Taxes & Tax Shelters: Taxing Corporate and Government Securities

A customer buys 10M of $1,000 par corporate bonds in the secondary market. The purchase confirmation shows that the customer paid 90 + $150 of accrued interest. Six months later, the customer sells the bonds in the market at 91 + $50 of accrued interest. The capital gain or loss is: A. 0 B. $100 capital gain C. $100 capital loss D. $200 capital gain

$100 capital gain The accrued interest on a bond has no bearing on the capital gain or loss that results from the liquidation of a position. Rather, the accrued interest is an adjustment to interest income paid or received for that tax year. These bonds were purchased in the secondary market at 90% of $10,000 = $9,000. The bonds were sold at 91% of $10,000 = $9,100. Thus, the capital gain is $100. The accrued interest paid when the bonds were purchased is a reduction of the investor's investment income in that tax year; while the accrued interest received upon sale is an increase of the investor's investment income for that year. Also note that because the bond was held for less than 1 year, the rule requiring the annual accretion of the market discount to be taxed as ordinary income does not "kick in" because any gain or loss is short term and would be taxed at the same higher tax rate as ordinary income. The bond must be held for more than 1 year to qualify for long term capital gains treatment, and the lower tax rate that comes with it. For positions held over 1 year, the tax rate drops to 15% (or 20% for very high earning taxpayers), from a maximum rate of 39.6%.

Two years ago, a customer purchased 1,000 shares of ABC stock at $45 per share. The stock has appreciated in value and is currently worth $60,000. The company announces that it is spinning off a subsidiary, DEF, to its shareholders. The value of the new company being spun off equals 5% of the old company. The customer will have: A. $45,000 cost basis in ABC; $0 cost basis in DEF B. $42,750 cost basis in ABC; $2,250 cost basis in DEF C. $60,000 cost basis in ABC; $0 cost basis in DEF D. $57,000 cost basis in ABC; $3,000 cost basis in DEF

$42,750 cost basis in ABC; $2,250 cost basis in DEF The aggregate cost basis does not change in a spin-off. The original investment in ABC stock had a cost basis of $45,000. The 5% spin off means that 5% of this value is now attributed to the newly spun-off DEF shares = $2,250. The remaining value of the ABC shares is $45,000 - $2,250 = $42,750. The current market value has nothing to do with cost basis.

A customer buys $100,000 of 30 year corporate bonds with 20 years remaining to maturity at 95. The customer elects not to accrete the discount annually. At maturity, the customer will have: A. no capital gain or loss B. a $5,000 taxable capital gain C. $5,000 of taxable interest income D. a $5,000 capital loss

$5,000 of taxable interest income Corporate bonds bought in the secondary market at a discount are termed "market discount bonds." There is an option of accreting the discount and paying tax annually on the accretion amount at full tax rates; or of waiting until the bond is redeemed or sold to pay the tax on the earned market discount at full tax rates. If the holder accretes the bond and holds it until maturity, there is no capital gain or loss, since the entire discount has been accreted and taxed over the bond's life. If the holder opts not to accrete the bond, the bond will be redeemed at par and the entire market discount is taxed as interest income received at maturity (not as capital gains).

In January, 20XX a customer buys 100 shares of ABC stock at $50 per share and pays a $2 commission per share. The customer receives $2 in cash dividends during the year. The customer's cost basis in the stock is: a. $48 per share b. $50 per share c. $52 per share d. $54 per share

$52 per share

On Monday, June 7th, 2017, a customer buys 5 XYZZ 9 3/8% subordinated debentures M' 8-01-37 at 89 5/8 plus accrued interest in a regular way trade. On January 13th, 2018, the customer sells the bonds at 90 3/8 plus accrued interest in a regular way trade. For tax year 2017, the customer's reported interest income is: A. $66.41 B. $169.97 C. $234.38 D. $401.04

$66.41 For tax purposes, interest is reported as it is received on a cash basis. Thus, only interest payments actually made by the issuer in tax year 2017 are included. The customer bought the bonds on Monday, June 7th, 2017. The customer receives the August 1st interest payment in 2017. The next payment will be made on February 1st, 2018, so only one interest payment is reported for 2017. One interest payment (August 1st) 9.375% bonds x $5,000 face amount = $468.75 annual interest income/2 = $234.375 interest payment reported on that year's tax return. In addition, the accrued interest that the buyer paid to the seller is deducted from the reported interest income. The bonds were purchased on Monday, June 7th, 2017, so regular way settlement takes place on Thursday, June 10th. Interest accrues up to, but not including the 10th. Thus, the buyer had to pay the seller accrued interest for: Feb: Mar: Apr: May: Jun: 30 days 30 days 30 days 30 days 9 days Total: 129 days 129 days/360 days per year x $93.75 annual interest per bond x 5 bonds = $167.97 accrued interest paid. The reported taxable interest income is $234.38 interest received less $167.97 accrued interest paid = $66.41 taxable interest income.

