Series 7 Chapter 15: Ethics, Recommendations, and Taxation

A 3% bond with 20 years to maturity is being issued by a syndicate with a reoffering yield of 4%. What is the term used to describe this bond? A) Secondary market discount. B) Original issue discount. C) Original issue premium. D) High-yield bond.

Your answer, Secondary market discount., was incorrect. The correct answer was: Original issue discount. Because the bond is being issued by a syndicate, it is a new issue (i.e., an original issue). Because the yield (4%) is higher than the coupon (3%), it is an original issue discount.

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 stock cross. C) a reverse stock split. D) a wash sale.

Your answer, a stock cross., was incorrect. The correct answer was: a wash sale. 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.

A broker dealer has encouraged its registered representatives (RRs) to move all customers into fee-based accounts paying a single annual fee based on a percentage of assets rather than having them pay commissions for every transaction separately. This would be deemed A) inappropriate for those customers who engage in large institutional size transactions B) appropriate for both large and small clients giving both the equal advantage of paying one annual fee C) appropriate because it is considered the reverse of churning which is a prohibited activity D) inappropriate for those customers who trade infrequently

Your answer, appropriate because it is considered the reverse of churning which is a prohibited activity, was incorrect. The correct answer was: inappropriate for those customers who trade infrequently Both churning and reverse churning are prohibited activities. Reverse churning is the practice of placing clients who trade infrequently in fee-based accounts paying a percentage of assets under management as an annual fee instead of paying commissions per transaction. If the annual fee would be greater than the total commissions paid, considering the number of transactions the client could reasonably be expected to do, this would be inappropriate. Fee-based accounts are more appropriate for those who trade frequently and/or commonly participate in larger size transactions.

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

Your answer, high yield corporate debt., was incorrect. The correct answer was: short-term government bonds. Remember to take all investor characteristics into account. Short-term government bonds will produce for the customer safe income with little price volatility.

A customer buys 100 shares of RFTQ at $10 per share. Several months later, the stock is trading at 4.60 - 5, at which time the registered representative offers to buy back the stock from the customer for his own account at $9 per share. This action is: A) permitted with the written permission of a principal. B) prohibited because it violates the Uniform Practice Code. C) permitted because it allows the customer to sell at a price higher than the current market. D) prohibited because FINRA rules do not allow registered representatives to guarantee customers against loss.

Your answer, prohibited because it violates the Uniform Practice Code., was incorrect. The correct answer was: prohibited because FINRA rules do not allow registered representatives to guarantee customers against loss. A representative may never guarantee a customer against a loss. This is specified in the Conduct Rules, not the Uniform Practice Code.

Four years ago, you declared a net capital loss of $23,000 on your tax return. You have had no further capital gains or losses since then. For that year and the following 2, you took the maximum allowable income deduction. How much may you deduct from your income this year, and how much loss will you have to carry forward? A) $3,000/$12,000. B) $2,000/$12,000. C) $2,000/$11,000. D) $3,000/$11,000.

Your answer, $2,000/$12,000., was incorrect. The correct answer was: $3,000/$11,000. The maximum allowable deduction against income is $3,000. You will have taken 4 such deductions against $23,000, which leaves you with $11,000 to carry forward ($23,000 - $12,000).

Interest income from all of the following are exempt from state and local taxation EXCEPT: A) Treasury bonds. B) FNMA mortgage-backed issues. C) Treasury bills. D) Series EE savings bonds.

Your answer, FNMA mortgage-backed issues., was correct!. As a general rule, the interest income from U.S. government and agency securities is subject to federal taxation only; it is generally exempt from state and local taxation. However, the interest income from mortgage-backed securities is fully taxable.

A customer owns 10M of 7% U.S. Treasury bonds. He is in the 28% federal tax bracket and the 10% state tax bracket. What is his annual tax liability on these bonds? A) $70. B) $98. C) $196. D) $266.

Your answer, $98., was incorrect. The correct answer was: $196. His tax liability is as follows: $1,000 × 7% = $70 annual interest per bond; $70 × 10 = $700 annual interest, which is taxable only by the federal government; $700 × 28% = a $196 tax liability.

A customer's portfolio has a beta coefficient of 1.1. If the overall market increases by 10%, the portfolio's value is likely to: A) decrease by 10%. B) increase by 11%. C) increase by 10%. D) decrease by 11%.

Your answer, increase by 11%., was correct!. A beta of 1.1 means the portfolio is considered to be 1.1 times more volatile than the overall market. If the market is up 10%, the portfolio with a beta of 1.1 is likely to be up 11%.

