Ethics, Recommendations and Taxation

XYZ Corp. owns 18% of the voting common stock of ABCD Enterprises. In the current tax year, XYZ receives $250,000 in dividend income from its investment in ABCD. If XYZ has a marginal tax rate of 34%, what is its tax liability on the dividend income received? A) $25,500. B) $85,000. C) $0. D) $42,500.

A) $25,500. Explanation Under the inter-corporate dividend exclusion rule, if a corporation owns stock in another corporation, 70% of the dividends received is excluded from taxation. Therefore, only 30% of the $250,000 received is subject to tax (30% × $250,000 = $75,000). Applying a tax rate of 34% to $75,000 results in a tax liability of $25,500.

A customer buys a municipal bond at 106 with 8 years to maturity. What is the amount of unamortized premium at the end of 4 years? A) $30. B) $50. C) $36. D) $40.

A) $30. Explanation The original premium was $60 for 8 years, which means that after 4 years the remaining premium is half that amount.

Which of the following is the best example of a passive investment management style? A) Exclusive use of index funds. B) Value investing. C) Investment in small capitalization technology securities. D) Use of index funds in conjunction with selecting specific securities in the index to overweight certain sectors.

A) Exclusive use of index funds. Explanation A passive investment style uses index funds because the manager does not believe that returns above the averages can be sustained for any length of time because the market is priced efficiently. Use of index funds in conjunction with specific securities in order to overweight sectors is an active style. Investment in small capitalization technology securities involves actively selecting securities that the manager believes will perform well or better than the market. Value investing involves the active search for securities that are undervalued by the market.

If a customer is in a low federal income tax bracket and his main investment objective is current income, which of the following securities should the agent recommend? A) Investment-grade corporate bond. B) City of Milwaukee GO bond. C) Zero-coupon bond. D) U.S. government bond.

A) Investment-grade corporate bond. Explanation If an investor is in a low-tax bracket any benefit from receiving tax-free municipal bond interest is diminished, making municipal bonds a less suitable investment. Zero-coupon bonds pay no interest until maturity and therefore are not suitable for someone seeking current income. To maximize income, the best recommendation of the choices listed is the corporate bond which offers a higher yield than a government bond with a similar maturity.

For the purpose of reporting sales to the IRS, which method available to investors by the IRS offers the most flexibility in anticipation of the investor's year-end tax needs? A) Share identification B) None offer any flexibility in anticipation of year-end tax needs C) First in, first out (FIFO) D) Average cost basis

A) Share identification Explanation Share identification is the most flexible of the three methods. The investor keeps track of the cost of each share purchased and specifies which shares to sell based on his anticipated year-end tax needs. For investors, the idea is to minimize tax liability if able by limiting gains or maximizing loses in anticipation of what one's year-end tax liability might be.

A customer who owns TCB stock wants to continue holding the security. The stock has fallen from 26 when he bought it on February 2 to a 52-week low of 20.75. He sells the stock on December 1 at the low and repurchases it at 21 on December 15. What is the tax consequence of this investment? A) The tax loss is not allowed. B) By repurchasing the investment at the same price, he keeps the original cost basis. C) He has a capital loss. D) The holding period for the stock was wiped out.

A) The tax loss is not allowed. Explanation Since the security was repurchased in less than 30 days, the IRS will not allow the loss due to the wash sale rule. It would have been allowed had the customer bought back the security after 30 days

The income from all of the following securities is taxable on the federal, state, and local income tax levels EXCEPT: A) Treasury bonds. B) GNMA certificates. C) reinvested mutual fund dividends. D) corporate BBB bonds.

A) Treasury bonds. Explanation The interest on U.S. government securities (such as Treasury bonds) is exempt from state and local income taxes, but not federal income taxes. Dividends (whether reinvested or not), Ginnie Maes, and corporate bonds of all types and/or ratings are taxable on all levels.

