CFP Quicksheet flashcards
Steps to the financial planning process
- Understanding the client’s personal and financial circumstances
- Identifying and selecting goals
- Analyzing the client’s current course of action and potential alternative course(s) of action
- Developing the financial planning recommendations
- Presenting the financial planning recommendations
- Implementing the financial planning recommendations
- Monitoring progress and updating
Financial advice
A communication that based on It’s content, context, and presentation, would reasonably be viewed as a recommendation that the client take or refrain from taking a particular course of action.
Financial Planning
A collaborative process that helps maximize a Client’s potential for meeting life goals through Financial Advice that integrates relevant elements of the Client’s personal and financial circumstances.
Self-determination theory
There are three main psychological needs that determine motivation.
Competence + relatedness + autonomy = intrinsic motivation
Five stages of change (money disorders)
- Pre-contemplation
- Contemplation
- Preparation
- Action
- Maintenance
Money avoidance
tries not to think about money; believes they do not deserve money
Money worship
buys things in an effort to create happiness
Money status
Needs to keep up the appearance of being successful
Money vigilance
alert and watchful in financial matters; may have anxiety about future
Behavior finance
Investment decisions are impacted by cognitive biases and heuristics
Affect heuristic
judging something as good or bad
Availability heuristic
Relying on knowledge already attained
Anchoring
Focusing on a particular reference point even if it is not relevant or pertinent to the issue in question
Herding
mimicking the actions of a larger group
Active listening
focuses on what the speaker is saying
Reflective listening
focuses on both the content being said and the feelings being expressed by the speaker
Motivational interviewing
focuses on overcoming ambivalence to change
Joining
making a connection with the client and establishing a trusting relationship
When the financial planner recognizes that a money disorder may exist
a referral should be made to a professionally trained financial therapist or mental health professional…
Fiduciary duty
At all times, a CFP professional providing financial advice must act as a fiduciary (act in the best interest of the client)
Duty of loyalty
clients interest ahead of planners and firms. Avoid or disclose, obtain clients informed consent, and manage conflicts of interest
Duty of care
skill, prudence, diligence
Duty to follow client instructions
if reasonable and lawful
Standard of conduct
A. Duties owed to clients
B. Financial planning and application of the practice standards for the financial planning process
C. Practice standards for the financial planning process
D. Duties owed to firms and subordinates
E. Duties owed to CFP board
F. Prohibition on circumvention (don’t go around the rules)
Compensation disclosures
Must be provided to the client prior to or at the time of the engagement. Oral or in writing if advice does not require financial planning. Written if CFP professional is required to provide financial planning in accordance with the practice standards
Fee only
may only be used if no sales related compensation to certificate or related party. Sales based bonus incentives are sales related comp
Fee based
must clearly state fees and commissions or not fee only
Disclosure of compensation
Certificants must disclose issues related to compensation. The specific dollar amount does NOT have to be disclosed unless requested by client, but the sources and calculation of compensation to the certificant, certificant’s employer, or a related party is necessary
Violation of CFP board’s procedural rules will result in one of the following sanctions;
- Private censure
- Public censure
- Suspension (maximum of 5 years)
- Revocation
- Temporary bar (respondent not yet a CFP professional)
- Permanent bar (respondent not yet a CFP professional)
*written notice to certificant’s firm required for public discipline
Principals of the code of ethics
- Act with honesty, integrity, competence, and diligence
- Act in the client’s best interests
- Exercise due care
- Avoid or disclose and manage conflicts of interest
- Maintain the confidentiality and protect the privacy of client information
- Act in a manner that reflects positively on the financial planning profession and CFP certification
Nouns acceptable for use after CFP (registered symbol) and CERTIFIED FINANCIAL PLANNER (registered symbol)
- Professional
- Practitioner
- Certificant
- Certification
- Mark
- Exam
Notice to CFP board: CFP professional must report to CFP board…
within 30 calendar days of BOTH initiation and conclusion:
-charge or conviction of a felony
-charge or conviction of a relevant misdemeanor (including 2nd or more alcohol or drug-related offense)
-conduct mentioned adversely in finding in a regulatory action involving failure to comply with the laws or rules governing professional services (except minor rule violations)
-suspension or revocation of a professional license
-termination for cause from employment involving allegations of dishonesty, unethical conduct, or compliance failures
-filing for a personal bankruptcy in which the CFP professional was a control person
-receipt of notice of a federal tax lien on property owned by the CFP professional
-conduct mentioned adversely in a civil action alleging fraud, theft, misrepresentation, or other dishonest conduct
Note: no need to report if timely & accurately reported on U4
Sanction for failure to timely report information to CFP board…
Public censure
Sanction guidelines for bankruptcies
-Report bankruptcy to CFP board within 30 days and inform client within 30 days
-Material changes and updates to bankruptcy information must be disclosed to a Client within ninety (90) days, together with the location(s) of the relevant webpages
-Any personal bankruptcy or business bankruptcy where the CFP professional was a control person is subject to public censure unless the CFP professional can rebut the presumption or inability to responsibly manage financial affairs
-Single bankruptcy: certificant may accept public censure without hearing or pay hearing fee with expedited adjudication
-Multiple bankruptcies: follow normal adjudication process
When providing financial planning in accordance with the practice standards (disciplinary disclosures)
The client must be provided with written disclosures, including the existence or any public discipline or any bankruptcy, and the web pages of relevant public websites of any government authority, SRO, or professional organization that provides disciplinary history
Monetary policy - feds goals
The fed seeks to support economic growth, full employment, and price stability
Four tools of the federal reserve to control the money supply
- Reserve requirements
- Discount rate (rate at which fed charges banks to meet reserve requirements)
- Open market operations
- Interest rate on required balances and excess reserves
Increases in the money supply causes
decrease in interest rates
Decreases in the money supply causes
increase in interest rates
Fiscal policy
Congress seeks to support economic growth and full employment
Three tools: taxation, spending, and debt management
Demand curve
Downward sloping. This reflects that at lower prices, people demand more of a normal good. At higher prices, people demand less.
Supply curve
Upward sloping. This reflects a producer’s willingness to supply more of a normal good at higher prices. At lower prices, there is less incentive for a producer to supply goods
Equilibrium price or “market clearing price”
Occurs at the point of intersection (where demand and supply curves cross) At that point the quantity supplied and demanded are equal
Change in quantity demanded
Movement along the demand curve driven by price change (price drops, people buy more)
Events that influence change in demand
Shift in demand curve (change in preferences, income, tax policy, etc)
Change in quantity supplied
Movement along supply curve driven by price change
Change in supply
Shift in supply curve (change in technology, competition, etc)
Substitute products
Products that have similar purpose (coffee, tea)
An increase in the price of one good increases the demand for the other good
Complement products
Products that are consumed jointly (coffee, creamer)
An increase in the price of one good decreases the demand for the other good
Inelastic demand
A large percentage change in price results in a smaller percentage change in quantity demanded
examples: necessities (gasoline, pharmaceuticals)
Elastic demand
A small percentage change in price results in a large percentage change in quantity demanded
examples: luxury goods (expensive cars)
unit elasticity
A percentage change in price leads to the same percentage change in quantity demanded
Business cycle
Shows changes in GDP (gross domestic product) GDP is the value of total output within a country (regardless of asset ownership) over a period or time
Gross national product (GNP) is the value of total output by the citizens of a country, regardless of where the production takes place.
Early expansion
Expectations of low inflation and current low interest rates support the expansion. Unemployment decreases as companies increase production. Monetary and fiscal policy actions support recovery. Stock market and housing market are typically strong.
Mid expansion
Fed manages inflation. Consumer demand is increasing but increasing supply helps maintain price levels. Firms may expand capacity. There is little interest rate movement. Unemployment continues to decrease. Consumer sentiment/spending is high. Yield curve likely is upward sloping to indicate interest rates will rise in the future
Late expansion
Price levels increase. Interest rates increase (reflect higher inflation expectations). Unemployment is at lowest level. GDP is highest at peak
Recession
Decline in GDP for 2 or more consecutive quarters. Stock market and housing are in decline. Unemployment rises. Consumer spending is less. Fed will try to stimulate the economy by reducing interest rates. Yield curve may be inverted to reflect expectation of lower rates. Recession bottoms out at trough. Economic forces at work to move into expansion.
Inflation
An increase in general price levels of good and services
If unemployment is high…
you are probably in a trough
Nominal rates of return
Does not consider inflation
Real rate or return
inflation adjusted
Disinflation
A slowdown in the rate of inflation
Deflation
a decrease in price levels
Stagflation
occurs when inflation and unemployment are both high during a period of slow or stagnant economic growth
Consumer price index (CPI)
Measures the overall price level for a basket of consumer goods and services
Producer price index (PPI)
Measures price level changes for materials used at the producer (or manufacturing) level
GDP deflator
A ratio of nominal GDP to real GDP and shows the change in the value of output that results from inflation
Income statements
Lists income and expenses over a period of time
Balance sheet
Lists assets, liabilities, and net worth at a moment in time
Assets are listed in what order on balance sheet
-Current assets
-investment assets
-personal use assets
How is cash value of life insurance generally classified on a balance sheet
Generally classified as an investment rather than cash/cash equivalent unless the client intends to borrow from or surrender policy within one year
Investment assets on a balance sheet typically don’t include
stamps collections, antiques, art. These are considered part of maintaining the quality of life and are not likely to be liquidated for retirement or education goals
Current ratio
Current assets / current liabilities
Savings rate
Annual savings / annual gross income
Savings rate should be greater than or equal to 10% if only goal is retirement. Employer match is included in annual savings total
Emergency fund ratio
Current assets / monthly non-discretionary expenses
This ratio gives the number of months covered. If there is one family income you need 3-6 months of non discretionary expenses; two family incomes requires only 3 months are necessary
Mortgage deduction
Up to $750,000 (for mortgages after 12/15/17; $1,000,000 for mortgages on or before 12/15/17) in acquisition debt can be considered for qualified residence interest itemized deduction
Debt/housing ratios
Principal plus interest plus taxes plus insurance (PITI) = housing cost (HC)
HC less than or equal to 28% of gross income
HC + all other recurring debt payments less than or equal to 36% of gross income
Non discretionary cash flows
Generally include all income statement expenses other than savings, entertainment, and income and payroll taxes (in the event of job loss)
Best asset classes to outpace inflation
Equities are the only asset class than can be expected to consistently outpace inflation and taxes. Historically, real estate and precious metals have also been decent hedges against inflation
Life cycle approach
Provides a general tool for financial planning that profiles a client based on a person’s age and stage. It is most useful when a planner has only partial information.
For example, a young couple with small children have life insurance needs, health insurance needs, education funding goals, housing considerations, as well as retirement and other long term considerations.
Asset accumulation phase for life cycle
20s to mid 50s
Conservation/risk management phase for life cycle
late 20s/early 20s to early 70s
Distribution/gifting phase for life cycle
Mid 40s to life expectancy
Risks and goals during life cycle
Early 20s to mid 60s
Risks
-Untimely death
-disability
-health problems
-unemployment
-loss of property
-loss from liability
Goals
-Financial security
-education funding
-lump sum expenditures
-legacy goals
Quick tip for FDIC insurance
only covers U.S. dollar deposits that are payable in the United States. FDIC insurance does not cover stocks, bonds, mutual funds (including money market funds) or cryptocurrency. Money market deposit accounts ARE covered.
FDIC Insurance
Applies only to deposit accounts (checking, savings, money market deposit accounts, CDs). FDIC insurance does not apply to stocks, bonds, mutual funds, money market mutual funds, insurance products, annuities, or cryptocurrency.
Insurance is per category/type of ownership. Within an insured institution, a person has $250,000 of insurance for all of their single accounts combined, $250,000 for their interest in all of their joint accounts combined, $250,000 total for certain retirement accounts (Traditional, roth, SEP, SIMPLE IRAs), $250,000 as beneficiary of a trust account (max 5 beneficiaries = $1,250,000 max per grantor in aggregate for all types of trust, including POD accts, effective April 1, 2024)
Chapter 7 bankruptcy
liquidation
Debtor gets a discharge from all but non-dischargeable debts. Student loans (unless meets “undue hardship” exception), back taxes (past 3 years), alimony or child support, are non-dischargeable debts. Other non-dischargeable debts are from “bad acts” such as fraud, misappropriation, etc. Debtor turns all non exempt assets over to trustee for liquidation
Protected assets:
-IRAs
$1,512,350; as indexed (through April 2025 when the next increase will occur)
-IRA rollovers
Unlimited (if not commingled with regular IRA contributions)
-Qualified plans
Unlimited
-Inherited IRAs
Not protected
-Pensions, life insurance, annuities
Chapter 11 bankruptcy
generally for business reorganizations
Chapter 13 bankruptcy
Adjustments of debts for individuals (means tested - repayment period is 36-60 months) Debtor keeps some non-exempt assets
Workers compensation laws and unemployment
Place absolute liability on the employer. Benefits are not taxable.
Unemployment compensation is funded by employer payroll tax. Benefits are taxable.
Retain risk
If event rarely occurs and loss is not significant
Retain risk but use risk reduction measures
Event occurs regularly and loss is not significant
Insure the risk
Event rarely occurs and loss is significant
Peril
Cause of a financial loss (fire, theft, collision, hurricane)
Hazard
Condition that increases the likelihood that a peril will occur
Physical hazard
Example: storing gasoline too close to an open flame (may cause a fire)
Moral hazard
Dishonesty; example - an insured files a fraudulent claim
Morale hazard
Carelessness; insured does not take proper precautions to protect an asset because asset is insured
Life insurance strategy
Mitigates against: loss of lifetime income due to early death
Metric: 12-16 times gross pay
Needs approach and human life value method may be used to determine insurance coverage
Health insurance strategy
Mitigates against: Loss of income and increased costs due to unforeseen accidents or illnesses
Metric: An appropriate plan for your health care needs
ACA (health care reform) has removed lifetime limits on major medical expenses
Disability insurance strategy
Mitigates against: Loss of income and increased costs due to unforeseen accidents or illnesses
Metric: 60-70% of gross pay; should cover sickness and accident
Should be guaranteed renewable or non-cancellable
Long term care insurance strategy
Mitigates against: increased costs of custodial care for elderly
Metric: Daily (or monthly) benefits greater than or equal to average cost of an appropriate facility
Benefits should be inflation adjusted. Benefit period greater than or equal to 36-60 months.
Homeowners insurance strategy
Mitigates against: property losses
Metric: less than or equal to full replacement value on both dwelling and content. Coverage for both should be open perils
A homeowner with a standard HO3, HO4, or HO6 policy should endorse personal property for open perils and replacement value. HO15 is a rider that adds opens perils coverage for personal property. Add HO15 if you have an HO3 policy because HO3 policies cover personal property on a broad peril basis.
Automobile insurance strategy
Mitigates against: Property losses
Metric: less than or equal to full fair market value for collision and comprehensive
Liability coverage is a necessity
Personal liability insurance strategy
Mitigates against: costs that arise from negligence or other acts for which the insured is held legally responsible
Metric: Minimum $1 million personal liability policy
May need to increase underlying liability coverages on homeowners/auto policies to satisfy PLUP issuer
Quicktip on education tax credits
Cannot use both the American Opportunity tax credit and the lifetime learning credit for expenses incurred by the same person in the same year
529 plans
(prepaid tuition plan, savings plan)
generally considered to be a parent asset for financial aid purposes. Unused funds from account open at least 15 years can be incrementally rolled into Roth IRA as a current year contribution (lifetime max: $35k)
No phaseout for contribution eligibility
Maximum contribution of $180,000 for a couple. 5 years of the annual gift tax exclusion amount of $18,000 X 5 years X 2 spouses
Can use up to $10,000 for payment of student loans
Can use up to $10,000 per year for tuition for elementary or secondary public, private, or religious school
10% penalty and included in gross income if not used for qualified education expenses. Exceptions of 10% rule include: death, disability and scholarship for beneficiary
Coverdell
(Contribution limit $2,000/year per beneficiary)
Funds must be used by age 30. No contributions past 18th birthday. Owner may change beneficiary. Used for college, secondary, or primary education. Generally considered to be a parent asset for financial aid purposes.
10% penalty and included in gross income if not used for qualified education expenses
high phase out for contribution eligibility
Traditional IRA and Roth IRA for education
10% penalty waived on non-qualified distribution for education
high phase out for eligibility
EE or I bonds for education
Purchased in parents name (at least 2 years old at time of purchase) No income tax on interest if used for qualified education expenses. Must be redeemed in same year expenses are incurred. May convert into 529 plan or Coverdell.
lower phase out for eligibility
UGMA, UTMA
Custodial assets. Unearned income may be subject to kiddie tax (children under 19, or a full time student under age 24). Considered assets of child. UTMA can include real estate
Grants
Pell, FSEOG - needs based
undergraduate only
Stafford subsidized
Stafford (subsidized) undergraduate
Need based
Stafford unsubsidized
Graduate or undergraduate - non needs based
PLUS loan
Parent loans for undergraduate students
Undergraduate only - not need based.
Student PLUS loans available for graduate students.
American opportunity tax credit
1st 4 years of post secondary education
100% of first $2,000, 25% of next $2,000 of qualified education expenses
Maximum annual credit is $2,500 per student
Lifetime learning credit
20% of up to $10,000 of qualified expenses
It is a per family credit
maximum credit is $2,000 per year. Lifetime usability
Securities act of 1933
Required full disclosure about new security issues. Registration statement must be filed with SEC. One portion is the prospectus. AKA paper act
Securities exchange act of 1934
Regulates secondary market. Established SEC as agency in charge of regulating securities laws, exchanges, and their members, brokers, and dealers.
Maloney act of 1938
Amended to act of 1934. Allows establishment of trade association to self-regulate the securities industry (FINRA; formerly NASD)
Investment company act of 1940
Defines/regulates investment companies (open-end, closed-end, UIT)
Investment advisors act of 1940
Defined an investment adviser (ABC - provides Advice, is in Business of providing advice, and received Compensation for providing the advice) Investment advisers must register at state level (assets under 100m), with SEC (assets more than 100m) assets between 100m and 110m you can choose to register with state or SEC.