A municipal bond is purchased at a discount in the secondary market at 90. The face amount is $10,000 and the bond has 10 years to maturity. If the bond is sold for 97 after 5 years, what is the taxable gain? A) $200. B) $700. C) Capital gains are not taxable on municipal issues. D) $300.

Your answer, $700., was incorrect. The correct answer was: $200. When a municipal bond is bought at a discount in the secondary market, the discount is accreted and taxable as ordinary income. Accretion increases cost basis. Therefore, 5 years later, the bond's cost basis is 95. At that point, the customer has a 2-point capital gain. Had the bond been bought as an OID, the annual accretion is considered interest income and is not taxable.

A municipal bond originally issued at 90 with a 10-year maturity will have a compound accreted value (CAV) after 5 years equal to: A) 95. B) 10. C) 5. D) 100.

Your answer, 100., was incorrect. The correct answer was: 95. CAV is the cost basis of the bond, in this case, after 5 years accretion. There are 10 points to accrete (the difference between the issue price of 90 and par) over 10 years. One point each year will be added, so after 5 years, the adjusted cost basis will be 90 + 5, or 95.

A customer buys a municipal bond in the secondary market at 96 that has 4 years to maturity. Two years later, the customer sells the bond at 99. The tax consequences of this investment are: A) 2 points of ordinary income and 1 point of capital gain. B) 3 points of capital gain. C) 3 points of ordinary income. D) 2 points of capital gain and 1 point of ordinary income.

Your answer, 3 points of ordinary income., was incorrect. The correct answer was: 2 points of ordinary income and 1 point of capital gain. When a municipal bond is purchased in the secondary market at a discount, the annual accretion is taxed as ordinary income. The annual accretion is 1 point per year (4 points divided by 4 years to maturity). Therefore, when the bond is sold 2 years later, its cost basis is 98. If the bond is sold at 99, there is a long-term capital gain of 1 point per bond. Also, there is ordinary income taxation on the accretion of 2 points.

If an investor practices value investing, which of the following stock types is he least likely to purchase? A) A stock with an above-average price-to-earnings ratio. B) A stock that is presently selling for two-thirds of net current assets. C) A stock that has exhibited a high dividend yield in the past. D) A stock with a low price-to-earnings ratio.

Your answer, A stock that is presently selling for two-thirds of net current assets., was incorrect. The correct answer was: A stock with an above-average price-to-earnings ratio. A growth investor looks for stocks with above-average price-to-earnings ratios. Conversely, a value investor focuses on stocks with low PE ratios, a low price-to-book value, and historically high dividend yields.

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

Your answer, High inflation risk; low default risk., was correct!. 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.

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) High-yield bond fund. B) Growth stocks. C) T-bills. D) Blue-chip equity fund.

Your answer, High-yield bond fund., was incorrect. The correct answer was: T-bills. 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.

A new customer asks you to offer recommendations of investments that would provide current income. You would include in your list: government and agency securities. real estate investment trusts (REITs). exploratory oil and gas direct participation programs. new IPO issues. A) I and IV. B) III and IV. C) II and III. D) I and II.

Your answer, III and IV., was incorrect. The correct answer was: I and II. Corporate bonds, municipal bonds, government and agency securities, income-oriented mutual funds, some stocks (including utilities and REITs), money market funds, and annuities are among the investments that can contribute current income through dividend or interest payments.

Your customer, a new investor, 24 years of age, earns $35,000 per year and has saved $10,000 to invest. She would like to purchase her first home in approximately 5 years. Which of the following would be the least suitable recommendation given her objective? A) Tax-free municipal bonds B) Preferred stocks C) Large-cap equity fund D) A balanced fund

Your answer, Large-cap equity fund, was incorrect. The correct answer was: Tax-free municipal bonds This new investor is not yet at an income level where the tax-free benefits of municipal bonds would be of great benefit. In addition, municipal bonds would have lower yields than other debt securities and would not be as likely to add to the growth needed to achieve her goal. Given her investment objective, each of the other choices would be more suitable regarding potential growth.

An investor has accumulated 3000 shares of XYZ common stock over several years via several separate purchases. If the investor sells 1000 shares and chooses to identify the specific shares sold for tax purposes, he must: A) Identify the specific shares to be sold prior to the transaction. B) Notify the IRS no later than the last business day of the month the trade occurred in. C) Notify the broker dealer who handled the sell transaction within 3 business days of the trade date. D) Notify FINRA on the trade date.

