) to their children with the balance taken against the unlimited marital deduction. This results in saving estate taxes on that $11.4 million. With the "portability" provisions of the tax law signed on December 17, 2010, this is of limited value.

The amount of federal income tax a U.S. citizen residing in the country will pay is dependent on all of these EXCEPT A) gender B) filing status C) age D) state of residence

A *Tax rates are not dependent upon one's gender. Age has an impact because there is an extra exemption for those at age 65. State of residence is a factor because certain state taxes are deductible on your Form 1040. Filing status is very important because in most cases, married filing jointly results in the lowest taxes.

If a husband makes a gift of $100,000 to his wife, a U.S. citizen, how much of the gift is subject to gift taxes? A) $50,000.00 B) $90,000.00 C) $100,000.00 D) $0.00

D *Interspousal gifts to citizens of the United States, regardless of amount, are not subject to gift taxes.

If an employed client has $12,000 of capital gains and $15,000 of capital losses in the most recent taxable year, how much unused loss, if any, is carried forward by the client to the following tax year? A) $0.00 B) $3,000.00 C) $15,000.00 D) $12,000.00

A *After netting the $12,000 capital gains and $15,000 capital losses, the client has a net capital loss of $3,000. Because all this capital loss may be used to offset ordinary income in any one taxable year, there is no amount of loss to carry forward.

The alternative minimum tax becomes a consideration when a taxpayer has so-called tax preference items. Included in that definition is A) interest from private activity bonds B) interest from U.S. Treasury bonds C) tips received while working at a restaurant D) overtime pay from a job

A *When an individual has tax preference items, AMT becomes an issue. One of the securities that generates preference income is a private activity bond, a revenue bond that is issued to benefit certain facilities such as airports, sports facilities and hospitals. Interest on Treasury securities is never a preference item and earned income, such as wages, salary, and tips, is not considered a preference item.

Sally Sherman purchased 100 shares of Chocolate Manufacturers Corporation for $19 per share on February 12. She received a 10% stock dividend on May 18. She sold all of her CMC at $13 per share in June of the same year. What were her tax results? A) $575 long-term loss B) $470 short-term loss C) $575 short-term loss; $105 long-term gain D) $575 long-term gain, $105 short-term loss

B *Sally paid $1,900 for 100 shares and sold 110 shares for $1,430 (13 at 110). Because the transactions all took place in less than a year, the transaction was a short-term loss.

A U.S. citizen owns stock in a Canadian company and receives dividends. The Canadian government withholds 15% of the dividends as a tax. As a result, the investor reports A) a nonrecoverable loss on the investor's U.S. tax return B) a tax credit on the investor's Canadian tax return C) a tax credit on the investor's U.S. tax return D) a reduction in the investor's ordinary income

C *An investor receives a credit for taxes withheld on investments by countries with which the United States has diplomatic relations; the tax credit directly decreases the investor's American tax liability.

Each of the following could cause an investor to be subject to the alternative minimum tax EXCEPT A) accelerated depreciation taken on certain property B) excess intangible drilling costs C) interest received on school district GO bonds D) interest received on private activity municipal bonds

C *General obligation GO bonds are not subject to the AMT.

A Schedule K-1 would NOT be used for tax reporting to the owners by which of the following business entities? A) LLC B) S corporation C) Limited partnership D) Sole proprietorship

D *Sole proprietorships generally complete Schedule C of the individual Form 1040. Legal entities that pass through income or loss use the Schedule K-1 to indicate the amount of that income or loss attributable to the individual shareholder/member/partner.

An example of an interest-on-interest reinvestment program is A) reinvesting the earnings on a bond UIT B) interest left to compound on a bank-insured certificate of deposit C) reinvesting the interest received on a bond D) reinvesting the dividends distributed on a bond fund

B *Interest-on-interest reinvestment is, as the term implies, the practice of compounding earnings by reinvesting them. This is traditionally the way a bank savings account or certificate of deposit builds in value. Reinvesting the dividends on a bond fund is dividend reinvestment, even though most, if not all, of the fund's income is generated by interest. Same with the UIT and there is no program for reinvesting bond interest similar to a DRIP for reinvesting dividends.