A new customer asks her registered representative to recommend undervalued or out-of-favor securities with relatively low prices. This portfolio management strategy is known as: A) value. B) growth. C) tactical. D) passive.

A) value. Explanation Value investing is the strategy of selecting stocks that trade for less than their book value. Value investors actively seek stocks of companies with sound financial statements that they believe the market has undervalued.

A corporation in the 35% tax bracket reports operating income of $4 million for the year. The firm also received $200,000 in preferred dividends. Assuming no other items of income or expense, what is the company's tax liability? A) $1,360,000. B) $1,421,000. C) $1,756,000. D) $1,370,200.

B) $1,421,000. Explanation The corporation's $4 million operating income is taxed at a rate of 35%. For tax purposes, corporations can exclude 70% of all dividends received from domestic common and preferred stocks. Thus, 30% of the $200,000 received from preferred dividends is taxed at the 35% tax rate ($200,000 times 30% equals $60,000). The $4 million in income plus the $60,000 in taxable dividends equals $4,060,000 ($4,060,000 multiplied by a 35% tax rate equals taxes of $1,421,000).

If a customer buys a municipal bond at 110, maturing in 8 years, but sells the bond 6 years later at 103½, the customer will have a: A) $10 per bond loss. B) $10 per bond gain. C) $35 per bond gain. D) $65 per bond loss.

B) $10 per bond gain. Explanation Municipal bonds that are purchased at a premium must be amortized. This bond has a premium of $100, which over 8 years amounts to $12.50 per year. The cost basis of the bond at the time of the sale is $1,100 − (6 × $12.50) or $1,025. If the bond is sold for $1,035, the customer has a gain of $10 per bond.

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) Treasury bond. B) General obligation bond. C) Industrial revenue bond. D) Corporate bond.

B) General obligation bond. Explanation 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.

An investor has losses on the sale of municipal bonds. Which of the following is TRUE for tax purposes? A) No losses on municipal bonds can be applied against gains on sales of any securities. B) The losses can be applied against the gains on the sale of any other security. C) The losses can be applied only against gains on the sale of other debt instruments (bonds). D) The losses can be applied only against gains on the sale of other municipal bonds.

B) The losses can be applied against the gains on the sale of any other security. Explanation Losses on the sale of one investment can generally be deducted against gains on the sale of any other investment

If an investor swaps identical issues of stock to establish a loss that is disallowed, the transaction is known as: A) a stock swap. B) a wash sale. C) a stock cross. D) a reverse stock split.

B) a wash sale. Explanation The wash sale rule disallows claiming a tax loss on the sale of stock if the investor purchases a substantially identical security within 30 days either before or after the date of such sale.

The risk that time value may erode the premium of an equity option even while the underlying issuer remains financially sound is an example of: A) reinvestment risk. B) capital risk. C) interest rate risk. D) currency risk.

B) capital risk. Explanation Capital risk is generally associated with equity instruments, such as common stock, and equity-related derivatives, such as options. It is the risk that invested dollars can be lost as the result of circumstances unrelated to an issuer's financial strength.

The IRS requires a bondholder to use straight-line amortization for the purpose of determining the annual: A) increase to a premium bond's cost basis. B) decrease to a premium bond's cost basis. C) increase to a discount bond's cost basis. D) decrease to a discount bond's cost basis.

B) decrease to a premium bond's cost basis. Explanation Premiums are amortized; discounts are accreted. For municipal bonds bought at a premium, the bondholder must adjust cost basis annually in such an amount that, if held to maturity, there is no reported capital gain or loss. The amortization is straight line, or the same amount must be amortized each year.

The capital asset pricing model assumes A) that those who participate in smaller transactions are generally wrong in regards to timing purchases and sales B) investors are averse to risk and expect to be rewarded for taking risk C) that prices are influenced by supply and demand only D) that no type of risk can be diversified away

B) investors are averse to risk and expect to be rewarded for taking risk Explanation CAPM takes into account systematic risk, the type of risk that investors use diversification to lessen. It assumes that investors are averse to risk, and, if taking on risk, expect to be rewarded for it and, therefore, the pricing of an asset must reflect that.