The act provides exclusions for Lawyers, Accountants, Teachers, and Engineers (LATE) as well as, broker/dealers, US government securities dealers, banks, and publishers of bona fide newspapers). The act also provides an exception for foreign advisors who had fewer than 15 clients in the last 12 months and do not hold themselves out to the public as an investment advisor
“The PUBLISHER was BROKE because he was LATE to the US BANK”
Securities exams
SIE: securities industry essentials: prerequisite to series 6 or 7
Series 6: Investment company products/variable contracts representative (sell mutual funds and variable insurance products - must hold insurance license to sell insurance products
Series 7: General securities rep (Sell general securities: stocks, bonds, options. Excludes commodities and futures)
Series 24: General securities principal (supervise and manage branch activities)
Series 26: Investment company products/variable contracts principal (supervise/manage sales activities for investment company products
Series 63: Uniform securities agent state law exam (solicit orders for securities in their state)
Series 65: NASAA investment advisors law exam (be an investment advisor representative)
Series 66: NASAA Uniform combined state law exam (satisfy completion requirement of both the series 63 and 65)
Sarbanes-Oxley act of 2002
Protects against corporate fraud, established corporate board structure and membership guidelines, created oversight board to monitor accounting industry, and required instant disclosure of stock sales by corporate executives
FINRA (Financial Industry Regulatory Authority)
An independent regulator of securities firms conducting business in the United States. The primary goal is to protect investors by maintaining fairness in the U.S. capital markets. Persons register with FINRA using Form U4
Advantages of LLC over S-corps
LLCs have several advantages over S-corps. LLCs can specially allocate income and deductions. S-Corps must allocate on pro rata ownership basis. S-Corps are limited to 100 owners. There is no maximum number of LLC members. S-Corps have limitations on ownership - only U.S. citizens/residents may be shareholders; partnerships and corporations may not be shareholders. LLCs do not have these restrictions
Sole Proprietor
Liability: unlimited
number of participants: 1
Taxation: individual level; must file form 1040, schedule C.
Income (reported on form 1040 schedule C)
is self employment income
General partnership
Liability: unlimited
number of participants: more than 1, no maximum
Taxation: flow through, must file form 1065
Income (reported on schedule K-1) is self employment income
Limited partnership
Liability: Limited
number of participants: at least 1 general partner and 1 limited partner, no maximum.
Taxation: Flow through, must file form 1065
Income (reported on schedule K-1) is self employment income for the general partner, may or may not be for limited partners
Family limited partnership (FLP)
Limited for limited partners; unlimited for general partner (though GP often retains small percentage ownership (such as 1%)
number of participants: more than 1, no maximum
Taxation: taxed as partnership, entity form 1065, schedule K-1s issued to general and limited partners
Purpose is to transfer assets to younger generations using annual exclusions and valuation discounts for minority interest and lack of marketability. FLPs, if properly structured, work extremely well for estate planning.
Limited Liability Partnership (LLP)
Liability: limited
number of participants: more than 1, no maximum
taxation: flow through, must file form 1065
Income could be self employment or ordinary reported on Schedule K-1
Limited Liability Company (LLC)
Liability: limited
number of participants: 1 or more members
taxation: Can be taxed as a sole proprietorship (file form 1040, schedule C) partnership (file form 1065), corporation (file form 1120), or s-corporation (file form 1120S)
income could be self employment, W2 income and ordinary income, W2 income.
Note: partnerships (in addition to LLCs) may also be taxed as another type of entity by filing form 8832 - entity classification election.
S-Corporation
Liability: limited
number of participants: no more than 100 shareholders
Taxation: flow through, must file form 1120S
Owners’ income flows through on schedule K-1. Employee’s income is reported on W2. Owner employees receive both schedule K-1 and W2
Corporation
Liability: limited
number of participants: no restrictions
taxation: Entity level - corporation pays tax, must file form 1120
Income (reported on W2 and form 1099-div) could be W2 income and dividend income
Ordinary Annuity
Payments occur at the END of each period
Used for debt repayments (car loans, mortgages, bank loans, student loans, credit cards) because interest is charged from day one but is paid in arrears
Annuity Due
Payments occur at the BEG (beginning)
Generally used for retirement funding and education funding. One needs money on the first day of retirement or college - not at the end of the month
Serial payment
A stream of cash flows where each payment increases at a constant rate over time, often at the rate of inflation
Risk defined for insurance purposes
Loss or no loss
Pure risk
insurable
Speculation risk
gain or loss (investment)
Fundamental risk
impersonal group risk (recession)
Particular risk
personal (your disability)
Static risk
caused by other than changes in the economy (earthquake)
Dynamic Risk
Caused by changes in the economy
Avoid the risk
Event occurs regularly and loss is significant
Insurance underwriters duty
Manages adverse selection of the insurance portfolio by using techniques on the front end (physicals for life insurance, history of claims for property insurance, etc.) and on the back end (raising premiums, canceling insured with excessive claims, etc.)
Insurable risk requirements “CHAMP”
Catastrophic -Losses cannot be Catastrophic to the insurer
Homogeneous-There must be a large number of homogeneous exposures
Accidental-Losses must be accidental as to the insured
Measurable and Predictable -Risks must be measurable and determinable
Social insurance
Mandatory in nature - examples include social security and workers compensation
Public insurance
mandatory in nature - examples include FDIC, SIPC, and PBGC
Private insurance
voluntary in nature - examples include insurance on the person, property, or liability
SIPC insurance (securities investor protection corporation)
Securities investor protection act of 1970
Protects investors from losses resulting from broker dealer failures. Does not insure against poor investment decisions
Covers up to 500k held with an investment company covered under SIPC. 250k in cash, 250k in securities
Areas of Law - ACT
Agency, contracts, torts
Contract law - 6 factors (CALLCO)
Consideration
Acceptance
Legal object
Legal form
Competent parties
Offer
Principal of indemnity
Cannot make a profit - idea is to make one whole after loss
Insurable interest
Insurable interest is required…
for life: at inception only
for property: at the inception and at the time of loss
Contract is personal
Cannot be transferred or assigned without the consent of the insurer with the exception of life insurance
Contract of adhesion
Ambiguities are charged to the writer/insurer, a take it or leave it contract. No negotiation, approved as is for sale in state by the state insurance commissioner.
Statements by the insured are representations not warranties, and must be material to void contract
Insurance contract breaches when
when one party in the contract does not fulfill their contractual duties
Contract is aleatory
parties may not give and receive equal dollar amounts (insured pays premiums and has no claims) the outcome is affected by chance
Contract is unilateral
one promise only and made by the insurer and conditional (conditioned on the insured paying premiums)
Tort Law
-Typically insurance covers for negligent and not intentional acts caused by the insured
-Children and minors may be held liable/parents may be vicariously liable for acts of children
-Damages may be compensatory. If the injury is a bodily injury, it is not taxable. Punitive and compensatory damages without bodily injury are subject to income taxation
-Defenses include: assumption of the risk, contributory negligence, comparative negligence, and last clear change.
-The statute of limitations for tort decisions may be up to two years (up to 3 years for property damage). It is recommended to have a personal liability umbrella insurance policy PLUP which covers the risk and also provides legal defense
Comparative negligence
If both the plaintiff (injured party) and the defendant contribute to the circumstances that result in injury, then the damages are adjusted to reflect their respective percentage of fault
Contributory negligence
If the injured party CONTRIBUTED in any way to the circumstances that result in injury, then the injured part cannot collect any damages
Agency law
An agency and agent binds the principal if in course and cope of agency
May result from express, implied, or apparent authority
Express authority
The explicit powers and permissions granted to an agent through a written agreement with the insurance company
Insurer is responsible for acts of an agent based on express authority
Implied authority
That which the PUBLIC BELIEVES, and a valid agency agreement exists.
The actual delivering of an insurance contract and accepting a premium is an example of implied authority
Insurer is still responsible if client is misled
Apparent authority - think “acting”
When the insured believes that agent has authority to act on behalf of the insurer when in fact, no authority actually exists.
Could be inferred based on business cards or sign on the wall, but the agency agreement is actually expired.
If an agents represents that insured can pay premiums late, but is wrong, the insurer is still responsible
General agent
represents one insurer, such as Geico
Independent agent
Represents multiple, unrelated insurers
Insurance broker
Represents the policy owner, not the insurance company
Subrogation
The insured cannot receive compensation from both the insurer and the third party for the same claim
after insured collects compensation from insurer, insurer then steps in the shoes of the insured to recoup any restitution from the 3rd party or the 3rd party’s insurer
Void contract
Contract was never valid and thus never came into existence. it is not an enforceable contract since it lacks one of the four elements
Voidable contract
A valid contract that allows cancelation by one of the parties however the other party is bound by the agreement
example: a minor enters into a contract to purchase a car, the contract is valid but voidable by the minor. The car dealership is bound to the contract
Warranty
Promise made by the insured to the insurer
A break of warranty is ground for avoidance
Insurance regulations and ratings
Regulation is by the state insurance commissioner
NAIC (National association of insurance commissioners) policy group
Rating by A.M best (A++ - S), Moody’s (Aaa - B3), S+P(AAA-B)
Needs appoach
the present value of dependent needs, including last medical, funeral, adjustment period, mortgage payment fund, dependency cost of living, education fund, and retirement fund
Human life approach
the present value of income expected less taxes and decedent consumption
Capitalization income approach
Decedent’s income (less taxes and consumption) divided by the inflation adjusted investment rate
Bounded rationality
rationality is limited by the available information, the tractability of the decision problem, the cognitive limitations of their minds, and the time available to make the decision. Decision makers in this view act as “satisficers” seeking a satisfactory solution rather than an optimal one.
One consequence of this concept is that having additional info does not lead to an improvement in decision making due to the inability of investors to consider significant amounts of info
Confirmation bias
people tend to filter information and focus on information supporting their opinions
Cognitive dissonance
the tendency to misinterpret information that is contrary to an existing opinion or only pay attention to info that supports an existing opinion
Disposition effect
AKA regret avoidance or “faulty framing” where normal investors do not mark their stocks to market prices. Investors create mental accounts when they purchase stocks and continue to mark their value to purchase prices even after market prices have changed.
Familiarity bias
Investors tend to overestimate/underestimate the risk of investments with which they are unfamiliar/familiar
Gambler’s fallacy
investors often have incorrect understanding of probabilities which can lead to faulty predictions. Investor may sell stock when it has been successful in consecutive trading sessions because they may not believe the stock is going to continue an upward trend.
Hindsight Bias
Looking back after the fact is known and assuming they can predict the future as readily as they can explain the past
“hindsight is 20/20”
Illusion of control bias
people overestimate their ability to control events, for example, it occurs when someone feels a sense of control over outcomes that they demonstrably do not influence
Overconfidence bias
An investor that listens mostly to himself or herself, overconfident investors mostly rely on their skills and capabilities to do their own homework or make their own decisions. This effect causes many investors to overstate their risk tolerance.
Prospect theory
Provides that people value gains and losses differently and will base their decisions on perceived gains rather than perceived losses. Investors are “loss averse” and have an asymmetric attitude to gains and losses, getting less utility from gaining, say, $100 than they would if they lost $100.
Recency bias
giving too much weight to recent observations or stimuli ; for example, focusing on short term past performance
Self attribution bias
you give yourself credit for all the good outcomes and any bad outcomes are due to outside factors
Similarity heuristic
used when a decision or judgment is made when an apparently similar situation occurs even though the situations may have very different outcomes
Taxation of life insurance death benefits
Generally not taxable to recipient except for transfer for value rule or a cash value policy held by a qualified plan
Transfer for value rule
When a life insurance policy is transferred for valuable consideration, death benefits may not be fully excluded from income taxation.
Exceptions to the transfer for value rule (i.e death benefits are not taxed) include transfers to: the insured, business partner of the insured (or to the partnership), a corporation in which the insured is an officer or shareholder, and a transferee whose basis is determined by the transferor’s basis (or tax free exchange or gift)
Surrender of policy
taxable to the extent surrender value exceeds premiums paid
exception: viatical settlements or accelerated benefits provision/nontaxable if insured expected to die within two years or chronically ill
Life insurance dividends
not taxable until beyond basis
Insurance loans
taxable if Modified endowment contract and then only to extent earnings are withdrawn as loans (LIFO)
MEC (modified endowment contract)
premium arrangement that fails the 7 pay test. All single premium insurance policies are MEC’s. This does not affect the taxation of DB. However, cash withdrawals (including loans) are taxable on a LIFO basis and are taxable (taxable portion also subject to a 10% penalty if the insured is under 59 1/2) remember, once a MEC always a MEC. Policy exchanged for a MEC is also a MEC
Insurance premiums
not tax deductible for personal or business insurance, except group term insurance
Cash dividend option - insurance
client receives the money and can use it or invest it as they wish
Accumulate at interest dividend option - insurance
the company invests the dividends and they are tax free up to the clients basis in the policy. Interest paid on the dividends is taxable
Reduce premiums dividend option - insurance
Decreases the out of pocket expense for premiums
Paid up additions dividend options - insurance
purchases additional insurance each year for insured regardless of health or occupation
One year term dividend option - insurance
adds term insurance each year to the policy face amount equal to cash value of the policy. Also known as the 5th dividend option on the CFP exam
life insurance nonforfeiture options
Cash surrender value
reduced paid up insurance
extended term insurance
cross purchase agreement
used for buy/sell agreements, protects closely held business partners. Number of policies is N x N-1
Advantage: step up in basis for remaining partners
Disadvantage: cost of policies may differ greatly due to age differences among owners
Entity purchase agreement
aka stock redemption plan
one policy per principal, owned by entity.
disadvantage: no step up in basis for remaining partners
Tax treatment for deceased/disabled owner - business insurance
when partner dies, his/her business interest gets step up in basis equal to fair market value at time of death (so no capital gain must be recognized) Not so with disability buy-sell. As such the capital gain on the sale of the disabled partner’s business interest can be significant
Personal liability policy (PLUP)
Look for $1m in coverage
provides legal defense - at no cost against the policy limits
usually covers personal injury liability, plus liability of libel, slander, and defamation
excludes rental property (possible exception) business liability, vehicle racing, intentional acts
Medicare
Federal health insurance plan for people who are 65 and older, whether retired or still working. People who are receiving social security disability for 24 months can qualify for Medicare. 5 month elimination period.
Those 65 or older and receive social security benefits automatically qualify. If not yet receiving social security benefits at age 65, you must enroll in Medicare
Medicare part A
Hospital insurance (covers places):
-inpatient hospital care
-skilled nursing care following a covered hospital stay (3 nights and then move to skilled nursing)
-home health care
-hospice
Covers:
-semi-private room, meals, operating and recovery room, lab tests, x-rays
Does not cover:
-custodial services (LTC)
Medicare part A benefit periods
Benefit period begins on 1st day in hospital and ends after 60 days of no further skilled care
Deductible is $1,632 per benefit period, 1st 60 days
Coinsurance
-$408 per day for days 61-90
-$618 per day for days 91-150 (lifetime reserve days - total of 60)
-$204 skilled nursing care days (21-100)
The amounts just double
One quarter of earnings for social security
$1,730 of earnings
Medicare Part B
Monthly premium for standard part B is $185
deductible is $257
Does not cover:
-Dental care
-Cosmetic surgery
-Hearing aids
-Eye exams
-Routine physical exams
-Care received in foreign country
Medicare part C
Medicare advantage or medicare managed care plan
You must have medicare part A and B and live in the plan’s service area to be eligible to join
in addition to your part B premium, you usually pay one monthly premium for services included in Medicare advantage plan
always covered for emergency and urgent care. Medicare Advantage plans must offer emergency coverage outside of the plans service area (not outside of U.S.). Might offer dental care, eyeglasses, or wellness programs. Could also include prescription drug coverage (part D)
Medicare Part D
Intended to save participants money on prescription drugs. Out of pocket spending cap is $3,300
Long term disability
covers the loss of income due to disability
typically covers periods when the insured is unable to work due to suffering an accident or sickness
amount of benefits: needs to be 60-70% of gross pay
Period or benefits: until retirement or for life
Elimination period: 30-180 days (serves as a deductible)
may be integrated with social security to reduce premiums in group plans
Any occupation disability
Most lenient. Covers you if you are unable to perform the duties of any occupation (least expensive)
Own occupation
covers you if you are unable to perform the duties of your own occupation (most expensive)
Split definition disability
starts as own occupation for usually two years, then converts to any occupation
Residual clause for disability
provides some benefits for returning to work in a lower paid position
Disability policies must be non-cancellable and guaranteed renewable
Non-cancellable: insurer cannot cancel and can’t raise premium
Guaranteed renewable: insurer cannot cancel but can raise premiums, but only if raised on entire group
Long term care private policies
Medicare does not provide LTC.
LTC must be either be non cancellable or guaranteed renewable
Eligibility: cannot perform two of six ADL’s (eating, bathing, dressing, transferring, toileting, or continence) for at least ninety days or substantial cognitive impairment. remember “BEDToChair”
small federal income tax deduction for premiums paid
BAP
Business auto policy, similar to PAP
CPP (commercial package policy)
Property and liability similar to homeowners insurance
Workman’s comp
Worker gets injured or sick on the job. employer is completely liable. mandatory for employers
CLUP
Commercial liability umbrella policy (similar to PLUP)
Professional liability insurance
Malpractice insurance: covers negligent acts that can result in bodily injury (think doctors)
Errors and Omissions (covers negligent acts)
Business provided insurance
Premiums are not deductible except for group term
Can provide long term care insurance on a group basis
Employer provided group term insurance
not taxable to employee for 1st $50,000 of death benefit coverage
split dollar
shares costs and benefits between key employees and entity. Any payment made by employer to split dollar plan is either: a loan (collateral assignment method) or as taxable compensation (endorsement method). If loan interest is zero (below market rates) difference between market rate and actual rate is treated as taxable compensation to employee. Employee and employer typically split the premiums and the benefit.
Disability for businesses
May be group disability for employees - fringe benefit and taxable to employees
Indemnity health insurance plan
pay for losses/ has deductible/ coinsurance on major medical and stock loss provisions/ doctors are independent
HMO
Uses co-pay/doctors are employees of HMO
can typically only use in network providers, usually cheaper
PPO (preferred provider network)
uses co-pay. Doctors are independent of insurer. Doctors agree to charge reduced rates in exchange for increased patient volume.