Three years ago, a customer bought 200 shares of ABC for $60.50 per share. Upon her death, she left the shares to her husband when ABC was trading at $98.25. If her husband sells the shares for $99.25, what is his cost basis for tax purposes? A) $99.25 B) $98.25 C) $79.38 D) $60.5

B *The cost basis to the recipient of inherited securities is the fair market value on the date of the owner's death. In this case the fair value is the market value of $98.25.

Using industry jargon, the tax on the last dollar of income is at A) the average rate B) the final rate C) the marginal rate D) the effective rate

C *The IRA defines marginal tax rate as "the highest rate that you will pay on your income." Basically, as you make more money, you pay tax at a higher rate incrementally. The effective tax rate is the average that you pay on all of your income.

The main purpose of dividend reinvestment in a mutual fund accumulation plan is to A) avoid taxes B) avoid commissions or sales charges C) compound the growth of a mutual fund investment D) protect against capital loss

C *Reinvesting dividends compounds the growth of the fund with periodic purchases of new shares. Taxes are due on dividends whether or not they are reinvested. Capital gains or losses will occur whether or not dividends are reinvested. The purchase of additional shares with reinvested dividends may increase the capital gain or loss in proportion to the dividends reinvested. Avoiding commissions or sales charges is not the main rationale for reinvesting dividends, even though sales charges are not applied to reinvested dividends.

If an investor is in the highest federal income tax bracket and is subject to the alternative minimum tax, which of the following securities should an agent recommend? A) Industrial revenue bond B) Corporate bond C) Treasury bond D) General obligation bond

D *Municipal bonds are suitable for the portfolio of an investor who is in a high tax bracket because the interest is exempt from federal income tax. A general obligation (GO) bond is a better recommendation than an industrial revenue bond because the interest on industrial revenue bonds is likely subject to the AMT.

Last year, an investor had a $5,000 loss after netting all realized capital gains and losses. This year the investor has a $1,000 capital gain. After netting his gains and losses, what will be his tax situation this year? A) He will have a $1,000 gain. B) He will have a $1,000 loss to carry over to the next year. C) There will be no tax consequences. D) He will offset $1,000 ordinary income this year.

D *Only $3,000 of last year's loss can be deducted against that year's income. Therefore, the losses carried forward from the previous year are the remaining $2,000. These losses are netted against the gain of $1,000 for a net loss of $1,000. That loss can be used to offset $1,000 of ordinary income. There are now no longer any losses to carry forward.

Which of the following is not included in adjusted gross income on an individual's federal income tax return? A) Wages and tips B) Income from a sole proprietorship C) State income tax refunds D) Stock dividends

D *Stock dividends (dividends paid as additional shares of stock rather than in cash) adjust the investor's cost basis and don't come into play until the stock is sold.

An investor purchases 100 shares of ABCE common stock at $70 per share. Thirteen months later, the stock is sold when the market price is $50 per share. Which of the following activities made 20 days after the sale of the stock at $50 per share, would NOT violate the wash sale rule? A) Purchasing an ABCE call option B) Purchasing an ABCE put option C) Purchasing 5 ABCE convertible bonds with a conversion price of $50 D) Purchasing 100 shares of ABCE common stock

B *The wash sale rule applies when the same or substantially identical security as a stock sold at a loss is acquired within the 30 day period prior to and after the sale. Buying a put is not a problem because the put only allows the holder to sell the stock, not buy it. Please note that a bond convertible at $50 is convertible into 20 shares, so 5 bonds will enable the investor to convert into 100 shares.

Jean owns a $1 million life insurance policy on her mother, Clara. Jean is named as sole beneficiary, and so far she has paid $150,000 in premiums. If Clara dies, which of the following will occur? 1. The proceeds will be exempt from income tax. 2. $850,000 of the proceeds will be subject to income tax. 3. The proceeds will be included in Clara's estate for estate tax purposes. 4. The proceeds will not be included in Clara's estate. A) I and III B) II and III C) II and IV D) I and IV

D *Life insurance proceeds are generally free from income taxes and will be free from estate taxes, if the insured possesses no incidence of ownership. In other words, a beneficiary other than the deceased's estate has been named, and the owner is someone other than the insured.