An investor purchases 100 shares of XYZ common stock for $70 and sells it one year later for $50. Which of the following activities would violate the wash sale rule? I. Purchasing an XYZ call option 20 days after the sale. II. Purchasing an XYZ put option 20 days after the sale. III. Purchasing 100 shares of XYZ common stock 20 days after the sale. IV. Selling short 100 shares of XYZ common stock 20 days after the sale. A) III and IV. B) I and II. C) I and III. D) II and IV.

C) I and III. Explanation The wash sale rule is violated when an investor sells a security at a loss and purchases the same or a substantially identical security within 30 days of the sale date. The IRS considers a call option substantially identical to the underlying stock because it represents the right to buy the shares.

If a new customer is preparing to buy his first home within the next year, and his investment objective is aggressive growth, which of the following investments would be most suitable for your customer's portfolio? A) Growth stocks. B) Blue-chip equity fund. C) T-bills. D) High-yield bond fund.

C) T-bills. Explanation While his profile indicates aggressive growth, the fact that he will need his funds in a year or less to purchase a home is the major consideration. With such a short time horizon, any equity investment involves too much risk, as does an investment in a high-yield bond fund. Of the choices, T-bills make the most sense.

When determining whether a tax swap of municipal bonds will result in a wash sale, each of the following are considered EXCEPT: A) maturity. B) coupon. C) principal amount. D) issuer. .

C) principal amount. Explanation In judging whether bonds purchased are substantially identical to bonds sold for a loss, the tax code considers maturity, issuer, and coupon rate. If at least two of the three are different, a wash sale will generally not result

One of your customers has donated securities that have appreciated over time since they were first purchased to her favorite charity. Wanting to use the donation as a tax deduction on her tax return the customer would be advised that she will be allowed to deduct A) the original cost of the securities when initially purchased B) the amount by which the securities have gone up in value above the purchase price C) the market value of the securities on the date the donation was made D) no portion of the donation

C) the market value of the securities on the date the donation was made Explanation When an individual has donated appreciated securities to a charity, the amount of the allowable tax deduction is equal to the current market value of the securities on the day the donation was made.

Which of the following best describes the investment characteristics of a high-quality long-term municipal bond? A) High inflation risk; high market risk. B) Low inflation risk; high market risk. C) Low inflation risk; low default risk. D) High inflation risk; low default risk.

D) High inflation risk; low default risk. Explanation A longer-term bond will be subject to more inflation risk. Since the quality of the bond is high, the level of default risk should be low.

All of the following statements about the taxation of municipal and corporate bonds are true EXCEPT: A) municipal bondholders must amortize premium bonds annually. B) corporate bondholders must accrete original issue discount bonds annually. C) municipal bondholders must accrete original issue discount bonds annually. D) corporate bondholders must amortize premium bonds annually.

D) corporate bondholders must amortize premium bonds annually. Explanation If an investor purchases a corporate bond at a premium, the investor has the option of whether or not to amortize the premium. Amortization reduces both reported interest income and cost basis.

A wealthy client owns a large percentage of a thinly traded common stock. When this client wants to sell a major portion of his securities, he will immediately face: A) market risk. B) interest rate risk. C) credit risk. D) marketability risk.

D) marketability risk. Explanation It is difficult to sell a large block of securities in a thinly traded stock without a substantial discount to market price. This is known as liquidity or marketability risk

A customer pursuing income using a defensive investment strategy while avoiding volatility would be most interested in: A) growth stocks. B) high yield corporate debt. C) limited partnerships. D) short-term government bonds.

D) short-term government bonds. Explanation Remember to take all investor characteristics into account. Short-term government bonds will produce for the customer safe income with little price volatility.