Unit 15: Tax Considerations
Which of the following is an example of a regressive tax? A) Income tax B) Estate tax C) Gift tax D) Sales tax
D) Sales tax Regressive taxes are those where the rate remains the same, regardless of the cost of the item subject to the tax. For example, if your state has a 6% sales tax, it makes no difference if you are buying an item for $1 or $10,000—the tax rate is the same 6%. The other choices given are progressive taxes, where the tax rate increases as the dollar amount being taxed increases.
If an investor swaps identical issues of stock to establish a loss that is disallowed, the transaction is known as A) a stock cross. B) a reverse stock split. C) a stock swap. D) a wash sale.
D) 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.
Owners of private activity municipal bonds might find themselves A) subject to the alternative minimum tax. B) receiving less interest than with a similar GO bond. C) in violation of MSRB rules if proper disclosures are not made. D) taking an extraordinarily high risk.
A) subject to the alternative minimum tax. The interest on private activity municipal bonds (used for things like airports, student housing, etc.) is exempt from federal taxation but is considered a preference item for the AMT.
Your customer redeemed 200 of her 500 Kapco common shares without designating which shares were redeemed. Which of the following methods does the IRS use to determine which shares she redeemed? A) Identified shares B) FIFO C) Wash sale rules D) LIFO
B) FIFO When a customer does not choose a method, the IRS uses FIFO (first-in, first-out). This will likely result in shares with the lowest cost basis being redeemed first, which creates a greater taxable gain.
An investor purchases 1,000 shares of ABC at $42 per share. One year later, the stock is trading at $50 per share and the investor receives 50 shares of ABC as a stock dividend. How will this dividend be currently taxed? A) As $2,500 ordinary income B) The shares are not subject to taxation C) As a $2,100 capital gain D) As a $2,500 capital gain Explanation
B) The shares are not subject to taxation Shares received per a stock dividend are not currently taxable. Instead, shareholders who receive stock dividends must adjust their cost basis in the shares downward. The total number of new shares, multiplied by their new adjusted basis, must equal the shareholder's total interest before the stock dividend was received.
There are many sources of taxable income to an individual. Included might be money received from which of the following? Sole proprietorship Subchapter S corporation Investments Life insurance death benefit A) I and II B) II and III C) I, II, III, and IV D) I, II, and III
D) I, II, and III 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). Of course, taxable income can be generated by investments in the form of dividends, interest, and capital gains. The death benefits are from a life insurance policy because those, unlike the death benefit from an annuity, are not subject to income tax.
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 offset $1,000 ordinary income this year. B) There will be no tax consequences. C) He will have a $1,000 gain. D) He will have a $1,000 loss to carry over to the next year.
A) He will offset $1,000 ordinary income this year. 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.
Many corporations make available dividend reinvestment plans for their shareholders. Among the benefits of using DRIPS are allowing the investment to compound. discounts from the current market price. reduced taxation. the ability to accept the dividend in cash or in additional shares of stock. A) I and II B) I and III C) I and IV D) II and IV
A) I and II DRIPs, like any other plan involving dividend reinvestment, offer the opportunity to have the investment compound. In most cases, shares are available at a slight discount from the current market and/or reduced or eliminated commissions. Many plans allow investors to add thousands of dollars to the reinvested dividend, taking advantage of the previous two benefits. However, there is no tax advantage and this is merely reinvesting a cash dividend, not receiving a stock dividend.
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) tips received while working at a restaurant. C) overtime pay from a job. D) interest from U.S. Treasury bonds.
A) interest from private activity bonds. 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.
The alternative minimum tax is designed to ensure that certain high-income taxpayers do not avoid all income tax through the use of various tax preference items. Those preference items are added back to the taxpayer's ordinary income on IRS Form 6251 and would include A) interest received from specified private-purpose municipal revenue bonds. B) long-term capital gains in excess of $3,000 annually. C) intangible drilling costs in connection with an oil drilling program. D) straight-line depreciation taken on investment real estate.
A) interest received from specified private-purpose municipal revenue bonds. The Internal Revenue Code provides that interest on specified private activity bonds is an item of tax preference. Therefore, this interest must be added to a taxpayer's regular taxable income in order to compute the taxpayer's AMTI. Accelerated depreciation and excess intangible drilling costs are preference items. In the real world, it is not only those with high incomes that are caught by the AMT, but the exam is not likely to go that deep.
A loss derived from a limited partnership may be offset against income from A) other limited partnerships. B) capital gains from municipal bonds. C) bonuses received in addition to a regular salary. D) dividends received from common stocks.