A number of corporations offer dividend reinvestment plans (DRIPs) where the client's dividends are automatically reinvested in additional shares of the issuer. In the case of a company that pays dividends with some degree of regularity, if the market price per share has declined over the year, an investor participating in one of these plans would find which of the following to be TRUE (assume no splits)? A) The value of the investor's account has gone up. B) There are more shares in the investor's account. C) The value of the investor's account has gone down. D) There are fewer shares in the investor's account.

B *With the dividends reinvested, there will be more shares. Although the market price per share has declined, we don't know the aggregate account value (with the additional shares) so we don't have enough information to tell if the overall value has risen or declined.

Under current federal tax law, which of the following would have an effect on the amount of taxes your client would pay? 1. Age 2. Citizenship 3. Marital status as of the last day of the year 4. Residency A) I, III, and IV B) I and III C) II and IV D) I, II, III, and IV

D *Each of these can affect your tax rate. Taxpayers age 65 and older get an extra exemption, so that lowers their tax. If you are not a U.S. citizen, and are considered a nonresident alien, you are taxed somewhat differently than others. Only married persons can file a joint return, which usually, but not always, results in lower taxes. Residency determines if you will also have to pay a state income tax and receive deductions for that (or a state sales tax) on your federal income tax.

When comparing the tax treatment of C corporations, S corporations, and LLCs, it would be CORRECT to state that A) all 3 of these have the same tax filing date B) only the C and S corporations offer the benefit of "flow-through" C) the C corporation is the only one that pays taxes D) registered personnel opening a brokerage account for any of these would follow similar suitability procedures

C *Only the C corporation is a separately taxed entity; the income (or loss) from an S corporation or LLC flows-through to the shareholders/members. The tax filing dates for the 2 flow-through entities is the same, generally March 15, while that for the C corporation is the 15th day of the 4th month after the end of the fiscal year (April 15 for a calendar year filer). The suitability for the S corporation and the LLC generally looks through to the individual owners where that is not the case with the C corporation.

An investment adviser representative specializes in the senior market. A number of his clients have reached the age where they are contemplating selling their homes and moving into an assisted living facility. The profit made on the sale of their homes will be used to defray the costs of their new residence. Under current tax laws, which of the following are TRUE? A single person pays no tax on the first $250,000 of net profit realized on the sale of a primary residence that has been occupied for at least 2 of the past 5 years. A single person pays no tax on the first $500,000 of net profit realized on the sale of a primary residence that has been occupied for at least 2 of the past 5 years. A married couple pays no tax on the first $250,000 of net profit realized on the sale of a primary residence that has been occupied for at least 2 of the past 5 years. A married couple pays no tax on the first $500,000 of net profit realized on the sale of a primary residence that has been occupied for at least 2 of the past 5 years. A) I and III B) II and IV C) II and III D) I and IV

D *When a primary residence that has been lived in for at least 2 of the 5 years is sold at a profit, the first $250,000 for an individual and the first $500,000 for a married couple is not subject to taxation. Everything in excess of that is taxed as capital gain on Schedule D of the Form 1040.

Which of the following statements regarding grantor trusts is NOT correct? A) The grantor may be taxed on trust income only if the grantor actually received the income. B) If the grantor can receive income from the trust, he is treated as the owner of the trust. C) If the grantor has the power to revoke the trust, he is treated as the owner of the trust. D) If the grantor can control the beneficial enjoyment of the trust, he is treated as the owner of the trust.

A *As long as the grantor has the power directly or indirectly to control the trust, he is treated as the owner. The grantor may be taxed on trust income if the grantor either actually or constructively receives the income.