In network or out of network. Discounted rates for in network, more expensive than HMO
POS (point of service) health insurance
combines HMO/PPO/Indemnity - as insured moves among providers deductibles, co-pays change accordingly
EPO (exclusive provider organization)
similar to HMO but no referral needed to see a specialist
ACA Obama Care plans
Bronze: plan pays 60% on average
Silver: plan pays 70% on average
Gold: plan pays 80% on average
Platinum: plan pays 90% on average
Catastophic: plans pays less than 60% on average. Available only to people under age 30 or those with a hardship exemption
Plans no longer have a lifetime limit or pre-existing condition clause
COBRA
Applies to any employer who has a health plan and 20 or more employees. Employee must be already part of the group plan
Total expense to employee of 102% of actual insurance cost
Employer must offer coverage for
-18 months for reduction in hours or normal termination
-36 months for death, divorce, medicare eligibility
-36 months for loss of dependency status by children of employee
-Up to 29 months if employee meets SS definition of disabled
Employees have 60 days to make COBRA election
HSA high deductible plan limit requirements
Must have high deductible health plan to start an HSA.
Health insurance deductible: single - $1,650, family - $3,300
Max out of pocket: single - $8,300, family - $16,600
HSAs allow for $1,000 catch up contribution (55 and older)
Nonqualified distributions: Ordinary income tax and 20% penalty if under 65
can be used to pay for LTC premiums
Contributions through payroll are exempt from FICA
FSAs (flexible spending accounts)
Used by employers as an employee benefit that permits employees to defer income ($3,200 limit for 2024) to be used to pay for health care expenses with pre tax dollars. limit for dependent care FSA if $5,000
Use it or lose it. No carry over to next year. Must use for medical expenses by 2 1/2 months after the end of year or forfeit back to company.
Cannot pay for LTC. Contributions thru payroll are exempt from FICA
Major categories of social security benefits
- retirement benefits
- disability benefits
- family benefits
- survivor benefits
- medicare
- supplemental security income (SSI) benefits. SSI benefits are not funded by social security taxes
FICA tax
OASDI is 6.2% (both EE and ER have to pay this) up to wage base of $168,600
Medicare is 1.45% (both EE and ER have to pay this) on an unlimited amount of wages
Additional medicare tax of 0.9% (EE) on income in excess of $200,000 if single or $250,000 for MFJ (unlimited amount of wages)
Taxation on annuities
Withdrawals prior to the start of the annuity
-pre 1982: FIFO
-post 1982: LIFO
know how to calculate exclusion ratio
Flood insurance
not included in homeowners policies. need to buy as separate policy
A flood policy has a 30 day waiting period until it kicks in from purchase
There is a 1 day waiting period if flood insurance is elected within 13 months following a map update to include your residence
Inland marine
coverage that is usually included on homeowners policy as a scheduled endorsement. $1,500 is standard coverage
-personal furs
-jewelry
-silverware floater coverage is the same as jewelry
-Golf equipment covers equipment kept in locket at clubhouse
-camera, fine art and antiques, stamp and coin collection, musical instruments, wedding presents, and personal property floaters
Social security disability eligibility
Covered for disability if:
-age 31 and greater; fully insured (40 quarters) and earned 20 quarters in the last 40 quarters
-24-31; 1/2 of calendar quarters elapsed since worker reached age 21
-if ages 21-24; 6 quarters earned
-currently insured has no spousal benefit
Social security definition of disability
disability is expected to last for 12 months or disability will result in your death AND cannot perform the duties or any occupation
Social security benefit reduction
Before full retirement age, reduction = 5/9 times months up to 36 months plus 5/12 for additional months beyond 36. For example, if FRA is 67, then only 70% of benefit (PIA) would be received at age 62.
67-62 = 60 months
First 3 years: 36 x 5/9 = 20%, plus
Next 2 years: 24 x 5/12 = 10%
total reduction is 20% + 30% + 10% = 70%
Social security earnings test
Benefit may be further reduced if earnings are too high (benefit is reduced $1 for every $2 above threshold)
In year in which full retirement age is reached, reduction is $1 for every $3 above a higher threshold
Social security divorced spouse benefit
Divorced spouse benefits may be better than benefits for the current spouse. Divorced spouse benefits are not subject to the family maximum. Also, none of the family beneficiaries can begin receiving benefits UNTIL the covered worker begins to draw benefits except a divorced spouse who is (age) eligible.
Social security income tax hurdles
MFJ 1st hurdle: $32,000, 2nd hurdle: $44,000
All others except MFS 1st hurdle: $25,000, 2nd hurdle: $34,000
-SS subject to tax: 0-85%
-Below first hurdle: 0 tax
-85% of SS benefits will be subject to tax when MAGI is above approximately 150% of the second hurdle
-about 20% to 25% of SS benefits will be subject to taxation at the second hurdle
Named perils policies
Basic: 12 perils
broad: 12 + 6 = 18 perils
open: all perils covered unless excluded (general exclusions are flood, intentional loss, earth movement, neglect)
Personal property and liability insurance
Take picture of chart
Investment policy statement
Written document that provides general guidelines for the investment manager. Consists of objectives (risk and target return) and constraints (time horizon, taxes, liquidity, legal considerations, unique needs/special circumstances) Does NOT identify specific investments
Holding period return
Not a compound rate of return. There is no consideration for time an investment was held. HPR questions will come from margin returns or after tax returns (best to calculate on a per share basis).
Sale price - purchase price +/- CF / Purchase price or equity invested
Made / paid
Arithmetic mean
simply sum the number and divide by “n”
Geometric average
compound rate of return. It will always be less than or equal to arithmetic mean.
Use PV (use -$1), FV (calculate HPR), n, then solve for “i”
use this instead of formula provided (HPR)
Weighted average
Portfolio expected return, portfolio beta, and portfolio duration are all calculated as weighted averages.
Standard deviation of a portfolio is NOT a weighted average (except when correlation is +1.0)
Standard deviation of a portfolio will be LESS than weighted average when correlation coefficient is less than 1
Real rate of return
use with education funding and retirement needs questions
Tax adjusted return
used to determine the after tax rate of return
after-tax return = pre tax return (1 - marginal rate)
When to use securities cash flows
IRR, yield to maturity, yield to call, time-weighted return
When to use investor’s cash flows
dollar-weighted return (use the investors cash flows)
Required return
Use CAPM to determine the required rate of return on an investment given its systematic risk
Expected return
Use current price and expected future cash flows to calculate the expected return on an investment
-required return < expected return = invest
-required return = expected return = invest
-required return > expected return = do not invest (asset is overvalued)
Actual return
use with sharpe, treynor, and jensen to determine risk adjusted performance
Difference in geometric mean and arithmetic mean
The arithmetic mean is more misleading with larger variations in returns. Consider a stock purchased for $100 that increases to $200 at the end of the first year and then decreases to $100 at the end of year 2. Arithmetic return equals 25% (100% + (50%)) / 2. Geometric return equals 0%
Sharpe
Excess return (rP - rF) divided by total risk (standard deviation); relative risk measure
higher the better
Treynor
Excess return (rP - rF) divided by systematic risk (beta); relative risk measure
higher the better
Jensen’s Alpha
Portfolio return minus CAPM (uses beta); absolute risk measure
formula is provided
higher the better
Information ratio
-Ratio of a portfolio’s return in excess of the returns of a benchmark (such as an index) to the standard deviation of those excess returns (tracking error).
-The ratio indicates the portfolio manager’s ability to consistently beat the index.
-The higher the IR, the more consistent the manager is in generating excess returns. —Relative risk adjusted performance measure
Which measures should be used to evaluate a manager’s performance?
High r-squared, all three measures are reliable (sharpe, treynor, jensen’s alpha)
Low r-squared, use sharpe (bad beta)
Coefficient of determination
r-squared
you find r-squared by squaring the correlation coefficient
if r-squared if .70 or greater, use BETA.
if r-squared is less than .70, use STANDARD DEVIATION
If the exam doesn’t give you r-squared, use SHARPE
PE ratio
-Market price of the common stock divided by EPS (earnings per share)
-How much investors are willing to pay for each dollar of earnings
-Growth stocks tend to have high PE ratios
-Value stocks tend to have low PE ratios
Price/EPS
Earnings per share EPS
(net income - preferred dividends) divided by # common shares outstanding
Easy way to solve for EPS = Price / PE
Qualified annuity taxation
?
1035 exchange
life insurance to life insurance = no tax
life insurance to annuity = no tax
annuity to annuity = no tax
life insurance to MEC = no tax
MEC to Annuity = no tax
MEC to MEC = no tax
MEC to life insurance = no tax
annuity to life insurance = taxable event
annuity to MEC = taxable event
Once an annuity, always an annuity
P/CF ratio
-Market price of the common stock divided by cash flow
-Useful ratio for evaluating non-dividend paying firms
Disadvantages of PE ratio
PE ratio has certain inherent limitations. Earnings are accounting based and thus do not reflect cash flow (or free cash flow), which is central to equity valuation. PE ratios also tend to be lower during times of higher inflation. Finally, keep in mind the difference between trailing and forward PE ratios
P/S ratio
-Market price of the common stock divided by sales
-Useful ratio for evaluating non-dividend paying firms or firms with low or negative profits
PEG ratio
-Stock’s PE ratio divided by 3.5 year growth rate of earnings
< 1.0, stock may be undervalued; PE ratio is less than average growth in earnings
If > 1.0, stock may be overvalued; PE ratio is greater than average growth in earnings
Standard deviation of a portfolio
SD of a portfolio will always be LESS THAN the weighted average of the standard deviations of the assets that comprise the portfolio **
If the correlation between the assets is perfect positive (i.e. +1.0) then the portfolio standard deviation will be EQUAL to the weighted average
Total risk of a security or portfolio
Systematic risk (beta) + unsystematic risk (SD)
Systematic risk
PRIME - Beta
undiversifiable risk. it’s in the “system”
Purchasing power risk
Reinvestment risk
Interest rate
Market risk
Exchange risk
Unsystematic risk
ABCDEFG
diversifiable risk. think company specific risk.
Accounting
Business
Country
Default
Event/Executive
Financial
Government/regulatory
Measures of total risk - 4 measures
-Standard deviation
-Variance
-Coefficient of variation: relative risk
-Semi variance: measures downside risk (measures volatility of returns that fall below the mean)
Kurtosis
A measure that indicates whether a distribution is more or less peaked than a normal distribution.
A distribution that is more peaked than normal is leptokurtic (think Leap over something) this is positive kurtosis
Platykurtic distributions have flat tails (think flat and plat) This is negative kurtosis
Mesokurtic is a normal distribution
Yield curve theories
Attempt to explain the shape of the yield curve
Expectations of yield curve
Expectations of inflation and the effect on future short-term interest rates determine shape - could explain normal and inverted curves
Liquidity preference - yield curve
investors accept lower yields for short term investments (prefer liquidity) and require premiums for longer term maturities - explains only a normal curve
Market segmentation - yield curve
the supply/demand for funds in ST and LT markets determine share of yield curve - could explain normal and inverted curves
Weak form of efficient market hypothesis
Past prices and volume information is reflected in asset prices
Investor cannot use technical analysis to achieve risk-adjusted excess returns
but they can use fundamental analysis and insider info
Does not support market anomalies
Semi-strong form of efficient market hypothesis
Historical and public information will not help investors achieve above average market returns. Insider information would be useful
investor cannot use technical analysis or fundamental analysis to achieve risk-adjusted excess returns
Does not support market anomalies
Strong form of efficient market hypothesis
All historical, public and private information is reflected in asset prices
investor cannot achieve risk-adjusted returns
rejects technical, fundamental analysis, and insider info.
go with an index
(think random walk theory)
Does not support market anomalies
Skewness
a distribution that is not symmetric is skewed
Negative skewness
distribution skewed to the left
Positive skewness
distribution skewed to the right
Lognormal distributions
bound by zero to the left and are positively skewed. A random variable follows a lognormal distribution if its nature logarithm is normally distributed. Asset prices may be lognormally distributed (prices cannot be negative)
Measure of systematic risk
Beta
-Market beta = 1.0
-Asset with 1.5 beta is 50% more volatile than the market
-Asset with .75 beta is 25% less risky (volatile) than the market.
r-squared should be high to ensure reliability of beta. More than .70
Portfolio risk
-Portfolio risk combines the individual risks of securities along with their interactive risk
-Standard deviation of a two asset portfolio
Respite care
provides families that are primary caregivers a professional to ensure their loved one is taken care of while they run errands, go to their own appointments, or take time to rest while their family member still receives the care they need.
provided at state and local level
Residential services
help individuals choose, obtain, and remain in community settings that enable them to live as independently as possible
provided at state and local level
Transportation services
allow individuals with restricted mobility to obtain assistance for transportation to doctor’s appointments and other needs
provided at state and local level
Assumption of Risk
You love car racing and attend a race knowing there’s a small chance a car could crash and fly into the stands. If that occurs, you may not be able to blame anyone since you knew the risk and decided to take it anyway.
Assumption of risk is a common defense used against charges or negligence along with contributory negligence
Long call
Buys the option
receives the RIGHT, but not the obligation, to buy the underlying asset at a predetermined price (strike price).
BULLISH
In the money: when stock price is more than strike price
Out of the money: when stock price is less than strike price
Short call
Sells the option
Obligated to sell asset at strike price of long position exercises
BEARISH
In the money: when stock price is less than strike price
Out of the money: when stock price is more than strike price
Long put
Buys the option and receives the right, but not the obligation, to sell the underlying asset at the strike price.
BEARISH
in the money: when the stock price is less than strike price
out of the money: when the stock price is more than strike price
Intrinsic value of a call
Stock price - strike price
Intrinsic value of a put
Strike price - stock price
Short put
Sells the option. If the long position exercises the option, the short position is obligated to buy the underlying asset from the long position at the strike price
BULLISH
in the money: when stock price is more than strike price
out of the money: when stock price is less than strike price
Binomial pricing model
Attempts to value an option based on the assumption that a stock can only move in one of two directions
For example, over the short-term you have determined that a security, now worth $10, will either be $12 or $8
Think tree graph
Black Sholes Option pricing model
Used to determined the value of a CALL option
Considered the following variables:
-Current price of the underlying security
-Time until expiration
-The risk free rate of return
-Volatility of the underlying asset
-Strike (exercise) price
all variables have a direct relationship on the price of an option, except the Exercise price. The higher the Exercise price, the smaller the call option premium.
Arbitrage pricing theory (APT)
-Asserts that pricing imbalances cannot exist for any significant period of time; otherwise investors will exploit the price imbalance until the market prices are back to equilibrium
-APT is a MULTI-FACTOR MODEL that attempts to explain return based on factors. Anytime a factor has a value of zero, then that factor has not impact on return
-APT attempts to take advantage of pricing imbalances
-inputs are factors such as inflation, risk premium, and expected returns and their sensitivity to those factors
Standard Deviation and Beta are NOT input variables for the APT
Factors necessary for determining duration of a bond
-Yield to maturity
-Time to maturity
-Coupon rate
Put/call parity
Attempts to value a PUT option based on the value of a corresponding call option
Flat markets for options traders
Better for option seller (writer, short position). The seller collects the options premium and hopes that stock price movement will negate the profit
if flat markets, you should sell a call or sell a straddle
Volatile markets for options traders
Better for option buyer (if speculating). There must be enough movement in the price of the underlying asset for the option buyer to recover the premium and make a profit
Hedging a futures contract
Position 1 - long the commodity, short the contract
Position 2 - short the commodity, long the contract
Option strategy that can result in maximum gain
Buying a call
Riskiest option position
Selling a naked call
Time value for an option
Premium - intrinsic value
Protective option strategy
Short stock/ long call
Portfolio insurance - option strategy
Protective strategy
Long stock/ long put
Short straddle
Income strategy, does not expect volatility
Short call/short put
Long straddle
Expecting volatility
Long call/long put
Collar strategy
Protects gain in appreciated stock
Long stock, then short a call, long a put.
Concentrated stock positions lack diversification; however, selling a large amount of the position in one year can cause substantial capital gains or initiate net investment income tax. A collar strategy can be used to spread the sale over multiple tax years while protecting the gain
covered call income strategy
Long stock/short call
LEAPs
Long term anticipation securities - similar to exchange traded puts and call but with expirations extending out to three years
Warrants
Like a call option issued by a company (bond). Often included in a new debt offering to make the bond more attractive to investors
expiration period is much longer than options, usually 5-10 years
Stock rights
Rights granted to existing shareholders to purchase new shares of a new stock issue before it is offered to the public. This allows shareholders to maintain their existing proportionate share of the company following a new equity offering
If trend of market is increasing, which strategies have a positive expected outcome
-Short a put
-long a call
-long the stock
-long the futures contract
If trend of market is decreasing, which strategies have a positive expected outcome
-Long a put
-short a call
-short the stock
-short the futures contract
Duration (Macaulay)
Time-weighted payback: the weighted average maturity of a bond’s cash flow. The greater the duration the more sensitive a bond’s price it to interest rate changes.
Three variables to determine a bond’s duration: coupon rate, YTM, time to maturity
Interest rate variables relationship to duration and convexity
The INterest rate variables are INversely related to duration and convexity
Immunization for a bond
Occurs at the point of duration. At that point (in the life of a bond) the interest rate risk and the reinvestment rate risk exactly offset one another.
Should be equal to or less than the investors time horizon
Bond convexity
Describes the ACTUAL relationship between bond price and changes in interest rates. “Convexity is my friend”
The greater a bond’s convexity, the greater the increase in price when interest rates fall, and the less the bond falls in value when interest rates increase.