A customer has purchased 1,000 shares of ABC stock at $30 per share, paying a commission of $1 per share for the transaction. ABC stock declares a 5% stock dividend. When the dividend is paid, the tax status of the investment is: A. 1,000 shares held at a cost basis of $30 per share B. 1,000 shares held at a cost basis of $31 per share C. 1,050 shares held at a cost basis of $29.52 per share D. 1,050 shares held at a cost basis of $30 per share

1,050 shares held at a cost basis of $29.52 per share There is no tax due when a stock dividend is paid; instead the investor gets more shares; with each share worth proportionately less. The payment of a stock dividend increases the number of shares held by the investor and the cost basis must be reduced accordingly, since each share is theoretically worth less after the stock dividend is paid. The customer will have 1,000 shares x 1.05 = 1,050 shares after the dividend. Each share originally had a cost basis of $31 ($30 price plus $1 commission). After the dividend is paid, the cost basis is adjusted to $31/1.05 = $29.52.

In 2017, a customer buys a 3 3/4% U.S. Government bond maturing in 2026 at 104-16. The customer elects to amortize the bond premium for tax purposes. If the bond is sold after 2 years, its cost basis at that time is: A. 104-16 B. 104 C. 103-16 D. 103

103-16 Both Government and corporate bond market premiums may be amortized, if elected by the owner - and this is the best choice for the owner because the annual amortization reduces the taxable interest income received from the bond. This Government bond costs 104-16, for a premium of 4 and 16/32nds = 4 1/2 points. Since the bond has 9 years to maturity, the annual amortization amount is 4 1/2 points divided by 9 years = 1/2 point per year. If the bond is sold after 2 years, 1 point of the premium will have been amortized. Thus, the bond's adjusted cost basis is 104 1/2 - 1 = 103 1/2. Converting to Government bond quotes (in 32nds), this equals 103-16.

Which statements are TRUE about amortization of bond premiums? I. Annual amortization amounts reduce reported interest income II. Annual amortization amounts reduce the interest amount received from the issuer III. Annual amortization amounts reduce the bond's cost basis IV. Annual amortization amounts reduce potential capital gain upon sale

Annual amortization amounts reduce reported interest income Annual amortization amounts reduce the bond's cost basis Amortization of bond premiums reduces reported interest income each year, but it does not represent a cash loss, since the issuer pays the stated interest amount. Yearly, the amortization amount reduces the bond's cost basis. As the cost basis is reduced, potential capital gains on sale increase (capital gain equals sale proceeds - adjusted cost basis).

Which of the following is reported on Form 1099-DIV? A. Cash dividends B. Taxable interest C. Tax-free interest D. All of the above

Cash dividends Form 1099-DIV is the report to the IRS by issuers of cash dividends paid and capital gains distributions made by mutual funds. Interest paid on taxable bonds and tax-free bonds is reported on Form 1099-INT.

Regarding corporate discount bonds, which statements are TRUE? I. Corporate original issue discount bonds must be accreted II. Corporate original issue discount bonds may be accreted III. Corporate market discount bonds must be accreted IV. Corporate market discount bonds may be accreted

Corporate original issue discount bonds must be accreted Corporate market discount bonds may be accreted The discount on original issue discount corporate and government bonds must be accreted annually - with the accretion amount being taxable annual interest income. The premium on original issue premium corporate bonds may be amortized for tax purposes; this election is beneficial to the bondholder since the annual amortization amount reduces taxable annual interest income. Corporate bonds bought in the secondary market at a discount are termed "market discount bonds." There is an option of accreting the discount and paying tax annually on the accretion amount at full tax rates; or of waiting until the bond is redeemed or sold to pay the tax on the earned market discount at full tax rates. If the holder accretes the bond and holds it until maturity, there is no capital gain or loss, since the entire discount has been accreted and taxed over the bond's life. If the holder opts not to accrete the bond, the bond will be redeemed at par and the entire market discount is taxed as interest income received at maturity (not as capital gains).