One of your customers purchased a variable life insurance contract through your firm. After 14 years, he had deposited $15,000 in premiums, and his death benefit had grown to $80,000. Shortly after taking out a loan against cash value of $10,000, he was killed in an automobile accident. What will be the tax consequences of this situation to the death benefit? A) His beneficiary must pay taxes on the amount of the death benefit that is over and above the cost base of $15,000 plus the unpaid loan. B) His beneficiary must pay taxes on the amount of the death benefit that is over and above the cost base of $15,000. C) His beneficiary need not pay taxes on the death benefit. D) The first $15,000 is tax-free with the excess being treated as a long-term capital gain

C *A death benefit payable on a life insurance policy or contract is not subject to taxation. The insurance company will deduct the balance of the $10,000 loan before it releases the death benefit to the beneficiary, but that does not affect the tax consequences.

An advisory client of yours discusses a business project she is involved with where the partnership is using accelerated depreciation to maximize losses in the early years. It would be prudent of you to inform the client that A) accelerated depreciation leads to a reduction in the partnership's cash flow. B) a maximum of $3,000 in losses can be taken against ordinary income in any year. C) accelerated depreciation could trigger the alternative minimum tax. D) a maximum of $3,000 in losses can be taken against passive income in any year.

C *Accelerated depreciation is a tax preference item and could result in requiring this client to pay the AMT. These would be passive losses and they can only be taken against passive income. There is no limit to the amount of passive loss that can be deducted against passive income. Because the most common way for a company to compute cash flow is: net income plus depreciation, the reduction to net income is zeroed out by the increased depreciation added back in.

A taxpayer's marginal tax rate is A) generally lower than the effective tax rate B) the rate of tax paid on total taxable income C) the rate of taxation on any additional taxable income received D) the rate of tax paid on margin account interest

C *Marginal tax rate is defined as the rate of taxation on any additional taxable income received. It is sometimes referred to as the tax on the "next" dollar or the "last" dollar of income. The effective tax rate is the overall rate paid on the total taxable income.

There are number of potential sources of income to a client that would have to be reported on their Form 1040 tax return. Among them could be all of these EXCEPT A) interests in a DPP B) death benefit received from a life insurance policy C) ownership of stock in an S corporation D) operation of a sole proprietorship

B *An individual can generate income from running a sole proprietorship or being a shareholder in an S corporation (the exam will possibly use the obsolete term, Subchapter S). And, if units of a DPP throw off income, that would be reported as well. Of course, taxable income can be generated by investments in the form of dividends, interest, and capital gains from any source. The death benefit is from a life insurance policy and those, unlike the death benefit from an annuity, are not subject to income tax. Depending on how the ownership is structured, the death benefit could be subject to estate tax, but that would be reported on the Form 706 and is generally not considered income.

Which of the following statements regarding taxation is NOT true? A) Passive income is derived from rental property, limited partnerships, and enterprises in which an individual is not actively involved. B) Earned income includes salary, bonus, and income as an owner of a limited partnership. C) Items that must be added back into taxable income for calculation of the alternative minimum tax (AMT) include: accelerated depreciation on property placed in service after 1986; local taxes and interest on investments that do not generate income; and incentive stock options exceeding the fair market value of the employer's stock. D) Portfolio income includes dividends, interest, and net capital gains derived from the sale of securities.

B *Earned income includes salary and bonus but not income as an owner of a limited partnership. Passive income is derived from rental property, limited partnerships, and enterprises in which an individual is not actively involved. Each of the other choices is true.

One of your new clients has only been working for 3 years but is already interested in retirement planning. In order to be fully eligible for Social Security, the client must A) have minimum credited earnings of at least $20,000 per year. B) have a minimum of 40 covered quarters of employment. C) have at least 40 years of employment. D) be at least age 62.

C *Current Social Security requirements are a minimum of 40 covered quarters of employment (10 years). A covered quarter is a calendar quarter during which the worker earned a minimum amount ($1,300 in 2017) which is indexed and, therefore, would never be tested. Reduced retirement benefits may begin as early as age 62, but disability payments can begin much, much earlier, as long as there have been 40 covered quarters. There is no minimum annual earnings limit.