Buying stock on Margin
When the stock price falls below the trigger price, the equity percentage has fallen below the required maintenance level and a margin call will result. Initial margin is set at least 50%, maintenance has to be at least 25%
Loan / 1 - maintenance margin
Short sales
Sell high, buy low
Short seller is responsible for dividends paid during short sale period
Rate anticipation swap - bonds
if interest rates are expected to increase, reduce duration of a portfolio. You would swap long duration bonds for shorter duration bonds
If interest rates are expected to decrease, increase duration of a portfolio. You would swap short duration bonds for longer duration bonds
Tax swap - bonds
Swap a bond (with a capital loss) for a similar bond. Be careful - avoid “wash sale” rule
Pure yield pickup swap - bonds
Swap lower coupon bond for a higher coupon bond to pick up yield
bond ladder
A portfolio of bonds with staggered maturities (short and long term). Maturing bonds are reinvested in long term bonds
bond barbell
Portfolio consists of bonds with short term and long term maturities. Strategy requires periodic rebalancing
Bullet strategy
Bonds with similar maturities are focused around a point of time
Duration of a zero coupon bond
The duration of a zero coupon bond = its maturity;
the duration of a coupon-paying bond is less than its maturity
a zero coupon bond is more interest rate sensitive than a coupon paying bond with same maturity
Forward contract
An agreement (initiated at one time) that involves the purchase of a sale of an asset at a later time. The price and quantity are specified at the inception of the contract. Forward contracts are traded over the counter, with contract terms negotiated between the parties
Future contracts
A “forward-type” contract that trades on an exchange. The contract is standardized (terms, quantity, expiration date). The long position agrees (today) to buy the assets in the future. Short position agrees (today) to sell the asset in the future. For hedging, take the position that is opposite to the current position.
Corn farmer is long corn, so hedge is to go short. Frito Lay inc is short corn, so hedge is to go long
Markowitz and Modern Portfolio Theory
Identifies efficient portfolios (in terms of risk/return). Inputs: asset volatility, security returns, and covariance of returns.
Efficient frontier
Portfolios lying on the frontier are efficient. Portfolios ling below the frontier are attainable but not efficient. Portfolios above the frontier are not attainable.
Modern portfolio theory
The acceptance by an investor of a given level of risk while maximizing expected return objectives.
The efficient frontier is the curve which illustrates the best possible returns that could be expected from all possible portfolios
Indifference curves are constructed using selections made based on this highest level of return given an acceptable level of risk
the steeper the indifference curve, the most risk averse. “I need to get compensated more for taking more risk”
Indifference curves
Constructed using selections made based on this highest level of return given an acceptable level of risk
Capital Market Line (CML)
Shows the risk and return trade off between a risk free asset an a well diversified risky portfolio
USES STANDARD DEVIATION
formula isn’t tested often. Still be familiar with it
Capital asset pricing model (CAPM)
determines required rate of return given an asset’s systematic risk (Beta)
calculates the relationship of risk and return of an individual security using beta as a measure of risk
Security market line
SINGLE FACTOR MODEL
Security Market Line (SML)
Graphical depiction of CAPM
Slope of SML is the market risk premium (rM - rF). Slope becomes steeper if investors become more risk averse (require higher rates of return to invest in the market, instead of investing in risk free assets). SML shifts (no change in slope) when market interest rates change.
if return plots below the line, it is overvalued. if return plots above the line, it is undervalued (getting more return for the same amount of risk)
USES BETA
Coefficient of variation
standard deviation divided by expected return (total risk per unit of return)
Useful when comparing two assets with different average returns
-the higher the coefficient of variation, the more risky an investment and less likely an investor is to achieve the average return
Correlation coefficient
Ranges from -1.0 to +1.0. no risk reduction occurs at perfect positive (+1.0). A correlation of zero indicates that the assets move independently of one another.
If you have perfect negative correlation, it drastically reduces risk but does not completely eliminate risk.
formula for correlation: covariance / product of the two standard deviation of the portfolios
Covariance
A measure of how much two assets move together
a measure of relative risk
If the correlation coefficient is know, or given, covariance is calculated as the deviation of investment “i” times the deviation of investment “j” times the correlation of investment “i” to investment “j”
Formula: COVij = correlation of i and j times SD of i and SD of j
Coefficient of determination
known as r-squared, this statistic tells us the percentage of variation in portfolio returns that is explained by the variation in the benchmark returns.
if r-squared is equal to or greater than .70, use BETA.
Calculating bond valuation
Enter FV, n, PMT, i, then solve for PV.
Calculating YTM
Expected rate of return on a bond.
Enter FV, PMT, PV (enter PV as a negative number), n, then solve for “i”
Calculating YTC
Enter FV (call price), PMT, PV (enter PV as a negative number), n (number of periods until callable), then solve for “i”
Current yield
Annual coupon interest / current bond price
Calculating conversion price of a convertible bond
bonds par value / number of shares per bond
Interest rate relationships for premium bond
CR > CY > YTM
think alphabetically
Interest rate relationships for discount bond
CR < CY < YTM
think alphabetically
Risks of a bond
-interest rate risk
-reinvestment rate risk
-default risk
-purchasing power risk
Real estate value
NOI / capitalization rate
“net operating income” / capitalization rate
Net operating income (NOI)
Gross income minus vacancy, operating expenses, property taxes.
Do not subtract depreciation, income taxes, mortgage payments/interest from total revenue to calculate NOI.
Closed-end fund
Fixed capitalization
The shares trade in the secondary market. Price is determined by the supply and demand for the shares. Shares tend to trade at a discount or premium relative to NAV.
Open-end fund
Capitalization is not fixed
Allowed to issue an unlimited number of shares. Shares are bough and sold through the investment company and the price is based on NAV.
Unit investment trusts (UITs)
unmanaged portfolio of stocks and bonds. The trust has a finite life and is sometimes described as a self liquidating portfolio. UITs may have income and or capital appreciation objectives. “Units” (not shares) are sold to investors
Preferred stocks for corporations
Many corporations invest in preferred stock. Corporate investors tend to like the fixed nature of preferred dividends. Also, at least 50% of dividends received by a corporation (common and preferred) are excluded from taxation
Date of record
The date on which you must be a registered shareholder in order to receive the dividend
Date of record is the same day as the ex dividend day
Regular way settle is T+1 so must buy trading day before date of record
Ex dividend date
Date the stock trades without the dividend.
To receive the dividend, an investor must purchase the stock prior to the ex dividend date.
Stock dividends
Not taxable to the shareholder until the stock is sold
lowers your basis per share
Cash dividends
Qualified dividends receive capital gains treatment
cash dividend is taxed upon receipt
Conversion value of a convertible bond
Conversion ratio (par value divided by conversion price) times the stock price.
Mortgage backed securities (MBS)
An asset backed security that represents a claim on the cash flows generated from a pool of underlying mortgages. GNMA, FNMA, FHLMC. Investors receive their pro rata share of interest and principal. Subject to repayment risk, interest rate risk, purchasing power risk, and default risk (not GNMAs)
Collateralized mortgage obligations (CMOs)
mortgage derivatives backed by residential mortgages. Different investment classes (tranches) have different maturities and risks. Interest payments and all principal payments flow to tranche 1 until it matures. Tranche 1 has the shortest maturity, least risk, and lowest expected return. Z-tranche has the longest maturity
REITs
Securitized real estate. Three types: equity, mortgage, and hybrid. Must distribute at least 90% of its taxable income to shareholders annually. At least 75% of gross income must be real estate related or cash
low correlation with stock market
American Depositary Receipt (ADRs)
A security issued by a domestic bank that represents shares of foreign stocks (deposited in a foreign custodian bank). ADR investors face foreign exchange risk even though they are denominated in dollars
does not eliminate exchange rate risk
Yankee bonds
US dollar-denominated bonds issues sold in U.S. by foreign firms/governments. U.S. Yankee bond investors are not exposed to foreign currency risk
Treasury strips
Zero coupon bonds created from coupon interest and principal payments that are “stripped” from treasury notes and bonds. STRIPS have considerable interest rate risk, but no reinvestment rate risk.
I bonds
Non-marketable. Redeemable after 12 months (with 3 months interest penalty). No interest penalty for redemption after 5 years. Fixed rate plus variable semiannual inflation adjustment
Accrues are paid at redemption
Subject to federal tax. Can be deferred until redemption. May be excluded from fed tax when used for education.
Unbiased expectations theory
Related to the term structure of interest rates. The theory holds that today’s longer term interest rated have imbedded in them expectations about future short term interest rates. Long term rates are geometric averages of current and expected future shorter term interest rates.
The formula for the UET is the same as the formula for geometric mean. The compound return equals the Nth root of the product of 1 plus the returns minus 1. As with GMR, the equation can be solved using TVM keys
Active (ordinary) income
Uses Cash Method of accounting. Doctrine of constructive receipt.
Classifying gains: the type of asset that was held
Portfolio income
Uses accrual method of accounting. Economic benefit doctrine.
Classifying gains: The use to which the asset was put
Passive income
Uses hybrid method of accounting. Doctrine of the fruit and the tree.
Classifying gains: The holding period (how long the asset was held)
Cash basis method of accounting
a cash basis taxpayer is deemed to receive income when it is credited to the taxpayer’s account, set apart for the taxpayer, or made available to be taken into the taxpayer’s possession. Most individuals use this
Constructive receipt doctrine
Accrual basis method of accounting characteristics and doctrine
accrual basis taxpayers recognize income when it is received (or set aside). most businesses use this. Taxpayers report an amount in their gross income on the earliest of the following dates:
-when payment is received
-when the income amount is due to the taxpayer
-when the taxpayer EARNS the income
Economic benefit doctrine
Capital assets
They can use it for personal purposes (personal use assets)
Tax free rental activities
Anti-abuse provision: Alternative minimum tax AMT
Ordinary income assets
They can use it in the active conduct of a trade of business (business assets)
Ordinary rental use activities
Anti-abuse provision: At risk rule limitations
IRC Section 1231 assets
They can use it for the production of income production of income assets)
Mixed use activities
Anti-abuse provisions: passive activity rules
Revenue rulings
Final regulation: Procedural regulations
U.S. Tax Court
Private letter rulings
Final regulation: Interpretive regulations
U.S. District court
Determination letters
Final regulation: legislative regulations
U.S. Court of federal claims
Main components of federal income tax
-Property taxation deals with acquisitions, holdings, and dispositions.
-Income taxation generally follows form 1040.
Statute of limitations
In general: 3 years
Understatement of gross income > 25% : 6 years
Fraud: no limit
Collection of deficiency by IRS: 10 years
Refund claim by taxpayer: 3 years
IRS Tax penalties
Failure to file: 5% per month up to 25%
Failure to pay: 0.5% per month up to 25%
Accuracy related: 20% of underpayments up to 30% (40% if due to substantial valuation misstatement, substantial overstatement of pension liabilities, or substantial estate or gift tax valuation understatement)
Fraud: 75%
Failure to file penalty is reduced by failure to pay penalty.
Partial months are counted as whole months (45 days = 2 months)
Tax court
Type of case: tax only
Required to pay tax: No
Maximum amount of claim: N/A
Jury available? No
Location: around the U.S.
Where are appeals brought: U.S. Court of Appeals
Tax court - small claims
Type of case: tax only
Required to pay tax: No
Maximum amount of claim: $50,000
Jury available: No
Location: around U.S.
Where are appeals brought: No appeals
U.S. District Court
Type of case: All types
Required to pay tax: Yes
Max amount of claim: N/A
Jury available? Yes
Location: around U.S.
Where are appeals brought: U.S. court of appeals
U.S. Court of Federal Claims
Type of case: Claims against U.S. government
Required to pay tax: Yes
max amount of claim: N/A
Jury available? No
Location: D.C. only
Where are appeals brought: U.S court of appeals - federal circuit
Taxable income
Income - deductions = taxable income
Tax liability
Taxable income X tax rate = tax liability
Gross income exclusions
-Interest income from Muni bonds
-Child support received
-cash or property received by inheritance
-specified employee fringe benefits
-qualifying distributions from Roth IRA during retirement
-Cash or property received by gift
-deferral contributions to certain retirement plans
-gain on sale of a principal residence
-scholarship or fellowship
-life insurance death benefit proceeds
Gross income inclusions
-Gains from sale of assets
-Distributions from retirement plans
-Rental income
-unemployment benefits
-royalty income
-compensation
-interest and dividend income
-alimony received pre 2019 divorce
-gross income from self employment
List of deductions FOR AGI
-Contributions to traditional IRAs
-Business expenses (all business deductions are for AGI)
-Student loan interest paid
-Rental or royalty income expenses
-losses from sale of business property
-moving expenses (armed forces)
-Keogh contributions
-1/2 Self employment tax
-HSA deduction
-alimony paid (pre 2019 divorce)
-Capital losses (up to 3k per year)
Surviving spouse tax filing
Surviving spouse will generally file MFJ in the year in which their spouse dies.
Qualifying child must meet these tests. Think “SARA”
Must meet all four tests: SARA
- Support test
- Abode test
- Relationship test
- Age test (under 17)
Qualifying relative: 4 tests (GRNS)
In addition to the joint return test and the citizenship or residency test, qualifying relatives must meet these 4 tests:
- Gross income test
- Relationship test
- Not a qualifying child test
- Support test
Multiple support agreements:
-Taxpayer provides more than 10% of the potential dependents support
-Two or more persons who individually provide more than 10% also provide more than 50% of the individual’s total support, and meets the requirements to claim person as a dependent.
Kiddie tax
Unearned income of a child under the age of 19, or a child under age 24 who is a full time student and is claimed as a dependent by his parents, may be subject to income tax at the parent’s tax rate.
Net unearned income does not include:
-Standard deduction of $1,300 for unearned income
-The next $1,300 of income which is taxed at the child’s marginal rate
-Therefore, the kiddie tax does not apply unless the child has unearned income greater than $2,600.
non-refundable credits
Credits that can be carried back or forward. Most important are the child and dependent care, lifetime learning, AOTC, child tax (refundable up to $1,700 of the $2,000 credit per child), qualified adoption, and foreign tax credits.
Refundable credits
Credits that can generate a refund. Most important are the AOTC (refundable up to 40% or $1,000), earned income credit, and child tax credit up to $1,700.
Child or dependent care credit
Qualifying child < 13 years old. $3,000 for one child/$6,000 for 2 or more children. Subject to earned income, 20% general to 35% of actual expenditure ($0-15k income) Typical credit: $3,000 x 20% = $600, $6,000 x 20% = $1,200
If married, both parents must work or go to school
Wash sale rule
Disallowed loss when a taxpayer disposes of securities at a loss and acquires substantially identical securities within 30 days before and after the date of the loss sale.
Index fund for index fund - wash sale rule applies
Index fund for managed large cap fund - wash sale doesn’t apply
Taxation on personal use assets
Gains: short term or long term capital gains
Losses: may not be recognized or deducted
Taxation on capital assets
Gains: short term or long term cap gains
Losses: capital loss (deductible to extent of capital gains plus $3,000, can be carried forward)
Taxation on trade or business
Gains: short term or long term capital gains
Loss: ordinary loss (deductible against ordinary income)
Taxation on trade ordinary income
Gains: ordinary income
loss: Ordinary loss (deductible against ordinary income)
Foreign tax credit
take credit or itemized deduction
Child tax credit
$2,000 for each qualifying child < 17 years old (U.S. citizen, 1/2 support, lived with claimant for > 1/2 of the year). Phaseout MFJ $400,000/$200,000 others/ Lose $50 per $1,000 over. Any additional tax credit unused up to $1,700 may create a refund.
Gains normally tax when realized
Gains from property transactions are taxed when they can be objectively determined through a sale or exchange (realization)
investment items included in gross income
-Capital gains
-Interest income
-Original issue discount bonds (OID)
-Accrued income when transferring a debt instrument (gift or sale)
-Dividend income
Income from annuities
Contract is annuitized when regular periodic payments begin for life or for a specified period of time in excess of one year. Use inclusion/exclusion ratio.
Inclusion/Exclusion of compensation for damages from injuries
Bodily injury: compensatory damages excluded, punitive damages included
Personal injuries not including bodily: compensatory damages included, punitive damages included
Lost income: compensatory damages included, punitive damages included
Any other type of injury: compensatory damages included, punitive damages included
Foreign income
Taxpayer can exclude up to $126,500 for 2024 of foreign earned income, or taxpayer can claim a credit for some or all of the taxes paid to the foreign country or taxpayers foreign taxes paid may be deducted as an itemized deduction
Fringe benefits
Require the employer to not discriminate against different classes of employees, especially employees who are not highly compensated
Highly compensated employees
Employees who:
-Hold a GREATER than 5% ownership interest or have compensation in excess of $155,000
-individuals who may enjoy fringe benefits: worker, spouse, dependents, retirees
-Health insurance = employer premiums deductible/no inclusion
Group term life insurance
An employer can deduct the cost of up to $50,000 of group term life insurance for each employee, and the employee can exclude the premiums paid by the employer from gross income
Meals and lodging provided by employer
Employees can exclude the value of meals and lodging provided by employer on the employer’s premises and for the convenience of the employer
No additional cost servies
Exclude value of any service provided to the employee by the employer if:
-offered for sale to customers
-in the line of business in which the employer works
-the employer incurs no substantial additional costs
Qualified employee discounts
Discounts for merchandise is limited to the gross profit percentage multiplied by the retail price. Discounts on services cannot exceed 20 percent of regular price.
A working condition fringe benefit can be excluded from the employee’s gross income; not subject to nondiscrimination requirements (e.g. company car)
Qualified transportation fringe benefits
The 2017 TCJA disallows a deduction by the employer after 2017 for expenses associated with providing any qualified transportation fringe to employees of the taxpayer, and except as necessary for ensuring the safety of an employee, any expenses incurred for providing transportation(or any payment or reimbursement) for commuting between the employee’s residence and place of employment.
Qualified moving expense reimbursement
2017 TCJA suspends the deduction for moving expenses for tax years 2018 to 2025, except for members of the armed forces on active duty who move pursuant to a military order and incident to a permanent change of station
Value of the use of athletic facilities
The value of use of on-premises gyms and other athletic facilities can be excluded from an employee’s income if:
1. the facilities are located on the premises of the employer
2. The employer operates the facilities
3. Substantially all the use of the facilities is by employees of the employer, their spouses, and their dependent children
Employer educational assistance program
The value of education assistance provided by employer to employee can be excluded from employee’s gross income up to $5,250 per year
Dependent care assistance
up to $5,000 of dependent care costs paid for by employer can be excluded from gross income. Dependent must be under age 13.
Employee achievement awards
Awards and prizes are normally includible in an individual’s gross income. The max amount that an employee can exclude $1,600 ($400 for awards that are not “qualified plan awards”) The award must be “tangible personal property” and cannot be cash, gift cards, vacations, sporting events, etc.
