Chapter 3: Client Investment Recommendations Flashcards
For Sole Proprietor, name the:
- Advantages
- Disadvantages
- Taxation
- Personal Liability
Advantages: (1) Fast, cheap, easy set up; (2) no meetings; (3) easy tax prep, (4) income direct to owner
Disadvantages: (1) Personal liability; (2) harder to obtain loans or attract investment capital
Taxation: Personal Income
Personal Liability: Yes
For General Partnerships, name the:
- Advantages
- Disadvantages
- Taxation
- Personal Liability
Advantages: (1) Flow through of income and expenses; (2) Equal ownership, returns, and costs;
Disadvantages: (1) Personal liability; (2) Equal responsibilities if one partner creates issue/defaults
Taxation: Flow through to owners
Personal Liability: Yes
For Limited Partnerships, name the:
- Advantages
- Disadvantages
- Taxation
- Personal Liability
Advantages: (1) Flow through of income and expenses; (2) Un-equal ownership whereas limited partners can only lose what they put in with recourse note allowing creditors to only come after personally invested or guaranteed debts (3) allows for partnership democracy which gives limited partner vote for dissolving partnership, suing GP for negligence//breach of duty and inspecting record
Disadvantages: (1) Personal liability: Requires min 1 General Partner that has unlimited liability; (2) Distribution of profits not as flexible
Taxation: Flow through to owners
Personal Liability: Yes for GP, Not for Limited
For Limited Partnership Company (LLC), name the:
- Advantages
- Disadvantages
- Taxation
- Personal Liability
Advantages: (1) Flow through of income and expenses; (2) Limited liability as owners are protected (3) More flexible distribution of profits (4) Unlimited number of members own LLC with both managing and non managing owners (similar to general and limited except all are protected from creditors) (5) No minutes or formal corp reporting required (6) avoids double taxation of income given flow thru of profits
Disadvantages: (1) Not good for attracting VC financing with direct flow of income/expense (2) More complexity in structure (3) Limited life based on filing with state and signed operating agreement
Taxation: Flow through to owners
Personal Liability: No, not even for negligence running business
For S-Corporation, name the:
- Advantages
- Disadvantages
- Taxation
- Personal Liability
Advantages: (1) Flow through of income and expenses via Schedule K-1; (2) No corporate tax (3) Liability protection from creditors due to corporate structure (4) Limit of 100 US resident individual, trust of estate shareholders own the corporation but are protected from personal liability (5) Protection against debts/lawsuits for owners but avoids double taxation (6) allows for business write offs and avoids being taxed as a legal entity
Disadvantages: (1) Not good for attracting VC financing with direct flow of income/expense (2) More complexity in structure and requires annual meetings and minutes of voting from each as org is filed with 3) One class of stock and limited to 100 stockholders residing in US with company located in US
Taxation: Flow through to owners
Personal Liability: No
For C-Corporation, name the:
- Advantages
- Disadvantages
- Taxation
- Personal Liability
Advantages: (1) Ability to attract capital investments and issue debenture (2)protects shareholders/owners from personal liability (3) not limited to # or classes of shareholders
Disadvantages: (1) Double taxation of corporate income on NI and personal income on dividends (2) More complexity in structure and requires annual meetings and minutes of voting from each as org is filed
Taxation: Taxed as business entity at flat corp rates
Personal Liability: No
What must first be determined before working with a client on investment recommendations
Income sources, Current expenses, Discretionary Income, Assets, Net Worth, Tax Bracket
Also good to know risk tolerance and time horizon
What 3 factors relative to investor situation must be assessed before / in making an investment recommendation
Investment Objective: income, appreciation, purchasing power protection..