A customer has purchased 5,000 shares of ABC Corporation stock in lots of 100 shares over an extended period of time at varying prices. The customer now sells 500 of the shares. Which statement is TRUE? a. IRS rules require that First In First Out accounting to be used to identify the shares sold when computing any gain or loss b. IRS rules require that LIFO accounting be used to identify the shares sold when computing any gain or loss c. IRS rules allow the taxpayer to specify which shares being sold d. IRS rules require that the method giving the largest capital gain be used

IRS rules allow the taxpayer to specify which shares being sold

Which of the following statements are TRUE for an original issue corporate bond purchased at a discount? I. If the bond is held to maturity, the customer has capital gains tax liability II. If the bond is held to maturity, the customer will have no capital gains tax liability III. At maturity, the bonds will be redeemed at par IV. At maturity, the bonds will be redeemed at a discount to par

If the bond is held to maturity, the customer will have no capital gains tax liability At maturity, the bonds will be redeemed at par The discount on original issue discount corporate and government bonds must be accreted annually. The annual accretion amount is reported as taxable interest income for that year; and increases the bond's cost basis. If the bond is held to maturity, the entire discount has been accreted and taxed as interest income over the bond's life; while the cost basis has been adjusted up to par. Since the bond is redeemed at par, there is no capital gain or loss at maturity.

Which of the following is (are) taxable in the year of receipt? I. Interest earned from investments II. Cash dividends from investments III. Stock dividends from investments

Interest earned from investments Cash dividends from investments Cash dividends and interest are taxable each year (unless the interest is exempt). Stock dividends and stock splits are treated as a "return of capital." The cost basis of the shares is reduced proportionately and the number of shares is increased for the stock dividend or stock split.

A corporation declares a dividend of $3.00 on Tuesday, December 6th. The record date is set at Friday, December 30th, with the dividend payable on January 6th. Based on this information, the ex date is set at December 28th. For the recipient of the dividend, the "tax event" occurs on: A. December 6th B. December 26th C. December 30th D. January 6th

January 6th For tax purposes, payments by issuers to securities holders are considered to be received as of the date the issuer sends the check. In this case, the check is sent on January 6th (payable date), therefore the income is taxable as of this date.

Under IRS rules, if a customer selling shares of stock wishes to use specific identification instead of FIFO for cost basis reporting, the broker-dealer effecting the trade must be notified of this no later than: A. Trade date B. Settlement date C. December 31st of that year D. April 15th of the following year

Settlement date If a customer says nothing at the time of a stock sale, IRS rules requires that FIFO be used to determine which shares are sold. If the customer wishes to use specific identification instead, this must be chosen by the customer no later than settlement date.

Which statements are TRUE about stock cost basis reporting? I. Stock cost basis is reported on Form 1099-DIV II. Stock cost basis is reported on Form 1099-B III. If there are multiple purchases of the stock and no instructions are received from the customer, cost basis is reported on a FIFO basis IV. If there are multiple purchases of the stock and no instructions are received from the customer, cost basis is reported on a specific identification basis

Stock cost basis is reported on Form 1099-B If there are multiple purchases of the stock and no instructions are received from the customer, cost basis is reported on a FIFO basis Cost basis reporting to the IRS is required on Form 1099-B. The Form includes the cost basis of the security, the sale proceeds, and whether the holding period is short term or long term. If there are multiple purchases of the stock position, absent customer instructions, FIFO is used to report cost basis. If the customer gives instructions to the broker, then specific identification can be used - which is beneficial if higher cost shares are selected to either reduce capital gains or increase reported capital losses.

When accreting an original issue discount bond, which of the following statements are TRUE? I. The bond's cost basis increases proportionately each year II. The bond's cost basis decreases proportionately each year III. If the bond is held to maturity, there is a capital gain IV. If the bond is held to maturity, there is no capital gain

The bond's cost basis increases proportionately each year If the bond is held to maturity, there is no capital gain When accreting an original issue discount bond, every year the portion of the discount is included as taxable interest income and the bond's cost basis is increased proportionately. If the bond is held to maturity, the entire discount is accreted and the bond has an adjusted cost basis of par. Since it is redeemed at par, there is no capital gain at maturity.

When amortizing a bond premium, which of the following statements are TRUE? I. The bond's cost basis is increased each year II. The bond's cost basis is reduced each year III. Any potential gain of the sale of the bond increases each year IV. Any potential gain of the sale of the bond decreases each year

The bond's cost basis is reduced each year Any potential gain of the sale of the bond increases each year Each year, the amortization amount reduces the bond's cost basis. As the cost basis is reduced, potential capital gains on sale increase (capital gain equals sale proceeds - adjusted cost basis).