Cafeteria plans - 2 types of benefits
Allows employees to choose between cash and certain nontaxable benefits
if cash is chosen, the amount received is taxable
if a nontaxable benefit is chosen, the benefit remains untaxable
LTC plans are NOT allowed in cafeteria plan
Non Qualified Stock Option (NQSO) taxation
At grant date: No income tax consequence if exercise price is greater than or equal to FMV
At exercise date: ordinary (W2) income = FMV - exercise price
At sale date: long term or short term capital gain/loss depending on holding period from EXERCISE. Basis = FMV at date of exercise
Incentive stock option (ISO) taxation
At grant date: no income tax consequence if exercise price is greater than or equal to FMV
At exercise date: No ordinary income. AMT preference = FMV - Exercise price
At sale date: If stock was held for 2 years from date of grant and 2 year from date of exercise then the gain is LTCG. If holding period is not met (disqualified disposition) then bargain element is treated as ordinary W2 income
Hobby losses
Not deductible. Mixed use real estate is treated as a hobby.
Three tier deduction system for hobbies and mixed use real estate:
1. Interest and taxes
2. operating costs
3. Depreciation (there are no net losses)
Personal home that is rented out partially
No income if rented < 15 days
Rental property turns into mixed use property when
Used personally for more than the greater of 14 days or 10% of rental days
Specific deductions
Bad debt - use cash basis
Worthless securities - go to year end to determine long or short term (capital loss)
1244 stock - first $100,000 is deductible as ordinary loss if MFJ ($50,000 if filing other). Balance of loss is capital loss.
Personal losses - not deductible
NOLs - no carrybacks. Carry forward (up to 80% of income)
Specific tax penalties for IRAs
-6% excise tax on excess contributions to IRAs
-10% early distribution penalty (prior to 59 1/2)
-25% for failure to take RMDs beginning at age 73 (for those who turn age 72 after 2022; age 75 for those who turn age 74 after 2032)
Other tax disallowances
1031 tax free exchanges - realized losses added to basis
Wash sale - the loss is deferred back and added to new basis
Related party transactions - double basis rule
Gifts below FMV - double basis rule
Double basis rule
When the FMV of gifted assets is less than the donor’s basis (lost property)
Basis to donee is FMV for losses, donor’s basis for gains, and no gain or loss if sold between the FMV and the donor’s basis.
Holding period for donee starts on the date of the gift
Recourse debt
Allows the lender to pursue the borrower’s personal assets for satisfaction of the indebtedness. Recourse debt adds to a taxpayer’s basis.
Nonrecourse debt
Cannot be recovered tax-free by taxpayer and is not added to basis
Items included in basis
-Purchase price
-Sales tax
-Freight
-Installation and testing costs
-“all costs to get the asset income operations”
Increases to basis
Additions to the investment
amortization of the discount on bonds purchased below face value
loans taken out for operation of a business
Decreases in bases
-Distributions from business entities that have pass through tax treatment (such as partnerships, LLCs, and S corporations)
-Depreciation deductions taken
Basis of inherited property
The fair market value of the assets on the date of the decedent’s death.
The basis of IRD assets do not receive a step to fair market value at the death of the transferor. IRD assets were not subject to ordinary income tax during the life of the transferor. IRD assets include things like IRAs, annuities, installment notes, and back wages payable to the decedent. IRD assets are included in the gross estate and subject to income tax when received by beneficiary. There is an income tax deduction for the estate tax attributable to the IRD assets (IRC 691(c) deduction)
Determining basis of gifted property with gift tax already paid
Donor’s basis + (net appreciation in value of gift / value of taxable gift) x gift tax paid
Basis of property transferred between spouses or incident to divorce
Section 1041 state that, regardless of whether property is sold or given to a spouse, the basis of the original owner spouse will carry over to the new owner spouse. This treatment is mandatory
Related party transactions for sales, gifts, and basis - IRC section 267
When property is sold to a related party and the sale with results in a gain to the selling part, the normal basis rules apply. If property is sold to a related party at a loss, the seller is not permitted to deduct the loss and the double basis rule applies
Basis of jointly held property
Always use actual contribution rule, except for spouse. For spouses, use deemed (50%) contribution rule, except for tenants in common (use actual).
Bonus depreciation for qualifying MACRS property
For qualified investors, a 40% bonus depreciation is available in the year the asset is placed in service, for new or used assets placed in service in 2024.
Modified Accelerated Cost Recovery System (MACRS). What type of property does it apply to
Applies to most types of depreciable property placed in service after 1986.
Use of MACRS on real estate
If real estate is used for residential rental purposes, the property is depreciated according to the straight-line depreciation method over 27 1/2 years. If real estate is commercial, depreciation occurs on straight line basis over 39 years.
Use of MACRS on personalty property (class lives)
3 year class life: autos used as taxis, hogs used for breeding, racehorses
5 year class life: most cars, trucks and airplanes, heavy construction equipment
7 year class life: office furniture, fixtures, and equipment
10 year class life: vessels, barges, tugs and water transportation equipment
15 year class life: improvements to land
20 year class life: farm buildings
Double declining balance method
Known as “200 percent method”
Used to depreciate assets that have a 3,5,7, or 10 year class life, then switch to straight-line depreciation when the straight-line method would produce a greater deduction than the double declining balance method.
doubles the straight line percentage. Half year convention permits 1/2 of deduction in first year. Thus for the first year, 33.33% of the basis will be deducted for 3-year property, 20% for 5-year property, and 14.29% for 7 year property
150 percent declining balance method
Used for property in the 15 and 20 year class life, then switches to straight line deprecation when the straight line method would produce a greater deduction for the current tax year.
Amortization of intangible assets
Intangible assets, such as the goodwill of a business, may be amortized on a straight-line basis over 15 years (180 months)
Section 179
Provides business owners with an options to elect to expense property placed in service during the year instead of capitalizing the assets and depreciating them using MACRS. To qualify, an asset must be used more than 50 percent of the time in a trade or business. Immediately expense up to $1,220,000 unless phaseout has been met. Reduced dollar for dollar for depreciable property placed in service during the year that exceeds $3,050,000
cannot results in a loss. max deduction is limited by the income of the business.
Additional limitations to section 179 expense election
The maximum section 179 expense that can be elected with respect to a sports utility vehicle is limited to $30,500.
1231 asset taxation
Sold for gain: Capital gains (part or all gain may require recapture as OI)
Sold for loss: ordinary loss treatment
Netting capital gains and losses
1256 contracts
Futures contracts, foreign currency contracts, nonequity options, dealer equity options.
Any gain or loss shall be treated as:
short term capital gain or loss, to the extent of 40 percent of such gain or loss
and
long term capital gain or loss to the extent of 60 percent of such gain or loss
Recapturing depreciation on personal property section 1245
For personalty used in a trade or business or for the production of income, depreciation is recaptured as ordinary income to the extent of the gain. 1245 applies to gain resulting from a reduced basis due to depreciation.
Compare the purchase price to the sales price. If sales price exceeds purchase price, the difference is capital gain. Any other gain is ordinary.
Treatment of gain under section 1231 for real property section 1250
1250 gain applies to realized gain on real property where the accelerated method was used. The lesser of the gain or the difference between depreciation taken and straight line depreciation is taxed as ordinary income.
if the gain exceeds the amount calculated above, the lesser of the remaining gain or the straight line depreciation taken on the property will be taxed at 25% (this is the “unrecaptured section 1250 depreciation”)
any gain in excess of the above two calculations is taxed at capital gains tax rates (0% to 20%) depending on tax bracket
Tax rates for corporations
Ordinary income and capitals gains are the same rates for corporations
Like-kind exchanges - section 1031
First determine whether the taxpayer is trading up or down. Taxpayers who receive only like kind property (real estate only) in the exchange will not have any current income tax consequences. The basis that they have in their investment, will be increased by any additional capital investments made. If taxpayer is receiving a more valuable asset, they will not generally recognize any gain, but will increase basis.
The party trading down (receiving less like kind property than given up) will be required to recognize gain to the extent of boot received. If boot exceeds gain, the amount in excess of gain is treated as a return of capital.
Debt relief is treated as boot, requiring gain recognition for the party no longer responsible for paying back the debt. The party assuming the debt will increase their basis in the replacement property by an equal amount.
Losses realized in a like kind exchange are not recognized until the replacement property is sold. The taxpayers basis in the replacement property equals the FMV of the property received in the exchange plus disallowed loss.
Recognized gain is the lesser of the realized gain or the net boot received
Like kind exchange property
Must have similar characteristics and nature.
Real estate exchanges:
-Improved realty may be exchanged for unimproved realty
-US realty, however, may not be exchanged for foreign realty
-Foreign realty may be exchanged for foreign realty
A replacement property must be identified within 45 days of the sale of the original property. The closing must take place by the earlier of 180 days from sale of original property, or the due date (including extensions) of the tax return for the year the original property was sold
involuntary conversions - section 1033
To avoid the recognition of the gain on an involuntary conversion, the taxpayer must reinvest the proceeds in a replacement property that has similar use to the property that was involuntarily converted either: 2 years from the end of the year, (12/31) in which realization (not the event) occurs, 3 years if caused by government, or 4 years if presidentially declared national disaster.
Section 1041
Under IRC section 1041, ALL transactions between spouses or incident to a divorce results in a carry over basis and carry over holding periods.
Section 121 personal residence sale
Taxpayer must have owned and used home for 2 out of the last 5 years. Has to be at least 2 years since he excluded gain on previous house.
If a principal residence is sold before the 2 year ownership and use test is met, or if the exclusion was used during the last 2 years, it may be possibly to qualify for a reduced exclusion. This is available when the sale of the principal residence is caused by: 1. change of employment, 2. a change in health, 3. unforeseen circumstance
number of month of use (or last exclusion) / 24 x applicable exclusion ($250k or 500k)
Passive activity rules
Anti-abuse provisions and apply to individuals, estate and trust, certain personal service corporations, and closely held regular corporations. these rules are intended to limit and/or suspend losses from businesses in which the taxpayer does not materially participate.
Active income
Income earned through the active conduct of a trade or business and earned from the provision of labor. Generally, active income is taxed at ordinary income tax rates.
Portfolio income
Interest, dividends, and capital gains. Some portfolio income is subject to ordinary income rates. Qualified dividends are capital gains
Passive income
includes income generated from all rental and real estate activities (unless specific exceptions are met) and income generated from trade or business activities when the taxpayer receiving the income does not materially participate in the conduct of that trade or business.
Passive activity
Passive income or loss is derived from the conduct of passive activity. Section 469 defined a passive activity as any activity:
-in which the taxpayer does not materially participate
-that is a limited partnership interest, or
-that is a rental activity, even if the taxpayer materially participates in the activity
Material participation
> 500 hours devoted to activity
100 hours devoted to activity and the most of any participants
100 hours devoted to several activities that add to more than 500 hours
Grouping of passive activities
it is possible to group several passive activities into an “appropriate economic unit”
Limitations imposed on passive losses
Passive losses are subject to 3 primary limitations: the basis limitation, the at risk rules, and the passive activity loss rules. When a taxpayer generates a loss that is considered passive, each of these limitations must be applied in sequence.
The basis limitation
The first limitation that is imposed on the deductibility of passive losses is the basis limitation. This states that the maximum allowable loss that the taxpayer can deduct is equal to his or her basis in the investment
At risk rules
The second test after the basis rule has been applied.
At risk rule states that a taxpayer may not deduct, in the current tax year, more than the amount that they have “at risk” for in the investment
Passive activity loss rules
After basis rule and at risk rule have been applied, then use passive activity loss rule.
Losses falling into the passive activity bucket from a passive activity can only be offset against gains that are in the passive activity bucket, unless special exceptions apply.
Suspended passive losses are fully deductible upon disposition of the trade or business
Suspended losses when taxpayer dies
If asset is stepped up, reduce the suspended losses by the amount stepped up
if asset is stepped down, deduct the full suspended loss
Passive activity loss exception
Real estate professionals exception and individual investor exception
the individual investor exception allows individual taxpayers who actively participate in rental real estate activities to deduct up to $25,000 of losses from that activity against non passive income for the year.
There are some limitations to the $25,000 loss deduction, however. In order to qualify, the taxpayer must:
-Actively participate in the activity
-own at least 10% of the value of the real estate, and
-have AGI equal to or less than $100,000-$150,000 (including the phaseout)
Summary of itemized deductions and AMT
Home mortgage interest
Deduction for regular tax: qualified mortgage interest only
Deduction for AMT: qualified mortgage interest only
Medical
Deduction for regular tax: excess above 7.5% AGI
Deduction for AMT: same
Taxes
Deduction for regular tax: property/sales/use/and ad valorem
Deduction for AMT: taxes are not deductible, except tax on qualified motor vehicles
Difference in deduction: lose all tax deductions under AMT (add all back except tax
on qualified motor vehicles)
Miscellaneous
Deduction for regular tax: not deductible if subject to 2% of AGI
Deduction for AMT: none
Difference in deduction: lose all miscellaneous itemized deductions (add back with
exceptions)
Charitable
Deduction for regular tax: Regular rules
Deduction for AMT: same as regular
Private activity muni bonds
This interest must be added back to regular taxable income to arrive at AMTI
incentive stock options - AMT
While the exercise of ISOs does not impact the taxpayer’s regular tax liability, it may result in the imposition of the AMT. The difference between the value of the stock on the date of exercise and the strike price of the option must be added to taxable income to arrive at AMTI
Summary of AMT investment related changes
Private Activity Muni Bonds
Regular tax: not taxable
AMT: taxable
Difference: AMT preference item
NQSOs
Regular tax: at exercise W2 income
AMT: same
Difference: none
ISOs
Regular tax; at exercise no regular tax
AMT: at exercise AMT income to extent FMV > strike price
Difference: AMT at exercise
Chartable deductions
the max deduction for charitable contributions is limited based on:
1. the type of property
2. the type of charity
3. the use of the property donated
The types of property are cash, ordinary income property (including short term capital gain property) and long term capital gain property.
Types of charities
Public (red cross)
Private (including private foundations and charitable lead trusts)
Charitable contribution deduction limits
Retirement funding basic percentages
SS benefits are skewed- 70% WRR for low income with same age non working spouse
Appropriate withdrawal rate - generally 4-5% but early significant losses can be devastating
Benchmark for investment assets as a percentage of gross pay
Age and investment assets as a ratio to gross pay
25 yo - 0.20:1
30 yo - 0.6-0.8:1
35 yo - 1.6-1.8:1
45 yo - 3-4 :1
55 yo - 8-10:1
65 yo - 16-20:1
Qualified pension plans - DCMT
Defined benefit
Cash balance
Money purchase
Target benefit
DB(k)
Qualified profit sharing plans
Profit sharing
401(k)
Stock bonus
ESOP
Age Based Profit sharing
New comparability
Thrift plan
Other tax advantage plans
IRAs
Roth IRAs
403(b)
SEPs
SIMPLEs
SARSEPs
Non-qualified plans - deferred comp plans
ISOs
NQSOs
ESPPs
Rabbi Trusts
Secular Trusts
Phantom stock
promise to pay
restricted stock
457 plans
Features of Qualified plans
- Employer contributions are deductible
- Employee contributions are deductible (except thrift and roth)
- Employer contribution not subject to payroll tax
- Employee Contributions are subject to payroll tax (except FSA)
- Earning within the trust are tax deferred (until distribution)
- ERISA non-alienation of benefits (IRAs are protected under federal bankruptcy law, but not ERISA)
- NUA (no age requirement, taxation and cost basis is ordinary, taxation of NUA is LTCG - must be lump sum)
Eligibility - plan testing
Age 21 and 1 year [1,000 hrs] in a 12 month period. Exception 2 years, 100% vesting - exception does not apply to 401(k) plans. In 2025, long term part time employees (2 years of service with greater than or equal to 500 hours) age 21+ are eligible to participate in 401(k) plans
highly compensated
Either a greater than 5% owner or compensation greater than $155,000. Exception is compensation greater than $155,000 and in the top 20% of paid employees.
Key Employees
Owner or officer
> 5% owner
officer with compensation of $220,000
1% owner with compensation > $150,000
Coverage tests
Must comply with one of the three coverage tests. These all concern the number of NHC employees who are covered..
- General Rule “safe harbor” (plan must cover 70% NHC)
- Ratio percentage test [NHC%/HC% greater than or equal to 70%
- Average benefits percentage test [NHC AB%/HC AB% greater than or equal to 70%]
Additional coverage test: DB only: 50/40 rule [“people come first”] - must cover the lesser of 50 employees or 40% of nonexcludable employees
Annual limits - Defined contribution
Defined contribution limits: IRC 415(c) - defined contribution limits - lesser of 100% of compensation of $69,000 for 2024 - includes contributions from EE, ER, and forfeitures
Annual limits - Defined benefit
$275,000 for 2024. The maximum distribution from a DB plan is the lesser of $275,000 or 100% of the average of the three highest consecutive years of compensation
Annual limits - covered compensation
$345,000 for 2024. Any income earned above this limit is not counted for qualified plans
Plan vesting
Post PPA 2006 (3 year cliff/2 to 6 graded) except for non-top heavy DB plans (5 year cliff/3 to 7 graded)
Cash balance plans - 3 year 100% vesting
DB(k) plans: 3 year cliff for ER contributions and 100% vesting for ER matching. Full vesting at normal retirement and upon plan termination
Top heavy vesting
If the qualified defined benefit retirement plan is top heavy, the plan must accelerate vesting from the standard vesting schedules to either a 2 to 6 year graded or a 3 year cliff vesting to maintain qualified status
Top heavy plans
Plan in which accounts or accrued benefits for key employees exceeds 60% of total for the plan.
1. Accelerated vesting: now only applies to DB plans
2. minimum benefits for non-key employees:
-DC: lesser of 3% or KE percentage if lower
-DB: 2% x years of service, but not to exceed 20%
ADP and ACP tests
The ADP test, typically found in 401(k) plans, limits the average deferral of highly compensated employees based on the average deferral of the non-highly compensated employees.
NHC: 0-2%, highly compensated 2 times the amount
NHC: 2-8%, highly compensated is plus 2 on NHC amount
NHC: 8+%, highly compensated 1.25 time the amount
If a plan rails the ADP test, there are ways to resolve
- Corrective distribution - distributions from HC employees occur until the ADP test is passed
- Qualified non-elective contribution - ER adds funds to all NHC until ADP is passed.
- Qualified matching contribution - ER adds funds to participating NHC until ADP is passed.