A) other limited partnerships. A limited partner may use only passive income to offset the loss derived from a limited partnership. A passive loss cannot be used to offset dividends received from common stocks. Passive loss from partnerships may be used to offset passive gains from partnerships, not gains from municipal bonds.
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 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.
Each of the following could cause an investor to be subject to the alternative minimum tax except A) excess intangible drilling costs. B) interest received on private activity municipal bonds. C) accelerated depreciation taken on certain property. D) interest received on school district GO bonds.
D) interest received on school district GO bonds. General obligation GO bonds are not subject to the AMT.
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 B) $15,000 C) $3,000 D) $12,000
A) $0 In this question, the client had $12,000 of capital gains and $15,000 of capital losses. Step 1: Offset the capital gains with the capital losses ($15,000 - $12,000). This leaves $3,000 remaining in capital losses. Step 2: Note that the client can apply up to a maximum of $3,000 of any remaining losses against ordinary income. Once all $3,000 in remaining losses is used to reduce ordinary income, this would leave $0 to carry forward to the next year. Therefore, the reason you would not carry $3,000 to the next year is that it would be used to reduce ordinary income for the current year. It can be safely assumed than an employed client of a broker-dealer makes at least $3,000 per year.
Which of the following statements regarding the alternative minimum tax is true? A) The excess of the alternative tax over the regular tax is added to the regular tax. B) The lesser of the regular tax or the alternative tax is paid. C) The tax bracket will determine whether the regular tax or the alternative tax is paid. D) The alternative minimum tax is added to the regular tax.
A) The excess of the alternative tax over the regular tax is added to the regular tax. The excess of the alternative tax over the regular tax is added to the regular tax amount. The taxpayer does not have the option of paying the alternative tax or the regular tax depending on his tax bracket. The purpose of the alternative minimum tax is to ensure that certain taxpayers pay a tax consistent with their wealth and income.
One of the benefits of owning a home is the tax treatment of a sale of a primary residence. Under current IRS regulations, A) a married couple is permitted to exclude the first $500,000 of gain as long as the proceeds are reinvested in another home. B) a married couple is permitted to exclude the first $500,000 of gain. C) a married couple is permitted to exclude the first $250,000 of gain. D) all gains from the sale of a primary residence are excluded from taxation.
A) a married couple is permitted to exclude the first $500,000 of gain as long as the proceeds are reinvested in another home. As long as the requirements are met, a married couple is permitted to exclude the first $500,000 of gain on the sale of a primary residence. The exclusion for singles is $250,000. Years ago, the gain was deferred if the proceeds were reinvested in a new home, but that no longer applies.
Using industry jargon, the tax on the last dollar of income is at A) the marginal rate. B) the final rate. C) the effective rate. D) the average rate.
A) the marginal rate. 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.
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 offset $1,000 ordinary income this year. C) There will be no tax consequences. D) He will have a $1,000 loss to carry over to the next year.
B) He will offset $1,000 ordinary income this year. 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.
You are working with a client who received her divorce earlier this year. She has two young children, ages four and seven, who both live with her. In general, it would be most advantageous for her to file her federal income tax claiming what status? A) Married, but separated B) Head of Household C) Single D) Joint
B) Head of Household Taxpayers claiming the head-of-household (HOH) 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: You are unmarried or considered unmarried on the last day of the year. 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.
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 two of the past five 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 two of the past five 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 two of the past five 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 two of the past five years. A) II and IV B) I and IV C) II and III D) I and III
B) I and IV When a primary residence that has been lived in for at least two of the past five 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 Form 1040.
Which of the following statements about capital gains are true? The minimum holding period required to qualify for long-term capital gains treatment is 1 day longer than 12 months. The highest federal income tax rate on long-term capital gains is less than the highest federal income tax rate on ordinary income. If an investor holds stock for 12 months or less and has no other transactions, any gain on the sale of the stock is taxed at the same rate as ordinary income. A) II and III B) I, II, and III C) I and II D) I and III
B) I, II, and III If an investor holds stock for more than 12 months and sells it for a gain, the gain will be treated as a long-term capital gain. The advantage of long-term capital gains is that the maximum tax rate on long-term capital gains is lower than the maximum rate on ordinary income. If an investor holds stock for 12 months or less, though, any gain will be considered a short-term capital gain and will be taxed at the same rate as ordinary income.