Your answer, Notify the broker dealer who handled the sell transaction within 3 business days of the trade date., was correct!. The IRS mandates that when an investor wishes to identify the specific shares sold for tax purposes the broker dealer who handled the sell transaction must be notified within 3 business days of the sale. For stock transactions this means by the settlement date.

Market timing is normally associated with which of the following portfolio management styles? A) Modern portfolio theory. B) Strategic asset allocation. C) Tactical asset allocation. D) Passive management.

Your answer, Strategic asset allocation., was incorrect. The correct answer was: Tactical asset allocation. Tactical asset allocation, which attempts to capitalize on short-term market swings, is a market timing strategy.

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 only against gains on the sale of other debt instruments (bonds). C) The losses can be applied against the gains on the sale of any other security. D) The losses can be applied only against gains on the sale of other municipal bonds.

Your answer, The losses can be applied only against gains on the sale of other municipal bonds., was incorrect. The correct answer was: The losses can be applied against the gains on the sale of any other security. Losses on the sale of one investment can generally be deducted against gains on the sale of any other investment.

At year's end, your client reports $12,000 in capital gains and $20,000 in capital losses. The net effect of this on his taxes would be: A) an $8,000 deduction from ordinary income. B) a $4,000 deduction from ordinary income with a $4,000 loss carry-forward. C) a $3,000 deduction from ordinary income with a $5,000 loss carry-forward. D) a $3,000 deduction from ordinary income with a $2,500 loss carry-forward.

Your answer, a $4,000 deduction from ordinary income with a $4,000 loss carry-forward., was incorrect. The correct answer was: a $3,000 deduction from ordinary income with a $5,000 loss carry-forward. The customer may offset all of the gains with the losses. This leaves a new loss of $8,000. Since the maximum net capital loss that may be deducted against ordinary income is $3,000 per year, we take off the $3,000 and have a carry-forward of the balance ($5,000).

All of the following statements regarding dollar-cost averaging are correct EXCEPT: A) an employee stock purchase plan (ESPP) is one way to use dollar-cost averaging. B) dollar-cost averaging decreases the risk of loss. C) dollar-cost averaging is the investment of a fixed amount of money each period. D) dollar-cost averaging is a passive investment strategy.

Your answer, an employee stock purchase plan (ESPP) is one way to use dollar-cost averaging., was incorrect. The correct answer was: dollar-cost averaging decreases the risk of loss. Dollar-cost averaging is a passive investment strategy using a fixed dollar amount to purchase shares no matter what the price is. The fixed dollar amount buys more shares when the price is lower and fewer shares when the price is higher. While this strategy can lower the average cost per share over time it does not assure profitability nor does it decrease the risk of loss.

If your client has a $21,000 net capital loss this year and he plans to apply the maximum deduction toward his ordinary income for the year, after this year he may: A) deduct a maximum of $3,000 per year and carry the remaining loss forward indefinitely. B) not carry the loss forward. C) carry the loss forward indefinitely and offset capital gains only. D) carry $3,000 of the loss forward.

Your answer, carry the loss forward indefinitely and offset capital gains only., was incorrect. The correct answer was: deduct a maximum of $3,000 per year and carry the remaining loss forward indefinitely. Capital losses may be used to offset capital gains. Once all capital gains have been offset, $3,000 of net capital losses may be used to offset ordinary income annually. Remaining losses may be carried forward in future years until the loss is exhausted.

An investor's portfolio has a beta coefficient of .85. If the overall market declined by 10% over the course of a year, the portfolio's value has likely: A) increased by 10.85%. B) decreased by 11.76%. C) increased by 8.5%. D) decreased by 8.5%.

Your answer, decreased by 11.76%., was incorrect. The correct answer was: decreased by 8.5%. A beta coefficient of .85 means that the portfolio is considered to be .85 times as volatile as the overall market. Therefore, if the market declines by 10%, the portfolio with a beta of .85 is likely to decline by only 8.5% (.10 × .85).

The term "churning" refers to: A) entering more transactions than necessary, solely for the purpose of generating commissions. B) purchasing calls on a particular stock for your own account before entering a large customer order for the stock. C) repeatedly selling a stock short in order to prevent a price rise. D) repeatedly purchasing stock in order to keep the price up.

Your answer, entering more transactions than necessary, solely for the purpose of generating commissions., was correct!. Unnecessary transactions entered into for the purpose of generating commissions constitute churning. A charge of churning can result from both excessive number and excessive size of transactions.