QNEC and QMC are both 100% vested. The ACP test is the same except it tests employer matching contributions and employee after tax contributions.
IRC 415(c) limit
The IRC 415(c) is an individual limit - max per employee from one employer. A plan limit of 25% is the max that can be contributed to a plan for all eligible employees.
Plan selection - key points
Age based profit sharing plans and DB plans may be good for older owners
integrated formulas generally benefit higher paid employees
DB plans can allow for higher annual funding above 415(c)limit
401(k) plans allow for higher funding than a SEP or profit sharing plan alone
DB plans and cash balance plans require actuaries and have higher admin costs.
SEPs and qualified plans can be set up after the end of the year
Defined benefit plan characteristics
Annual contribution limit: The greater of sum of the plan’s funding target, target normal cost, and a cushion amount over the value of the plan assets, or the minimum required contribution for the plan year
Investment risk? Employer
Allocated forfeitures? Reduce plan costs
PBGC coverage? Yes (except professional firms with less than 25 employees)
Separate accounts? no
Credit for prior service? Yes
Defined contribution plan characteristics
Annual contribution limit: 25% of covered compensation
Investment risk? Employee
Allocated forfeitures? Reduce plan costs, pay plan expenses, allocate to participants
PBGC coverage? No
Separate accounts? Yes
Credit for prior service? No
Rules when an employer has both DC and DB plan
The general rule is that the total deduction is limited to the greater of 25% of covered compensation or the required DB plan contribution. The combined limit does not apply if the plan is subject to PBGC, is a multiemployer plan, or if contributions do not exceed 6% of compensation. Salary deferrals are ignored for this limit.
Pension plan characteristics
Legal promise of the plan: paying a pension at retirement
In service withdrawals: 59 1/2 only
Discretionary contributions? No
Percentage of plan invested in employer securities: 10%
Qualified joint and survivor annuity and qualified pre survivor annuity? Yes
Profit sharing plan characteristics
Legal promise of the plan: deferral of compensation and tax
In service withdrawals: yes (after 2 years) if plan documents permits
Discretionary contributions? Yes
Percentage of plan invested in employer securities: up to 100%
Qualified joint and survivor annuity and qualified pre survivor annuity? No
A tax deduction for the employer up to 25% of covered compensation
Establishing and funding a qualified plan
-Adoption of a written document - plan must be in writing
-SPD(summary plan description) - must be provided to eligible employees and participants within 90 days of being covered.
-Generally , employers will use a prototype plan with an adoption agreement
-Determination letters - IRS approved plan as written. Does not eliminate possibility of disqualification
-Plans must generally be funded by the due date to the tax return plus extensions
Defined benefit plans
-Standard type formula: x% times years of service time salary
-Example: 1.5% x 30 years x $100k = annual ret. benefit: $45,000 per year for life
-COLA - Government generally yes; private generally no.
-Prior service can be granted for benefits and vesting
-Allocation methods include flat amount, same percentage, and unit credit
Cash balance plans (pension plan)
- Credits to Employee hypothetical account:
A. compensation credit (pay credit) examples:
-3% of salary - it can fluctuate or increase based on years of service
-2.25% for <5 years, 2.75% between 5 and 10 years, 3.25% between years 10 and
20, and 3.75% for 20+ years
B. Interest credit: can be fixed or variable and/or tied to a benchmark. Examples:
-interest rate is based on average interest rate for one year US treasury securities
plus 1%
-4% - CB plans look like DC plans but are DB plans
Money purchase pension plan
-Flat percentage between 0 and 25%. Must be funded annually.
-Could be integrated with social security
Target benefit pension plan
Money purchase pension plan with contributions allocated based on age and compensation. Like an age-weighted profit sharing plan, but a pension plan.
maximum contribution of 25% of covered compensation by employer
412(e) plans
-funded entirely through purchase of individual insurance contracts or annuity contracts - no traditional trust
-The guaranteed rate in the policies is used to establish funding limits for the plan. Since this rate is relatively low, it allows for significantly higher contributions than traditional plans
-IRS has looked at these plans for abuses
-No actuary required
Example: doctor (age 55) wants to establish a qualified plan
Dr has one nurse who is age 25. his 2024 max EE/ER contribution into a DC plan is $76,500 (with catchup). A DB plan could boost his contribution for himself to well over $100,000 for fund the DB annuity. The contribution for the nurse would be relatively low.
Pension benefit guarantee corporation
- All DB plans are subject to PBGC, except professional firms with less than 25 employees
- pension plans pay PBGC yearly insurance premiums: $37 per worker or retiree in multiemployer plans. $101 per worker or retiree plus $52 for each $1,000 of unfunded vested benefits in single employer plans.
- For single employer plans ended in 2024, workers who retire at age 65 can receive up to $85,295 per year
DB(k) plans
Profit sharing plans
Contributions are flexible and discretionary - they should be substantial and recurring
-Allocation methods include same dollar amount to all participants (flat), same percentage, permitted disparity or age weighted
-Permitted disparity (benefits higher paid employees)
-Integration level generally equal to employee’s social security wage base, but not always
-Excess percentage = 2 x base limited to 5.7%
-New comparability formulas are also available and generally skew benefits towards owners. these plans are generally more expensive to maintain.
-Age weighted - contributions are skewed based on age and compensation
Stock bonus plans
Very similar to profit sharing plans. Key differences:
-Pass through voting - participants get voting rights for shares held in a stock bonus plan
-EEs have right to receive ER securities as a form of distribution
-Put options - EEs can sell stock back to plan at FMV
-60 day window after distribution
-Another 60 day window is required in the following year
-Deduction for non cash contribution of stock
-Allocation methods - same as profit sharing plan
-Valuation issue - increases cost for privately held company since there is no readily established market. Must pay an appraiser to value company at least annually
-Concentrated portfolio issues
-Distributions may qualify for NUA treatment
CODAs (401k plans)
ER and EE - double stack - cannot exceed annual additions limit ($69,000), except for catchup contributions
Vesting: EE deferral always 100% vested. Match & ER PS contribution - 3 yr cliff or 2-6 year graded.
Must meet the ACP and ADP tests (except safe harbor plans and starter 401k plans)
Safe harbor 401k plans
-Standard
-Required ER contribution: Match: dollar for dollar up to 3% plus 50% on next 2% OR non-elective (NE): 3%
-ER contribution is 100% vested
-Qualified Automatic contribution arrangement (QACA)
-Required deferral
year 1: at least 3%
year 2: at least 4%
year 3: at least 5%
year 4: at least 6% (not to exceed 15%)
-Match: 100% for first 1% plus 50% from 1% to 6% or NE 3%
-Vesting: 2 years, 100%
Plans may allow employees to elect roth ER matching contributions (increasing EE taxable income; may require increased withholding or estimated tax payments)
ESOPs
ESOPs are stock bonus plans with additional features
-Similar to stock plans: pass through of voting, right to demand securities upon distribution, put option.
-Distributions must be completed within 5 years - unless amount exceeds annual limit.
-Stock is allocated to employee’s accounts over time by the trustee in lieu of cash contributions
-Plan can borrow funds - generally a prohibited transaction.
ESOP non recognition of gain treatment for sale to ESOP
-ESOP must own at least 30% of stock after sale
-SH must have owned stock for at least 3 years
-SH must purchase qualified replacement property within 12 months after transaction [or 3 months prior]
Qualified replacement property:
1. securities of domestic companies: stocks, bonds, warrants
2. Max 25% from passive investments - no mutual funds
3. Could be an S corp
20% withholding rule
Distributions from qualified plans are generally subject to a 20% withholding for federal income taxes.
Keogh plans
For the self-employed
Calculation:
step 1: determine self employment income
step 2: subtract 1/2 of SE tax from income in step 1
step 3: determine appropriate multiplier for determining the max contribution = plan limit divided by 1 + plan limit (.25/1.25 = .20) or .15/1.15 = 13.0435
Example: George has schedule C net income of $180,000 and SE tax of $20,000. What is the max contribution?
[$180,000 - $10,000] x .20 = $34,000
Qualified joint and survivor annuity - pension plans
Distribution option that provides annuity to participant and surviving spouse. The surviving spouse’s benefit is generally between 50% and 100% of the participants benefit. This option is actuarially equivalent to other distribution options
Qualified pre-retirement survivor annuity - pension plans
Provides benefit to a surviving souse if the participant dies before attaining normal retirement age . Offered to the nonparticipant spouse
Qualified optional survivor annuity - pension plans
offered to a participant who waived the QJSA. It is an annuity for the life of the participant with survivor annuity for the life of the participant’s source that is equal to a specified applicable percentage (75% or 50%) of the annuity payable during the participant’s life
Waiver for QJSA & QPSA
Requirements for participants to waive:
1. The spouse must consent in writing
2. The election to waive must designate a beneficiary that cannot be changed without spousal consent.
3. Spouse’s consent acknowledges the effect of the election and is witnessed by a plan official or notary.
Prohibited transaction penalty
Penalty of 15% of the amount involved with respect to the prohibited transaction and a 100% penalty is not corrected within the taxable period
Prohibited transactions
Any direct or indirect:
-sale or exchange, or leasing, of any property between a plan a disqualified person
-lending of money or other extension of credit between a plan and disqualified person
-furnishing of goods, services, or facilities between a plan and a disqualified person
-transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan.
-act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account
Plan loans - quicktip
loans are funded from the assets in an employee’s account and are repaid by the employee to the employee’s account with after tax dollars
Loans (typically in 403b and 401k plans)
Lesser of 50% of vested account balance or $50,000 (100% of vested balance/max $100,000 for qualified disaster). This amount is further reduced by the highest outstanding loan amount within the last 12 months
De minimis – loans of up to $10,000 can be made without adhering to the 50% limit
Term for repayment - generally 5 years, 30 years for home purchase
Unpaid loans upon termination are generally treated as distribution
403(b) plan annual contribution limits
$33,500 [$23,000 + $7,500 + $3,000] for age 50+
403(b) plans
Similar to 401k plans
-for 501(c)(3) organizations or public schools
-immediate vesting for employee contributions
-same limits as 401k plans
-Special catchup - $15k total - $3k per year - for unused deferrals, only for employees of H.E.R (health, education, religion)
-Investments - limited to mutual funds and annuities
-Loans are permitted
10% early withdrawal penalty waived for qualified plans
-death
-59 1/2
-disability
-substantially equal periodic payments
-medical expenses > 7.5% AGI
-payments under a qualified domestic relations order (QDRO)
-attainment of 55 and separation from service
-Public safety of employee separated from service after the earlier of age 50 or 25 years of service under the plan
-distributions to individual called to active duty (>179 days)
-birth or adoption (up to $5,000 per individual)
-terminal illness
-qualified federally declared disaster (max. $22,000)
-domestic abuse
-emergency personal expenses (up to $1,000)
-pension linked emergency savings account distributions
10% early withdrawal penalty waived for IRA
-death
-59 1/2
-disability
-substantially equal periodic payments
-medical expenses > 7.5% AGI
-education expenses
-first time home purchase (up to 10k)
-payment of health insurance premiums by unemployed
-distributions to individual called to active duty (> 179 days)
-birth and adoption (up to $5,000 per individual)
-terminal illness
-qualified federally declared disaster (max $22,000)
-domestic abuse
-emergency personal expenses (up to $1,000)
-distribution earnings on corrective distribution of excess contributions
RMDs
Penalty - 25% of the amount that should have been distributed that was not distributed
Required beginning date - April 1st of the year following attainment of 73 (75 for those who attain age 74 after 2032).
Exception to RMDs
Participant is still employed and is not a 5% owner - then delayed until April 1st of year after retirement - only for employer’s plan
Minimum distributions for inherited IRAs
penalty - same 25%
-beneficiaries of inherited IRAs and QPs are required to take distributions from these plans. The applicable distribution rules depend on whether the participant died prior to or on/after january 1, 2020.
Qualified plan excess contribution penalties
10% excise tax for overfunding qualified plan
-employer has 2 1/2 months to fix an excess contribution
Qualified roth distribution
5 year rule. Taxpayer must have established Roth IRA at least 5 years ago
The distribution must be on account of the following 4 events: age 59 1/2, death, first time home purchase (10k), or disability
Non qualified roth distribution
First - contributions (no tax, no penalty)
Second - conversions (no tax, possibly penalty)
Third - earnings (taxed, possibly penalty)
IRA deductibility for single taxpayer and not active participant
Fully deductible, no AGI limit
IRA deductibility for active participant
AGI limits on single and MFJ
Spousal IRA contributions, one spouse is active participant
Must stay below phaseouts for spousal contribution
Setting up SEP IRAs
-SEPs can be established as late as the due date on the return plus extensions. They are attractive because of their simplicity and ease of establishment
SEP eligibility
age 21 and earned $750 in 3 out of last 5 years
SEP contributions and vesting
Discretionary and flexible
Contribution limit is lesser of 25% or $69,000
Immediate vesting since SEPs use IRAs
EE may elect Roth ER SEP contributions (results in taxable income to the EE; may require increasing withholding or estimated tax payments)
SIMPLE IRAs characteristics
-Company with 100 employees or less each with $5,000 of compensation in the preceding year. Mostly an employee funded plan.
-No other plans permitted (unless plan converts to safe harbor or starter 401(k))
-Uses IRAs as funding vehicle, generally.
SIMPLE IRA contribution limits
Limit employee to $16,000. 50 and older catchup of $3,500.
SIMPLE IRA employer match and early distribution
Dollar for dollar up to 3% or 2% non elective
Maximum match is $16,000
early distribution - 25% penalty within 2 years from the period when an individual first participated in the SIMPLE
For low income, SIMPLEs can be better than SEPs because SIMPLEs are limited to 100% opposed to 25%
EE may elect roth contributions
IRC 409A - deferred comp (flexible plans)
Provides for taxation of deferred income and penalties for deferred comp plans that do not meet requirement of this section. Specifically excludes most qualified plans, NQSO/ISO plans, bonus plans, and 457(b) plans.
Deferred comp(flexible plans) characteristics
To be deferred, funds must avoid constructive receipt and be subject to substantial risk or forfeiture (bankruptcy counts)
Tax rules on deferred comp (flexible plans) contributions
ER tax deduction - the employer will receive a corresponding income tax deduction when executive includes deferred income for tax purposes - matching
Payroll tax - applies when the deferred income is earned or nonforfeitable
Deferred comp (flexible plans) arrangements
Arrangements: unfunded promise to pay, secular trust or rabbi trust. Rabbi trust is an irrevocable trust that is funded, but subject to a substantial risk of forfeiture due to the funds potentially being used in bankruptcy/liquidation.
Deferred comp (flexible plans) 83(b) election
allows taxpayer to include the value of stock into taxable income today to allow for future growth as a capital asset. Taxpayer must file election within 30 days of grant - not always a great idea. No ability to recover loss
Public 457 (b) plan features
-Eligible
-sponsors are government entities
-assets are protected by trust
-elective deferral limit is $23,000
-eligible employees: rank and rile and key management
Public 457(b) plan tax features
-Pretax contribution
-tax deferred growth
-50 and older catch-up
-3 year catchup provision ($23,000)
-rollovers are permitted to 401k, 403b, 457b, or IRAs
-no 10% early penalty unless the funds were part of a rollover from another type of plan or IRA
Private 457(b) plan features
-Eligible
-sponsors are tax exempt organizations under 501(c)
-assets are not protected by trust, available to employer’s creditors
-elective deferral limit is $23,000
-eligible employees: key management and HCs for tax exempt orgs, all employees if church related org
Private 457(b) plan tax features
-pretax contribution
-tax deferred growth
-no 50 and older catchup
-3 year catchup provision ($23,000)
-rollovers are not permitted unless rolled into another 457(b)
-early withdrawal penalty not applicable
457(f) plan features
-Ineligible
-sponsors are governmental entities (rare) and tax exempt entities under 501(c)
-assets are not protected by trust, available to employer’s creditors
-no limit on deferral contributions
-eligible employees: key management and HCs
457(f) plan tax features
-pretax contribution
-tax deferred growth
-no 50 and older catchup
-no 3 year catchup
-rollovers are no permitted
-early withdrawal penalty is not applicable
Types of employer stock options
Nonqualified stock options (NQSO)
Incentive stock options (ISO)
Stock appreciation rights (SAR)
Employee stock purchase plans (ESPP)
NQSO characteristics
no tax upon grant (as long as the exercise price is greater than or equal to FMV on date of grant - typical). Upon exercise, difference between exercise price and FMV is taxable as ordinary income. Subsequent gains are capital, long or short depending on HP.
Cashless exercise on NQSO
simultaneous exercise of the option and sale of the stock. Employee receives net proceeds minus withholding and transaction costs
ISO charactistics
Must be part of a plan, expire within 10 years, have an exercise price not less than FMV upon grant, not be transferrable, and cannot exceed the $100k limit.
Exercise of ISOs - AMT
The exercise of an ISO results in no regular income, but an AMT adjustment and will result in a different basis for regular tax purposes and AMT purposes. The difference will be reconciled upon disposition of the shares of stock.
Taxation rules for ISOs
ISO shares must be held for 2 years from date of grant and one year from the date of exercise. if not, then the sale is deemed a disqualifying disposition resulting in ordinary income on the bargain element in lieu of capital gain
SARs - stock anticipation rights characteristics
right that grant holder cash in the amount equal to the excess of FMV of stock over exercise price. Conceptually, the same as a cashless exercise for a NQSO
ESPP (employee stock purchase plan) characteristics
stock plan that permits employees to use after tax funds to purchase company stock at 85% of the value of stock. Annual limit per employee - $25,000. plans must not be discriminatory
Durable power of attorney
survives incapacity and disability but not death
must be in writing and are always revocable
advance medical directive
also known as a living will. provides direction regarding the artificial sustainment of life
Power of attorney
agent has the power to act
Power of appointment
power of an agent to appoint the assets of a principal (can cause inclusion in gross estate)
Statutory will
drawn by an attorney, and comply with the statutes for wills of the domiciliary state. Often referred to as witnessed or attested wills. Must be typed or be in writing, be signed by the testator, and be signed by witnesses.
Holographic will
Must be handwritten, dated and signed by a testator
Nuncupative will
Dying declaration only covering tangible personal property
Legal capacity - wills
Necessary to make a will. Generally 18 years of age, but less capacity than to make a contract.