Benefits of structuring a business as a general partnership would include A) the ability to raise large sums of money B) that general partners are only liable to the extent of their investment C) avoidance of taxation at the entity level so the partners are not taxed twice D) longevity

C *General partnerships file a Form 1065 and pay no tax. Instead, each partner's share of the income is reported on Schedule K-1 making for a single rather than double layer of tax.

One of your ultra-high net worth clients would like to give some low cost basis stock as gifts to her adult grandchildren. It would be prudent for you to tell her that A) making the gift under the Uniform Transfer to Minors Act is generally the most advantageous for the child. B) unlike an inheritance, there is no stepped-up cost basis. C) it would be wise for her to use a TOD account to avoid probate. D) for purposes of the gift tax, her cost basis will be used.

B *One of the benefits of inheriting low cost basis securities is the stepped-up basis and that does not apply to gifts. Although the donor will not be the one subject to capital gains tax, it would be the right thing to do to let her know that the donees (her grandchildren) will be receiving the stock at her cost basis. TOD would not apply to stock that is the subject of a gift; it is only when the stock remains in the grandmother's name and has been designated for the grandchildren after her death. When computing the value of a gift to determine if there is a gift tax obligation, it is the fair market value of the gift that is used. Finally, the question states these are adult grandchildren - UTMA would not apply to them.

An investor has made the following purchases, all in the same calendar year: 100 ABC at $20 on January 15; 200 ABC at $25 on April 4; and 100 ABC at $30 on July 23. With ABC currently selling at $22, if this investor needed to sell 200 ABC, the best decision from a tax standpoint would probably be to A) use FIFO B) use average cost C) use LIFO D) hold the stock until the price reaches $25

C *The best decision from a tax standpoint is to arrange things to show the largest loss. Remember, losses can be used against gains and, if there are more losses than gains, up to $3,000 of that loss can reduce taxable income. Using a form of share identification known as LIFO (last in first out), enables the investor to designate the 100 shares purchased at $30 in July and 100 of the shares purchased at $25 in April. That will result in a short-term capital loss of $1,100 ($800 on the July shares purchased at $30 plus $300 on the April shares purchased at $25.) That loss may be used either against realized gains or, if this is the investor's only transactions, deducted in full against ordinary income. The average cost method is only available for mutual funds. If this investor used FIFO, the sale would be of the 100 shares bought in January at $20 per share and 100 of the shares bought in April at $25 per share. The sale of the January purchase results in a $200 gain ($22 - $20 × 100 shares). The sale of the April purchase results in a $300 loss ($22 - $25) = -$3 times 100 shares. Combining them generates a net loss of $100. From a tax standpoint, declaring a loss of $1,100 is preferable to a loss of $100.

The term "earned income" would include A) alimony received as part of a divorce decree executed on January 15, 2019. B) death benefit from a variable annuity policy. C) a bonus paid as a result of your division exceeding its goals. D) death benefit from a variable life insurance policy.

C *The IRS defines earned income as wages, salaries, tips, and other taxable employee pay, such as bonuses. The death benefit from a variable annuity policy is taxed as ordinary income, but is not earned. The death benefit from a variable life insurance policy is generally free of income tax so it cannot be earned income. Under the TCJA of 2017, alimony received from a divorce decree dated January 1, 2019 or later is not earned income.

Grandma has decided to give her grandson some stock that she bought many years ago. When the grandson sells the stock, how is the tax liability figured? A) Her date of purchase is used, but the cost basis is from the date of the gift. B) Both the cost basis and holding period are determined from the date of the gift. C) Her cost basis and date of purchase is used. D) Her cost basis is used, but the holding period begins on the date of the gift.

C *When stock is given as a gift, the donee (recipient) takes over the cost basis and the holding period of the donor.

When looking at an individual's income statement, which of the following would be included? A) Child support B) Jewelry C) Stocks and bonds D) Alimony

D *An individual receiving alimony as part of a divorce decree must report that as income for tax purposes. The ex-spouse paying the alimony treats that as a deduction from income. There are two problems here. First, we're not told which side this individual is on - paying or receiving the alimony. Second, if we are doing a profile for a client, the receipt of child support is considered income in terms of figuring any discretionary income, even though it is not taxed. But, NASAA doesn't always think of these things so we have to give them the answer the way they want it.