If an investor wants to do a tax swap, he could reasonably expect to pay more money if he buys bonds with a: A) lower coupon and lower rating. B) higher coupon and similar rating. C) lower coupon and similar rating. D) higher coupon and lower rating.

Your answer, higher coupon and similar rating., was correct!. An investor will pay more for a higher coupon with the same rating. A higher coupon translates into a higher price.

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

Your answer, increase to a premium bond's cost basis., was incorrect. The correct answer was: decrease to a premium bond's cost basis. 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.

After knowing a customer for a short time a registered representative (RR) is able to discern that the customer's primary investment objective is to preserve his initial principal investment with minimal or no risk. The customer is aware of and comfortable knowing that the account value is not likely to generate current income or returns that will keep pace with inflation. The RR best characterizes the customer's investment profile as A) moderate B) moderate conservative C) aggressive D) conservative

Your answer, moderate conservative, was incorrect. The correct answer was: conservative This investor's objective and risk tolerance can only align with a conservative profile.

A registered representative sits down with a new customer to complete the customer account form. During this time the customer expresses being comfortable with some risk to his initial investment in exchange for potentially higher returns. After the registered representative explains that the willingness to accept some risk may allow the account to keep pace with inflation but that it also means the account could lose value, the customer acknowledges that he understands. This customer's risk tolerance would best be defined as A) aggressive B) moderate C) moderate aggressive D) conservative

Your answer, moderate, was correct!. An investment risk tolerance in which the customer is willing to accept some risk to the initial principal sum invested and the potential loss of the funds in exchange for the opportunity to earn higher returns is best defined as moderate.

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) principal amount. C) issuer. D) coupon.

Your answer, principal amount., was correct!. 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.

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) tax credit on the investor's Canadian tax return. B) non-recoverable loss on the investor's U.S. tax return. C) reduction in the investor's ordinary income. D) tax credit on the investor's U.S. tax return.

Your answer, reduction in the investor's ordinary income., was incorrect. The correct answer was: tax credit on the investor's U.S. tax return. 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.

Your broker/dealer provides occasional research reports to an institutional trading desk in exchange for that institution doing executions for its various fund portfolios through your broker. This is known as A) soft dollar arrangement B) customer portfolio margining (CPM) C) front running D) churning

Your answer, soft dollar arrangement, was correct!. Soft dollar arrangements are ones in which a broker/dealer may provide products or services to an advisor or fiduciary in general, in exchange for that advisor directing brokerage transactions to the broker/dealer for execution.

If a registered representative perceives that unethical trading practices are occurring at his firm or another firm, the RR can report this information to A) the FINRA regulatory tip line in Washington DC B) the FBI C) the Director of Arbitration of FINRA D) the Investor Complaint Center operated by FINRA

Your answer, the FINRA regulatory tip line in Washington DC, was correct!. FINRA operates a regulatory tip line that allows industry insiders to file information relating to rules violations.

A customer's order to buy 500 shares of QRS at 60 is executed when the registered representative reports the trade execution to the customer. One hour later, the customer notices that QRS is down 2 points and he informs the representative that he no longer wants the stock, nor is he planning to pay for it. The representative should tell the customer that: A) the firm will repurchase the securities from the customer for the price paid. B) the customer may sell the stock at the purchase price in the open market. C) the representative will personally repurchase the securities from the customer for the price paid. D) the customer owns the stock and must submit payment.

Your answer, the customer may sell the stock at the purchase price in the open market., was incorrect. The correct answer was: the customer owns the stock and must submit payment. The customer has entered into a contract to purchase a security as soon as the buy order is executed, and must pay regardless of any subsequent change in the market price. The firm and the representative are prohibited from offering to repurchase the securities at the original price.

A married couple who files jointly has a $5,000 long-term capital loss with no offsetting capital gains. Regarding the tax treatment of this loss, all of the following statements are true EXCEPT: A) capital losses can be deducted dollar for dollar against capital gains. B) the maximum they can deduct this year is $3,000. C) they can carry forward $2,000 to future years. D) capital losses can be used to offset capital gains only.

Your answer, they can carry forward $2,000 to future years., was incorrect. The correct answer was: capital losses can be used to offset capital gains only. Capital losses are deducted from ordinary income and, therefore, reduce tax liability. The maximum that individuals or married couples can deduct is $3,000 annually. If the long-term capital loss exceeds the maximum, the excess is carried forward to future years until the loss is exhausted. Under current IRS regulations, $1 in losses results in $1 in deductions.