A customer buys a NASDAQ stock in a principal transaction at $79 plus a $1 mark-up. Which statements are TRUE? I. The cost basis for tax purposes is $79 per share II. The cost basis for tax purposes is $80 per share III. The trade will be reported to the tape at $79 per share IV. The trade will be reported to the tape at $80 per share

The cost basis for tax purposes is $80 per share The trade will be reported to the tape at $79 per share For tax purposes, any commissions or mark-ups charged to buy stock are considered to be part of the cost basis (therefore, they are not deductible). The cost basis is $79 plus $1 mark-up = $80 per share. The trade is reported to the tape exclusive of commissions or mark-ups, which are added well after the trade occurs. Remember, all trades are reported within 10 seconds, and the trade is reported at $79 per share.

Which of the following statements are TRUE regarding corporate bonds purchased in the secondary market at a discount? I. The discount must be accreted II. The discount may be accreted III. The discount may be taxed as a long term capital gain if held for over 1 year IV. The discount will be taxed as ordinary income

The discount may be accreted The discount will be taxed as ordinary income Corporate bonds bought in the secondary market at a discount are termed "market discount bonds." There is an option of accreting the discount and paying tax annually on the accretion amount at full tax rates; or of waiting until the bond is redeemed or sold to pay the tax on the earned market discount at full tax rates. If the holder accretes the bond and holds it until maturity, there is no capital gain or loss, since the entire discount has been accreted and taxed over the bond's life. If the holder opts not to accrete the bond, the bond will be redeemed at par and the entire market discount is taxed as interest income received at maturity (not as capital gains).

Which of the following statements are TRUE? I. accrued interest is added to the buyer's confirmation II. accrued interest is added to the seller's confirmation III. accrued interest is included in the buyer's cost basis IV. accrued interest is included in the seller's sale proceeds

accrued interest is added to the buyer's confirmation accrued interest is added to the seller's confirmation

All of the following are true regarding corporate bonds which are purchased in the secondary market at a discount and accreted EXCEPT: A. the interest income is subject to Federal Income tax B. the interest income is subject to State and Local tax C. if the bond is held to maturity, there is no taxable capital gain D. if the bond is held to maturity, there is a taxable capital gain which is taxed as ordinary income

if the bond is held to maturity, there is a taxable capital gain which is taxed as ordinary income Corporate bonds bought in the secondary market at a discount are termed "market discount bonds." There is an option of accreting the discount and paying tax annually on the accretion amount at full tax rates; or of waiting until the bond is redeemed or sold to pay the tax on the earned market discount at full tax rates. If the holder accretes the bond and holds it until maturity, there is no capital gain or loss, since the entire discount has been accreted and taxed over the bond's life. If the holder opts not to accrete the bond, the bond will be redeemed at par and the entire market discount is taxed as interest income received at maturity (not as capital gains).

The premium on market premium corporate and government bonds: A. must be amortized annually B. may be amortized annually C. must be accreted annually D. may be accreted annually

may be amortized annually Corporate and government bonds bought at a premium (either new issue or those trading in the secondary market) are treated the same way. There is an option of amortizing the premium annually, reducing both taxable interest income and the bond's cost basis annually; or of waiting until the bond is redeemed or sold to deduct the accumulated amortization amount. The clearly better choice is to amortize annually, taking the annual deduction, rather than to wait until maturity to take the accumulated deduction.

The discount on original issue discount corporate and government bonds: A. must be amortized annually B. may be amortized annually C. must be accreted annually D. may be accreted annually

must be accreted annually The discount on original issue discount corporate and government bonds must be accreted annually. The annual accretion amount is reported as taxable interest income for that year; and increases the bond's cost basis. If the bond is held to maturity, the entire discount has been accreted and taxed as interest income over the bond's life; while the cost basis has been adjusted up to par. Since the bond is redeemed at par, there is no capital gain or loss at maturity.

A customer buys $10,000 of a new issue 10 year corporate bond at 92. At maturity, the customer will have: a. no capital gain or loss b. an $80 capital gain c. an $800 capital gain d. an $800 capital loss

no capital gain or loss

A customer has invested $100,000 in a CMO. In the first year, the customer receives $12,000 of payments, which consist of $9,000 of interest and $3,000 of principal. Which statement is TRUE? a. all $12,000 received is taxable b. all $12,000 received is not taxable c. the $3,000 of principal is not taxable and the $9,000 of interest is taxable d. the $3,000 of principal is taxable and the $9,000 of interest is not taxable

the $3,000 of principal is not taxable and the $9,000 of interest is taxable