Will provisions
-residuary clause
-guardianship clause
-survivorship clause or simultaneous death clause
-contingent legatee clause (per stirpes “by the root”, usually less than number of heirs for per capita “by the head”)
-a codicil is an amendment
Terrorem clause (no contest) will only be effective if the decedent has left the legatee in question enough of a legacy so as to not risk losing the contest
Survivorship clause or simultaneous death clause - wills
a survivorship clause is superior to a simultaneous death clause, but should not exceed 6 months in the case of the spouse or it will be considered a terminable interest and will not qualify for the unlimited marital deduction for a citizen spouse
Types of property
Real property
tangible and intangible personalty (moveables)
-legal ownership is title (could be a trustee)
Equitable ownership
the economic right to enjoy the benefits of the property (beneficiary)
Sole ownership characteristics
-100% of value included in gross estate
-included in probate
-no automatic survivorship feature
-qualifies for UMD if spouse is heir/legatee
Tenancy in common characteristics
-no deemed contribution rule for spouse
-% owned is includable in gross estate of decedent
-% owned is included in probate
-no automatic survivorship feature
-qualifies for UMD if spouse is heir/legatee
-property is partitionable without consent of joint owner
Joint tenancy with ROS characteristics
-actual contribution rule included in gross estate but if owned with spouse then 50%
-not included in probate
-automatic survivorship feature
-qualifies for UMD if spouse is joint owner
-property is partitionable without consent of joint owner
Tenancy by the entirety characteristics
-50% deemed contribution included in gross estate
-not included in probate
-automatic survivorship feature
-qualifies for unlimited marital deduction
-property is NOT partitionable without consent of joint owner
Community property characteristics
-50% deemed contribution included in gross estate
-50% of value included in probate
-no automatic survivorship feature
-qualifies for UMD if spouse is heir/legatee
-property is NOT partitionable without consent of joint owner
-one half of community property passes through probate, but both halves receive a step up to FMV at the death of the first spouse
Property titling with a survivorship clause
Will automatically pass (by law) to the survivor joint tenant and may not be the best from the decedent’s perspective. If you don’t trust them, put it in a trust.
Community property when decedent dies intestate
The surviving spouse may have a legal usufruct (right of the assets) over the decedent’s half of the community property, if the decedent dies intestate
Community property gifting
no gift splits (only joint gifts) of community property
Community property states
Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin
Property that passes through probate
Sole ownership
tenants in common
1/2 community property
automobiles
household goods
Gifts
a voluntary transfer without full consideration - the value of the gift tax purposes is the FMV at the date of the gift
a gift must be of a present interest for the annual exclusion
Who should you gift property that is expected to appreciate greatly to?
Youngest donee
2503(b) and 2503(c) trusts
Trusts for minors that are deemed gifts of a present interest, otherwise, use a crummey provision
2503 (b) trusts
may hold property in trust for the lifetime of the beneficiary (or beneficiaries), but must make income distributions to the beneficiaries on an annual basis.
gifts made to a 2503(b) trust will partially qualify for the gift tax annual exclusion. the portion qualifying for the exclusion equals the present value of the income interest that the child will receive over the team of the trust
2503(c) trusts
allows income to be accumulated in the trust, and allows the grantor to qualify the entire gift to the trust up to the annual exclusion amount. Can only have 1 beneficiary.
The trust must terminate when the child reaches age 21, or, at minimum, the child must be given the right to receive the trust assets at age 21
Transfers that are not subject to gift tax
legal support
-qualified transfers paid directly to educational or medical provider
-transfers to political organizations
-payments to divorced spouses
-transfers in business setting
-gifts to a spouse (citizen: unlimited, non-citizen: $185,000)
Imputed interest on gift and below market loan
From $0 - $10,000 (none)
From $10,000 - $100,000 (lesser of net investment income of borrower (if < $1,000 then $0) or federal rate times loan.)
Over $100,000 (federal rate times loan principal)
Gift basis
Gift basis for income tax is the carryover basis of the donor unless FMV < donor’s basis at the time of the gift in which case double basis rule (FMV for losses, donor’s basis for gains)
if gift tax is paid by donor on appreciated property the prorata share of the tax association is added to the donor’s original basis to determine the donee’s basis
It is best to not made gifts where FMV < basis (loss property) to avoid double basis rule
Gross estate (think balance sheet)
Gross estate includes the FMV of all assets owned by decedent at death or the value using the alternate valuation date (6 months later) if property selected (gross estate down, tax liability down)
FMV of a financial security for decedent
The average of the high and low trading prices for the decedent’s date of death or alternate valuation date
Alternate valuation date
6 months from date of death
-all assets valued at the alternate valuation date
except:
-assets distributed or sold before 6 months which are valued at the date or distribution or sale
-wasting assets (annuitized annuities, patents, royalties, installment notes, lease income) must be valued at the date of death.
needs to reduce estate and taxes due in order to use
Life insurance rule for gross estate
Added to the gross estate is any life insurance in which the decedent had incidents of ownership within 3 years or death, and any assets over which decedent had a general power of appointment
Form 706
Think “6 feet under” when you think about form 706
Due 9 months from date of death - can get 6 months automatic extension - does not apply to payment of tax
to value equity securities for form 706, take the average of the high and low for the date of death
Charitable gifts and bequests
can be made with cash, ordinary income producing property, or long or short term capital gain property
Charitable gift deductions for long term capital gain property
If the gift is long term capital gain property (including tangible personalty put to a related use) then the donor may take an income tax deduction equal to the FMV of the gift extent of 20% of AGI if the gift is to a public charity
Charitable gift deductions for property that doesn’t qualify for LTCG
the basis may be deducted for income tax purposes up to 50% (60% for cash) of the taxpayer’s AGI
Unused deductions for charitable gifted property
Unused deductions are carried over for up to 5 years (total of 6 deductions possible)
Advantages of lifetime gifts to charities
-provides an income tax deduction, and
-the donated property and any future appreciation are out of the gross estate of transferor
Bargain sales
Part sale and part gift
Charitable gift annuities (CGA)
donor transfers property to a charity in exchange for an annuity that is for less than full value of the property transferred. The donor receives an income tax deduction for the difference between the value of the transfer and the PV of the annuity stream
Think PBS charitable annuity with Mona
Pooled income funds
similar to a pooled or comingled CRT, maintained by a charity. The funds are managed by the charity with variable income paid to the donor and the reminder passing to the charity at the donor’s death
Charitable remainder trust (CRT)
Trust established by transferring assets (often appreciated) with income paid to the donor (and/or donor’s spouse or family) and a charity receiving the remainder interest
-Donor receives an income interest in the form an annuity CRAT or CRUT. Taxable under three tier system (ordinary, then capital gains, then basis)
-Donor receives an income tax deduction equal to FMV of asset transferred less the value of the income interest (PV of annuity or unitrust payments)
Managed by a trustee, not a charity.
CRAT
-A CRAT must pay to an annuitant a fixed amount greater than or equal to 5% per year regardless of earnings
-CRAT does not accept additional contributions after inception
-The remainder interest must be at least 10% at the inception
-Term -usually a single or joint life. Fixed term of less than or equal to 20 years
CRUT
Must have a unitrust payment of greater than or equal to 5% but may have a provision limiting the payout to earnings and may have a provision for making up prior payments when future income is sufficient.
-Term: usually a single or joint life. Fixed term less than or equal to 20 years
-Requires annual valuation since unitrust payments is a fixed percentage of assets in the trust. You can make additional contributions to CRUTs.
-Remainder interest must be greater than or equal to 10% at inception of trust
Charitable lead trust (CLT)
Charity receives income or use interest and generally family member (non donor) receives remaining interest.
-generally no income tax deduction for the donor with a CLT as income is received by the charity
-CLTs can be used to transfer property to a loved one in the furfure at a lower transfer cost
Testamentary transfers to charity
-No income tax deduction/unlimited estate tax deduction
-outright bequest, or bequest in trust (CRAT, CRUT, CLT)
IRA transfer to charity (qualified charitable distribution)
-Must be over age 70 1/2
-can donate up to $105,000 per year directly from IRA to charity (of which a one time distribution of $53,000 may go to a CRAT, CRUT, or CGA)
-donor does not include distribution as taxable income nor does the donor receive a charitable income tax deduction
-the donation counts as a distribution for RMD purposes
Non-citizen spouse deduction
non-citizen spouses are not permitted the UMD. instead, there is a super annual exclusion of $185,000 during life, but not UMD at death unless the executor elects to put the assets in a qualified domestic trust (QDOT)
Requirements for unlimited marital deduction
-Surviving spouse must receive property from the decedent’s estate
-only net value of qualifying property left to the SS will qualify
-Property bequests that are outright, in a POA trust, or in a QTIP will qualify
-Terminable interest property includes transfer such that the SS’s interest terminates at some future point and does not qualify for UMA
Terminable interest property that still qualified for UMD
-survivorship contingency that does not exceed six month
-an interest where the SS has a general power of appointment over the assets. A general POA trust requires that only the SS receives income at least annually and the GPOA is exercisable by the SS alone, and that no other person other than the SS may appoint assets to any other other than SS during SS’s life.
-QTIP requirements same as POA except that SS does not have POA over assets but can require trustee to invest in income producing property.
-A charitable remainder trust where the SS is the only non-charitable beneficiary
Over/under qualification of the unlimited marital deduction
Due to portability, overqualification (over using the marital deduction) is not as much of a problem as in the years prior to portability. Underqualification is simply leaving too much to a non-spouse beneficiary such that the first decedent spouse has an estate tax liability
Portability
Estates of decedents dying after Jan 1, 2011 can elect to transfer any of the deceased spouse’s unused exclusion (DSUE) to the surviving spouse. The election is made by filing a timely form 706 (9 months after death)
Bypass (B) or “credit shelter” trust
Remains a viable option for the credit equivalency amount to remove highly-appreciating property from the estate of the surviving spouse.
utilizes the decedent’s unused exemption and bypass inclusion in the estate of the surviving spouse. A bypass trust can be either an inter vivos (during lifetime) or a testamentary (at death) trust.
$13,610,000 applicable exception for 2024
Crummey power benefits
many transfers to trusts are transfers of a future interest and therefore not eligible for the annual gift tax exclusion. A Crummey power makes it possible to qualify a transfer to an irrevocable trust for the gift tax annual exclusion
Life insurance trusts (ILITs)
An irrevocable life insurance trust is an irrevocable inter vivos trust. The purpose of an ILIT is to prevent an insured party from having incidents of ownership in the life insurance policy on his life
If insurance polity is transferred into the ILIT, it can still be included in grantors gross estate.
If insurance policy is bought with the ILIT, it can be excluded from grantors gross estate
Testamentary bypass trust
transferring property to a bypass trust does not deprive the surviving spouse from enjoying the property. The bypass trust can be structured so that all income of the trust is payable to the surviving spouse. May have powers to invade corpus for surviving spouse.
Inter vivos bypass trust
While most bypass trusts are created at death, an inter vivos bypass trust can yield greater benefits. Once created, all future growth and appreciation in the property transferred to the bypass trust escapes federal estate taxation at the decedent’s death
power of appointment trust
Inter vivos or testamentary irrevocable trusts. The trust grants the beneficiary a power of appointment over the trust assets. The power of appointment can be a general power of appointment or a limited (special) power of appointment. However, the power must be a general power of appointment to qualify for the marital deduction.
Qualified terminal interest property trusts (QTIP)
Typically created at the death of the first spouse. It grants the SS a lifetime right to the income of the trust while transferring the remainder interest to individuals of the grantor’s choosing. A QTIP trust qualifies for the unlimited marital deduction even though the spouse does not receive outright access to the assets.
Executor must make a QTIP election to use marital deduction for terminable interests
Totten trusts
Not a trust, but rather a bank account that includes pay on death clause with a named beneficiary (PODs)
Blind trust
A revocable trust arrangement whereby an individual transfers property to the trust for management purposes when self-management of the assets might be deemed to be a conflict of interest (i.e. political officials during their term in office)
1035 exchanges of life insurance
Policy exchanges are not taxable from
-life insurance to life insurance
-life insurance to annuity
-annuity to annuity
exchanges are taxable for
-Annuity to life insurance
Accelerated life insurance benefits
Insured is deemed to have died (per IRC) due to chronic illness or terminal illness. Therefore, proceeds will not be taxable:
-chronically ill: a person cannot perform at least 2 of 6 ADLs
-terminally ill: expected to die within 24 months
Value of life insurance for gifts and bequests
Term insurance - gift value is the unexpired premium
Insurance in pay status - gift value is sum of the interpolated terminal reserve (cash value) and any unearned premiums.
Out of pay status - gift value is replacement value
change of beneficiary is not a gift
Life insurance policy included in gross estate if
-decedent had any incidents of ownership
-death benefits are paid to the estate
-policy was transferred within 3 years of death (IRC 2035) - (note: any gift tax attributable to the transfer is also included in the gross estate)
Arms length transactions
Sales, installment notes, and exchanges. NO impact on gross estate of transferor
Special sales
to loved ones, private annuities, an SCINS (possible transfers without transfer taxes)
Partial gifts
GRATs, QPRTs, TPPTs
outright gifts and gifts in trusts
Annual exclusion gifts and 529 plans
Transfers not subject to gift tax
qualified transfers, legal support, transfers to spouse pursuant of divorce
Private annuity (PA)
Between loved ones/ transferor in ill-health based on table life expectancy. Exchange at FMV for life annuity. The transferor has investment risk similar to bond. Transferee has business risk. Annuity is taxable (three tiers: ordinary income, then capital gains, then basis) Per IRS regulations after 2006, gain is recognized at exchange
Self-cancelling installment notes (SCINs)
similar to Private annuity except term certain and premium must be paid for right to cancel at transferor’s death - serial payment is taxable (three tiers: ordinary income, then cap gains, then basis) - transferee’s basis equal to sale price until private annuity
Grantor retained annuity trust (GRAT)
a gift of equal FMV of property placed in irrevocable trust less the PV of the annuity stream retained. Transferor must outlive trust term to remove asset from gross estate.
Qualified personal residence trust (QPRT)
The same as a GRAT except used with a person residence (can be secondary residence)- the gift equals the FMV minus PV of use.
Tangible personal property trust (TPPT)
Same as QPRT but used with tangible personal property (usually art)
Family limited partnership
Transfers to FLP for 1% general partner interest and 99% limited partner interest, then making use of marketability/liquidity discounts and annual exclusions - transfers of LP interests to family members while retaining total control with no or limited transfer tax
Transfers at death
By will, by intestacy, by operation of law (contract, titling, or trust) - no annual exclusion
results in no asset or appreciation out of the gross estate
no charitable income tax deduction available for bequests
Trust
legal entity created and funded by grantor. Legal title to property is in name of the trustee who manages the property for the benefit of the beneficiary
The principal benefits of a trust
- management of assets
- creditor protection
Common uses of trust
- divide an asset into income and remainder interests (split interests)
- avoid probate
- if irrevocable, to reduce taxes on appreciation, taxes on income, and transfer taxes
Taxation of trusts
Taxes at 37% above $15,200
Types of trusts
Simple (must pay out income annually)
complex (may accumulate income)
Tax filing for trusts
Form 1041 due April 15th or with extension. If simple, all income is distributed to beneficiaries annually
Grantor
person who created and initially funds the trust
Trustee
Individual or entity responsible for managing the trust assets and fulfilling the directions of the grantor as expressed in the trust instrument
Gift tax on revocable trusts
a transfer to the trust is not a completed gift and will not be subject to gift tax
Gift tax on irrevocable trusts
any transfer to the trust is a taxable gift (unless the grantor retains some interest in the trust) subject to gift tax.
Gift tax on irrevocable trust for charity
the unlimited gift tax charitable deduction is available to avoid gift tax on the portion that is determined to be for the charity
Revocable trusts
Grantor retains the right to revoke the trust at any time. Commonly used to avoid probate and provide management of the grantor’s assets should grantor become incapacitated
Irrevocable trust
the grantor cannot take back the property that was transferred to the trust
inter vivos trust
trust created during lifetime of grantor
Testamentary trust
trust created in the will of the grantor and comes into existence after the death of the grantor
Standby trust (contingent trust)
Created during the grantor’s lifetime that is either unfunded or minimally funded. The trust simply stands by and waits for a triggering event to activate it
Pourover trust
Capable of receiving assts from another source, generally the grantor’s estate at the grantor’s death
Grantor trust
Can be revocable or irrevocable. To qualify, the trust must be an inter vivos trust. The grantor, not the trust or the beneficiaries, is responsible for paying the income tax attributable to the trust’s income
Funded or unfunded
A trust can either be funded or unfunded. An unfunded trust is a trust that has been created, but not funded.
inter vivos revocable trusts
All revocable trusts are grantor trusts for income tax purposes, requiring the grantor of the trust to pay income tax. Advantages of revocable trusts include, 1. probate avoidance, 2. privacy for decedent and the decedent’s family, and 3. contests are discouraged. However, they are not effective for reducing taxes for estate planning purposes
Inter vivos irrevocable trusts
To achieve estate and gift tax benefits, a trust created during the grantor’s lifetime must be irrevocable. When an inter vivos irrevocable trust is created, the grantor cannot take the property back after it has been transferred to the trustee.
Liquidity needs to post mortem planning
Last medical, funeral, transition period, administrative costs, and income, estate, and GST taxes
Post mortem sources of liquidity
life insurance, sale of assets, IRD accounts, corporate redemptions, loans from ILITs, and asset purchases by ILITs
Income tax return after date of death
Form 1041 (fiduciary tax return). Executor must elect tax year for 1041 - this cold be calendar year or any other period
Tax form for unpaid medical bills of decedent
Form 1040 or Form 706
Tax form for qualifying casualty losses before death
Form 1040
Tax form for casualty losses after death
Form 1041 or Form 706
Tax form for executor fees
If not waived, form 1041 or Form 706
Examples of IRD assets
income earned but not yet taxes as of date of death
-IRAs
-qualified plans
-U.S. savings bonds
-Installment notes
-annuitized annuities
-accrued dividends
-accrued wages
Disclaimers
Anyone can disclaim in writing to the executor any amount, fraction, percentage, or asset.