If a high-income taxpayer is subject to the AMT, which of the following preference items must be added to adjusted gross income to calculate his tax liability? A) Interest on a general obligation municipal bond B) Interest on a private-purpose municipal bond C) Distributions from a corporate bond mutual fund D) Dividends paid on preferred stock
B) Interest on a private-purpose municipal bond The interest received on private-purpose municipal bonds is considered a tax preference item for the AMT. The interest on GO bonds and income received on corporate securities are never considered preference items under the AMT. In the real world, it is not only those with high incomes that are caught by the AMT, but the exam is not likely to go that deep.
A married couple has lived in the same home for 40 years and now, with the children all gone, they've decided to sell and move to a retirement village. They purchased the home for $80,000 and have accepted a contract for $800,000. The tax consequence of this sale is A) a $0 capital gain. B) a $220,000 capital gain. C) a $720,000 capital gain. D) a $470,000 capital gain.
B) a $220,000 capital gain. As long as a homeowner has lived in the primary residence at least two of the previous five years, the first $250,000 of profit on a home sale is excluded from tax. In the event it is a married couple, as in this question, the exclusion is doubled to $500,000. The profit on the sale was $720,000 ($800,000 minus the cost of $80,000) and the exclusion of $500,000 reduces the reportable gain to $220,000.
Using industry jargon, the tax on the last dollar of income is at A) the effective rate. B) the marginal rate. C) the final rate. D) the average rate.
B) the marginal rate. 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.
One of your clients buys 300 shares of RIF common stock in March at $25 per share. Three months later, the client purchases 200 shares of RIF at $30 per share. One month later, RIF pays a dividend of $1 per share. Then, five months later, another purchase of RIF is made—this time 400 shares at $35 per share. If the client were to sell all RIF at $30 per share, what is the client's capital gain or loss? A) $500 gain B) No gain or loss C) $500 loss D) $400 gain
C) $500 loss The investor's total cost is $27,500 for the 900 shares purchased. The proceeds of the sale are $27,000 (900 × $30). That results in a capital loss of $500. The cash dividend has nothing to do with capital gain or loss.
Investors looking to minimize the effects of taxation on their investments would probably receive the least benefit from A) an S&P 500 Index fund. B) an apartment building. C) a corporate bond. D) a growth stock.
C) a corporate bond. Investors receive interest income from corporate bonds. That income is fully taxable at ordinary income rates. Real estate ownership has certain tax benefits, such as depreciation and a deduction for operating expenses. Index funds are known for their high tax efficiency, and investors in growth stocks anticipate long-term capital gains, which are taxed at a lower rate than ordinary income.
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 the case of dividend and capital gains reinvestment plans, taxes are deferred until liquidation. B) in the case of interest on interest plans, taxes are deferred until liquidation. C) in both plans, all income is taxable in the year received, whether reinvested or not. D) in both cases, all income is deferred until liquidation.
C) in both plans, all income is taxable in the year received, whether reinvested or not. 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.
An example of an interest-on-interest reinvestment program is A) reinvesting the earnings on a bond UIT. B) reinvesting the dividends distributed on a bond fund. C) interest left to compound on a bank-insured certificate of deposit. D) reinvesting the interest received on a bond.
C) interest left to compound on a bank-insured certificate of deposit. 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.
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) hold the stock until the price reaches $25. B) use average cost. C) use LIFO. D) use FIFO.
C) use LIFO. 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.
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 100 shares of ABCE common stock C) Purchasing 5 ABCE convertible bonds with a conversion price of $50 D) Purchasing an ABCE put option
D) Purchasing an ABCE put option 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.
Which of the following offers the opportunity to realize a capital gain rather than ordinary income? A) Cash dividends B) Section 529 plans C) Deferred annuities D) Stock dividends
D) Stock dividends Stock dividends, unlike cash dividends, are not taxable in the year of receipt. Instead, they reduce the owner's cost basis and, when sold at a price above that cost basis, are treated as a capital gain rather than ordinary income. Deferred annuities never generate anything but ordinary income, and qualified withdrawals from Section 529 plans result in no taxation on the earnings. If they are not qualified, there is ordinary income tax plus a penalty.
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 fewer shares in the investor's account. C) The value of the investor's account has gone down. D) There are more shares in the investor's account.
D) There are more shares in the investor's account. 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.
An investor purchased 100 shares of a stock at $100 per share on January 1. On the following July 1, the shares were sold for $120 per share. The tax consequences are A) a $2,000 short-term loss. B) a $2,000 long-term gain. C) a $2,000 long-term loss. D) a $2,000 short-term gain.
D) a $2,000 short-term gain. One hundred shares sold for $120 per share that were purchased for $100 per share results in a capital gain of $2,000. Because the holding period did not exceed one year, the gain is considered short term for tax purposes.