Property included in a deceased's gross estate is generally valued for estate tax purposes at A) the amount the deceased paid for it B) its fair market value (FMV) on any date the estate chooses to use C) its original cost less depreciation D) its fair market value (FMV) on the date of the deceased's death

D *Property included in the gross estate is generally valued at its fair market value (FMV) on the date the deceased died. An estate can also elect to value property on the alternate valuation date, which is usually 6 months after the date of death.

A U.S. citizen purchases a bond issued by the government of Sweden. The interest payments received are taxed at which of the following levels? Federal State Local A) I, II, and III B) II and III C) I only D) II only

A *Interest on foreign bonds is taxed in the United States by federal, state, and local governments.

Many different investments offer the opportunity to reinvest income. If one were to compare the difference between interest-on-interest reinvestment plans and dividend and capital gain reinvestment plans, A) in both plans, all income is taxable in the year received, whether reinvested or not B) in the case of interest on interest plans, taxes are deferred until liquidation C) in the case of dividend and capital gains reinvestment plans, taxes are deferred until liquidation D) in both cases, all income is deferred until liquidation

A *Regardless of the type of plan, any income, whether reinvested or not, is always taxed in the current year. Think of an interest-on-interest plan as a passbook savings account where the interest is credited and compounded. Whether taken out or not, the earnings are reported on an annual basis. On the exam, the question may ask for a difference as we have here, but, as you can see, there is no difference.

You are working with a client who received her divorce earlier this year. She has 2 young children, ages 4 and 7, who both live with her. In general, it would be most advantageous for her to file her federal income tax claiming what status? A) Head of Household B) Married, but separated C) Joint D) Single

A *Taxpayers claiming the Head of Household filing status benefit from a higher standard deduction and lower tax rates than single taxpayers. There are several requirements that must be met to qualify for HOH status. Some of them include the following: 1. You are unmarried or "considered unmarried" on the last day of the year. 2. A "qualifying person" lived with you in the home for more than half the year (except for temporary absences, such as school). This is generally your children. *Because she is divorced, she can't claim married or joint and, as stated above, filing as HOH offers many tax advantages over single.

Using industry jargon, the tax on the last dollar of income is at A) the marginal rate B) the effective rate C) the final rate D) the average rate

A *The IRS defines marginal tax rate as "the highest rate that you will pay on your income." Basically, as you make more money, you pay tax at a higher rate incrementally. The effective tax rate is the average that you pay on all of your income.

Under the current gift tax marital deduction, how much can an individual give a spouse who is a U.S. citizen without incurring a gift tax? A) An unlimited amount B) No more than $15,000 per year C) No more than $152,000 per year D) No more than $30,000 per year

A *The gift tax marital deduction permits an individual to give a spouse an unlimited amount of property without incurring a gift tax. However, if the spouse is not a U.S. citizen, the maximum marital gift is $155,000 (2019).

When are estate taxes due? A) 9 months after valuation B) 6 months after valuation C) 6 months after death D) 9 months after death

D *Estate taxes are due 9 months after death. The taxes are based on either the value at death or the alternative valuation 6 months after death.

After receiving some money from an inheritance, an individual purchases a rare gold coin for $10,000. Five years later, he gives the coin to his daughter-in-law after receiving an appraisal showing the coin is worth $15,000. The daughter-in-law's cost basis of the coin is A) $0.00. B) $15,000. C) $5,000. D) $10,000.

D *When a gift is made of an asset, whether it be a security or a collectible, the donor's cost basis passes to the donee. In this case, the original cost is $10,000 and that becomes the cost basis for the daughter-in-law and is used to determine a gain or loss when that coin is sold. Do not confuse this with the annual gift tax exclusion. Because the value of the gift did not exceed $15,000, the donor has no gift tax obligation, but that is completely different from the daughter's cost basis.