-Must be in writing within 9 months
-The beneficiary disclaiming cannot have benefited and cannot direct the disclaimed assets
QTIP election and other characteristics of QTIPs
Executor must make QTIP election to use marital deduction for terminable interests.
Assets are contributed to a QTIP trust on behalf of the SS
-SS must receive all income annually
-No one can appoint property to anyone other than SS during SS’s life
-SS can require that all trust property be income-producing property
IRC 6166 installment payments
If closely held business exceeds 35% of adjusted gross estate, the executor may elect to pay the estate tax in two or more installments, but no more than 10.
-Executor can delay first payment of tax for up to 5 years
-The amount can be paid on installment is the percentage of estate tax that is the same ratio as the closely held business bears in the adjusted gross estate.
-2% interest rate on first $740,000 of tax
IRC 2032A - special use valuation of real property (farms)
FMV implies “highest and best use”. The FMV of property must be included in the gross estate regardless of the use. This creates an issue for certain businesses and farms - forced sale to pay taxes.
-IRC 2032A allows for valuation of property based on the current use of the property in lieu of FMV, but not reduced below FMV by more than $1,390,000
Requirements for IRC 2032A special use valuation of real property (farms)
-Decedent must be a US citizen
-Farm(or trade or business) must have been actively managed by decedent or family 5 out of the last 8 years prior to death.
-Value of the real and personal property used in a qualifying manner must equal or exceed 50% of gross estate.
-Value of the real property must equal or exceed 25% of the gross estate
-Property must pass to qualifying heir who must then actively participate in the farm or business for 10 years
Form 706 breakdown
Gross estate
-Tentative total allowable deductions
= tentative taxable estate
- state death tax and UMD & UCD
= taxable estate
+ Adjusted taxable gifts
= Tentative tax base
= tentative tax (based on rate schedule)
- total gift tax paid (or payable)
= gross estate tax
- basic exclusion amount
- DSUE (portability)
- other credits
=net estate tax
+ GST tax
= total transfer tax
Generation skipping transfer (skip persons)
is two or more generations down if lineal, or more than 37 1/2 years younger if non-lineal.
-Trust may be considered a skip person if all interests in trust are held by a skip person or distributions can be only made to skip persons
-Exception: if a child of the transferor is deceased, then the child’s descendants move up one generation. Also applies to transferor’s grandniece/grandnephew if transferor has no living lineal descendants.
-Taxable termination - non skip person dies leaving only skip person in trust
-Taxable distribution - distribution to a skip person
Qualified disclaimer for GST
Cannot be used to avoid GSTT
Qualified transfers for GST
Tuition payments made directly to a qualified educational institution or medical payments made directly to a hospital (health care provider) on behalf of a skip person are not subject to GSTT.
-Transferor or his executor may affirmatively allocate GST exemption. This allocation is made on form 706 or form 709
Form 709
United states gift (Generation skipping transfer) tax return
Value Line research
Ranks stocks on a scale from 1 to for timeliness and safety (1 highest rank)
Only stocks
Morningstar research
Ranks mutual funds, stocks, bonds, and ETFs using 1 to 5 starts.
5 stars is the best
Dividend declaration date
the date when the board of directors declares a dividend payment
Qualified dividends
-Paid by an american company or qualifying foreign company
-cannot be listed as a dividend that doesn’t qualify by IRS
-Held the stock for more than 60 days during the 121 day period that begins 60 days before the ex-dividend date
-Capital gains treatment
Stock splits
Increases shares outstanding and reduces stock price
-A 2 for 1 split for an investor with 100 shares at $50 per share
Number of shares after split? 200
Price per share after split? $25
-A 3 for 2 split for an investor with 100 shares at $60 per share
number of shares after split? 150
price per share after split? $40
(100 shares x 3/2, $60 per share x 2/3)
Certificates of deposit
Time deposit at a bank with a set interest rate and maturity date
Treasury bills
less than a year, direct obligation of the government
denominations of $100
Commercial paper
short term loans between corporations
maturities 270 days or less, denominations of $100,000
Bankers Acceptance
Facilitates imports/exports
Dow Jones industrial average
Simple price weighted average
does not incorporate market cap
S&P 500
Value weighted index - incorporates market cap of individual stocks into average
Standard deviation
Measure of total risk of an undiversified portfolio
-measures how something flip flops around an average
-the bigger the SD, the most the risk
68%, 95%, 99%
Beta
-beta is a measure of systematic or market risk
-Beta is appropriate measure of risk for a well diversified portfolio
should use beta if coefficient of determination (r-squared) is .70 and above
measure of individual’s security’s volatility relative to that of the market
BETA IS A WEIGHTED AVERAGE
Socialization
the process by which individuals acquire skills beliefs, values
Multicultural psychology
we are influenced by so many different things like our upbringing, socioeconomic upbringing, our religion, our views on certain things. So it’s not just one thing that makes up our mindset. Combination of things like gender, disability, class status, etc.
Social consiousness
investment decisions that are influenced from our environment, social issues, etc. Aligning their goals with their values. Think about client who wants to invest in only ESG companies.
In creating a portfolio, diversifying across asset types (stocks and bonds) is less effective than diversifying within an asset type
FALSE. You get more by diversifying across asset categories than inside an asset category
Modern “asset allocation” model
The risk, return, and covariance of assets are important input variables in created portfolio
Is the efficient frontier relatively insensitive to the input variable?
NO. It is very sensitive to input variables. It is created by the inputs.
Holding period return calculation when given periodic returns
Determine 3 month holding period return assuming monthly returns of 2%, 3.5%, and -1.5%
$1(1.02)(1.035)(.985) = 1.0339 or 3.99%
Effective annual rate
on formula sheet
This formula calculates the effective annual interest rate earned on investments when the compounding occurs more often than once per year.
Calculating weighted average
Investor owns 15 shares of “X” at $12 per share, 5 shares of “Y” at $15 per share, and 1 share of “Z” at $27 per share
15($12) + 5($15) + 1($27) / total number of shares
Duration of a portfolio
weighted average
Expected return on a portfolio
Weighted average
Net present value
used to evaluate capital expenditures that will result in differing cash flows over the useful like or investment period.
if NPV is greater than 0, IRR is greater than our required rate of return (make the investment)
if NPV is equal to 0, IRR = required rate of return (make the investment)
If NPV is less than 0, IRR is less than our required rate of return (don’t make the investment)
Internal rate of return
IRR is the discount rate that sets the NPV formula equal to zero.
NPV = PV of cash flows - initial cost
IRR can also be thought of as a compound rate of return
IRR should be calculated when you have uneven cash flows and you are asked to calculate compound rate of return. Solve for IRR/YR
Dollar weighed return
The IRR using the investor’s cash flows
Time weighted return
IRR using the securities cash flow. Assume buy and hold.
Determine without regard to the investors cash flows
Mutual funds report on a TIME WEIGHTED BASIS
Dividend discount model
AKA intrinsic value model, AKA constant growth model
The dividend discount model values a company’s stock by discounting the future stream of cash flows.
D0 is always the CURRENT dividend.
If required rate of return decreases…
The stock price will increase
think about inverse relationship between price and interest rates
If the dividend is expected to increase…
The stock price will increase
If the required rate of return increases…
The stock price will decrease
think about inverse relationship between price and interest rates
If the dividend is excepted to decrease…
The stock price will decrease
Calculating expected rate of return and intrinsic value of a stock
Use dividend discount model formulas
for intrinsic value, use V = D1 / r-g
for expected rate of return, use r = D1/p +g
Calculating intrinsic value of a stock when the question gives you multiple dividends that have inconsistent growth
First step is to solve for value of stock from the year in which the dividend starts to become consistent (constant dividend formula)
Second step is to use cash flow method to solve for NPV. Use dividends in cash flow inputs
Solving for Expected price per share using EPS
(earnings per share) x (P/E multiplier) = expected price per share
Dividend payout ratio formula
Common stock dividend / earnings per share
The higher the payout ratio, typically the more mature the company.
A high dividend payout ratio may also indicate the possibility of dividend being reduced
Return on equity formula
Net income or earnings per share/ equity
need to use total dollar on both or per share on both.
Return on assets formula
Net income / assets
Dividend yield formula
Dividend per share / stock price
Random walk theory
-the behavior of stock prices closely resembles a random talk
-price of stocks are “unpredictable” but not “arbitrary”
-at any given moment prices that exist on securities are the best incorporation of all available information and a true reflection of the value of that security
-prices are in equilibrium
Market anomalies
January effect
-small firm effect
-value line effect
-PE effect
-AFC/NFC
-Presidential election
Market anomalies do not support EMH or any of the 3 forms
Series E bonds and Series EE bonds
-sold at face value
-non marketable, nontransferable
-Do not pay interest periodically
Series H bonds and Series HH bonds
They pay interest semiannually - different than EE bonds
Series I bonds
Inflation protected via fixed rate + variable rate
Do not pay interest periodically
US treasury taxation
Not taxable at state and local levels
taxable at fed level
TIPS
Treasury inflation protected securities
-Principal adjusts for inflation
-coupon does not change as with the case for I bonds
STRIPS
Separate trading of coupon payments and principal amount
essentially creates may zero coupon bonds
Secured bonds
-Mortgage bonds
-Backed by pool of mortgages
-Payment consists of both principal and interest
-Biggest risk: default and payment risk
-Collateral trust bonds
-backed by an asset that the company owns
Unsecured bonds
-Debentures
-Subordinated debentures
-income bonds
-Variable interest rate bonds
Private activity bonds
Think stadiums
interest received is a tax preference item for AMT
Insured municipal bonds
-American Municipal Bond Assurance Corp AMBAC
-Municipal Bond Insurance Association Corp MBIA
Bonds issued by territories of the US (puerto rico)
Not subject to taxes at fed, state, or local.
After tax yield
(corporate rate) x (1-marginal tax rate)
Tax equivalent yield on treasuries
US treasury yield / 1 - state tax
Yield ratio
For munis vs corporates
Rtf (tax free) / Rt (taxable)
The higher the ratio, the more favorable muni bonds become
Calculating holding period return of a bond when they do not give you sell price
price = current annual coupon dollar amount / current yield
then use made / paid
Bond yield relationships
Accrued interest of a bond
-Buyer of bond pays the seller for accrued interest since the last payment
-Buyer received a 1099 for total coupon payment
-Buyer in entitled to a deduction for accrued interest paid
Accrued interest of a bond example
Original issue discount
OID is the discount value that a bond is issued for (originally sold) versus par. (zero coupon bonds)
-The OID must be accreted (recognized) each year. Therefore, the bond owner is paying income tax on phantom interest income since they are not receiving the actual interest payments until maturity
-Upon maturity the holder will receive the face value of the bond and no additional income tax will be owed since the tax was paid while interest accrued within the security
Calculating price of bond if interest rates change
First, you have to solve for duration if not yet know
then use change in bond price formula (on formula sheet)
Determining price of a preferred stock
Ppfd = D / r
Preferred stock tax advantages for corporations
For tax years beginning after Dec. 31, 2017, the 70% dividends- received deduction is reduced to 50% and the 80% dividends-received for 20% or more owned corporations is reduced to 65%
the same deduction applies to common stock dividends as well
Property valuation formula
Value = net operating income (NOI) / cap rate
Net operating income practice question
A share mutual fund expenses
-Front end loan
-Small 12b-1 fee
-No redemption fee
B share mutual fund expenses
-Redemption fee
-Max 12b-1 fee of 1%
-No front end load
-May convert to A shares
-Many funds no longer offer B shares
C share mutual fund expenses
-No front end loan
-Usually charge a small back end load
-Max 12b-1 fee of 1%
Cryptocurrencies
-Virtual currency not associated with any country or central bank
-Number of “coins” are limited
-Not widely accepted as a form of payment
-Considered a high risk investment
SAFEST option strategy in a flat market
Sell a call
BEST option strategy in a flat market
Sell a straddle
Option question when client bought and sold stock and also bought or sold an option***
Gift taxes paid on gifts within 3 years of death
included in gross estate
Gifting $1,000,000 after already using lifetime GST tax exemption
The GST tax of $400,000 is added to the gift for the determination of the gift tax. Thus, $1,400,000 X .40 = $560,000
5 qualifying dependency tests
1) Gross Income Test
2) Support Test
3) Member of Household or Family Member Test
4) Citizenship Test (U.S., Canada or Mexico)
5) Joint Filing Test
When a question asks you to calculate intrinsic value using the constant growth dividend valuation model and gives you beta and risk free rate
First, solve for required rate of return using CAPM
second, use constant dividend growth formula
The unholy trinity or the Goodman Triangle
The owner, insured and beneficiary are three different people/entities
“The policy beneficiary is a grantor trust of the decedent but the policy is owned by a closely-held corporation”
INCLUDED in gross estate of decedent
Deductions FROM AGI
-Medical expenses (>7.5% of AGI)
-certain state and local taxes (up to 10k)
-contributions to qualified charitable orgs
-casualty losses
-certain personal interest expenses
-qualified business income
-Miscellaneous itemized deductions not subject to 2% floor (2017-2025)
Permitted disparity (social security integration)
Allows a higher contribution or allocation of benefits to employees whose compensation exceeds the social security wage base for the plan year. “reverse discrimination”. It is not discriminatory
Permitted disparity levels reduce benefits in a defined benefit plan if employee retires early
It isn’t possible to have a defined benefit plan formula which eliminates benefits for lower paid employees
The maximum permitted disparity is 100% of the base benefit level or 5.7%, whichever is lower.
The excess benefit percentage can range between 0% and 11.7%
Maximum allowable expense for business related gifts is how much
$25 per customer
Deduction of costs associated with investigating the purchase of a new line of business
If the new line of business is purchased and it is in a different line of business as the current trade or business operation, the costs of investigation ARE RECOUPED by capitalizing the expenses and amortizing it ratably over a 60-month period.
Services that are provided on a discount or free basis to employee are not included in taxable income
-The employer must incur no substantial cost in providing the service.
-Services offered to the employees must be in the line of business in which they are working.
-If there is a reciprocity agreement between two unrelated employers in the same line of business
State income tax deduction and AMT consequence
State income taxes deducted as an itemized deduction will be added back into regular income to calculate Alternative Minimum Taxable Income
A parent-subsidiary group exists if the parent company owns what percentage of voting stock in another corporation
At least 80%
Personal exemption for tax returns
Not allowed anymore
Convention used to depreciate real property
Mid-month convention
modified no fault coverage
the plan where injured parties do not give up the right to sue, but simply refrain from such action until either a dollar threshold or a verbal threshold is reached
Five elements of Qualified dependency test
-Gross income
-support
-member of household or family
-citizenship or residence
-joint return
Amount that can be deducted as a charitable contribution
Only materials and actual costs can be used. Rental of space or time contributions are not deductible
Capital preservation for funding
“I need $500,000 at the beginning of retirement” $40,000 income goal / .08
Capital utilization for funding
“I need $424,143 at the beginning of retirement” (use a TVM calculation to arrive at this number)
Capital needs analysis formula
Capital needed = Annual Income Need / Interest Rate
Last date to establish qualified plans for the previous year
Tax filing deadline of next year plus extensions
Classifications of property subject to cost recover
-Personalty (tax term for personal property) assets are used in a business and subject to depreciation
-Natural resources are subject to depletion
-Intangibles are subject to amortization
Estimated tax payments
90% of current year, 100% of prior year, 110% of prior year
If client’s AGI from last year is greater than $150,000, the safe harbor is 90% of current year tax or 110% of prior year tax.
If client’s income varies widely then use 110% of prior year
First In First Out inventory system (FIFO)
The FIFO method is concerned with movement of costs through inventory, not goods. The cost of the first units purchased are the first costs to be transferred to cost of goods sold when the goods are sold.
Revenue act of 1913
imposed the first constitutional income tax
The tax preparer penalty for willful or reckless conduct
Greater of $5,000 or 75% of the income derived by the preparer for the return
Automatic mileage AKA standard mileage method
It is used to calculate business mileage deductions for tax purposes.
can be used on a car that is either purchased or leased by the taxpayer
Actual expense method - mileage
A method of calculating vehicle expenses for tax deductions based on actual costs incurred
Personal holding company tax rules
If the business is deemed to be a PHC by the IRS, then a penalty tax of 20% can be imposed on the undistributed personal holding company income.
Medical expense deductions for traveling to see specialists
You may deduct $0.21 (2024) cents per mile for the travel associated with the medical care and may deduct up to $50 per night per person for lodging
Add back items for calculating AMT
-Depreciation of property placed in service after 1986
-The standard deduction, if taken in lieu of itemized deductions
-Passive activity losses
Installments sales undertaken after March 1, 1986
Unrelated business taxable income
often reported on limited partnership K-1s. Can cause partnership earnings to be taxable currently even if partnership is held in an IRA
Neglected firm effect
This anomaly is said to exist because the security in question is allowed greater potential for movement as a result of the lack of scrutiny by analysts
Mid-month convention under MACRS
Nonresidential real property and residential rental property use the mid-month convention
Mid-quarter convention under MACRS
Use if mid-month convention does not apply (excluding nonresidential real property and residential rental property, property placed in service and disposed of in the same year, and property that is being depreciated under method other than MACRS)
You treat all property placed in service or disposed of during any quarter of the tax year as placed in service or disposed of at the midpoint of that quarter. This means that 1 1/2 months of depreciation is allowed for the quarter the property is placed in service or disposed of
Half-year convention
Use this convention if neither the mid-quarter convention not the mid-month convention applies.
Under this convention, you treat all property placed in service or disposed of during a tax year as placed in service or disposed at the midpoint of the year. This means that a one-half year of depreciation is allowed for the year the property is placed in service or disposed of.
Qualified dividends
Must hold onto stock for more than 60 days in the 121 days surrounding the record date
Amortization of goodwill
when the cost of the goodwill of the company is expensed over a specific period. Amortization is usually conducted on a straight-line basis over a 10-year period, as directed by the accounting standards
Section 1231
Capital gain tax
Qualifying widower
Applies for the 2 ears following the year of the spouse’s death
Classifications of income - 3 types
active, passive and portfolio
Increasing whole life and decreasing term are describing group paid-up life benefits.
Group paid-up life insurance
Penalty for fraudulent income tax return
75% of deficiency
Calculating AGI for Self employed client
Multiply gross business income by 92.35% then multiply that by 15.3%. From there divide that amount by 2