Investment Time Horizon: Short, Intermediate, Long
Risk Tolerance: High, Medium, Low
What are exempt accounts (not allowed) for purposes of establishing margin accounts
Retirement Accounts
Open End Mutual Funds
Options
Primarily for stock traded on national exchanges
What are exempt securities for purposes of registering with state
Any security excused from registration requirements based on Uniform Security Act, such as
- US Treasuries,
- Munis,
- Canadian Govt or other foreign govt with
diplomatic ties
- Banks, S&Ls, Credit Union, Trust company
- Insurance company debt
- Railroad or Public Utility
- Federal covered
- Non Proft
- Pension/employee benefit program investment
What is CAPM and how calculated
Capital Asset Pricing Model that states the expected return on a stock is equal to the risk free rate an investor could get on 3 mo T-Bill plus the potential return on stock above risk free rate based on formula
Rf + B(Rm-Rf)
where Rf = risk free, B= Beta of stock, Rm= market return
What are key elements of Modern Portfolio Theory
Assesses how an investment affects the risk reward ratio of entire formula such that based on level of risk, any portfolio with risk adjusted returns landing on the curve is equally efficient, where as those inside the efficient frontier, with similar risks may different levels of efficiency based on returns and opposite for those with similar returns relative to different risks
What is:
- Recency Bias
- Mental Accounting
- Framing
- Primacy Effect
- Overconfidence/Dunning Kruger
- Loss Aversion
- Recency Bias: placing a higher weigh on recent information, often leading to mistiming on market (buy in when market hot, sell when not)
- Mental Accounting: Using rules of thumb or break even on losses to make decisions
- Framing: Based on way information is presented can confirm /reinforce behaviors
- Primacy Effect: First experience is given overweight to future decisions….ie..if made huge profits initially will expect to continue to do same
- Overconfidence/Dunning Kruger - Belief that know information, and overrate ability to make sound decisions even when really no nothing leading to overtrading as dont realize impact on portfolio
- Loss Aversion - avoiding losses more painful that potentials for gain by 2:1 (ie…50/50 chance of gaining $2500 or losing $1000 before proceeding)
What are 3 types of stock and investment styles for equity investing and examples from highest risk / volatility for each
Growth: Low to no dividend, high P/E, capital appreciation: - Large Cap is least volatile, Mid Cap, Small Cap is most volatile of all
Value: Higher dividend, low P/E - undervalued, some capital appreciation: Large Cap is least volatile of all equity, Mid Cap, Small Cap
Blend: Mix of growth and income; Mid range P/E - with some dividend and some capital appreciation: Large Cap is least volatile of blend, Mid Cap, Small Cap is more volatile
Reference Equity Mutual Fund chart; Determination of $ cut off between small and large is fluid
Name 2 investment styles and associated charcteristing
Passive - Efficient market theory, uses indexes and associated with asset allocation and rebalancing, more buy and hold strategies
Active - Weak to inefficient market theory, market timing and technical trading are associated with these investors
What are 2 types of asset allocation and how used
Strategic - Rebalancing, focused on individual investor age, time horizon, risk levels
Tactical - Market timing based on movements in market, Portfolio manager managing basket of stocks to beat market
Name the different portfolio management techniques and key characteristic
Buy and hold - low transaction costs, long term , lower tax impact - individual / retail investor
Sector Rotating - Buy and sell different class groups based on market movement to under or over weight the particular class via fundamental or technical analysis - portfolio mgr/active investor
Dollar Cost Averaging - buying fixed amount of security over regular schedule of time (ie..1/3 each mo) to take advantage of price fluctuations causing investors average cost to be lower than average share price. Used in determining cost basis when selling stock as opposed to FIFO (avg cost basis for Mutual Fund reporting by investor as part of NAV..long term cap gain).
How are governments securities taxed
US Treasuries and US Govt Securities - Fed only
Municipal : out of state - State/Local only
Municipal: in state/local - Tax exempt
Corporate/Govt Agency (GNMA,FMLA) - Fed,
State, Local
See notes - chart
How are OIDs taxed
Zero Coupons/STRIP discounts realized at maturity are amortized over life of bond and taxed as ordinary income - phantom tax; however as each year tax amount is paid the amount is added to cost basis so at maturity principal and basis are same so no cap gains, and if sold sooner reduced by this “accretion”
Munis are tax exempt so accretes the cost basis but does not pay taxes
For Premium bonds, the amount accreted is a loss that can be used to offset ordinary income received through interest payments
Bonds purchased on secondary market at a lower than par price are market discount bonds and are not tax exempt, but any gain is recognized as ordinary income
How are cost basis determined for cap gains tax purposes
FIFO is default
Average Cost can be used especially with dollar cost averaging
Specific share is used when shares can be tracked via CUSIP number
What are wash sale rules
Losses can not be claimed if same security (or derivative) is sold then repurchased within 30 days before and 30 days after purchase date (61 days), and loss amount is added back to cost basis of security
How are convertible securities taxed
Interest payments taxed as ordinary income when received plus if the bond is converted then sold, any gain is also taxed based on proceeds from sale minus the cost basis equivalent to original purchase price of the bond . (ie..if paid $1000 for convertible, then when converted, cost basis for sale = $1000) Only if sold, otherwise no capital gain
What is AMT and how used
Alternate Minimum is separate calculation that excludes certain deductible items (such as accelerated depreciation and other tax preferences to ensure that everyone who benefits from these pays minimum amount of taxes
What are common tax deferred individual retirement plans and key characteristics of each
Individual:
- Traditional IRA - 100% earned (now allowed past age 72 before Secure Act 2.0) only up to $7500 in 2023 ($6500+$1000) can be deducted, 6% Overfunding penalty and 10% penalty for early withdrawal before 59 1/2 except for death, perm disability, first home purchase, substantially equal payments, medical and higher education expenses; Taxed as ordinary income and subject to RMD beginning at 72 with 50% penalty on amount not taken. Collectibles can not be purchased and used in IRA without 59 1/2 10% penalty, except US minted gold or silver bullion; Income limits do not apply unless self or spouse covered by company plan.
- Roth IRA - 100% earned only up to $7500 in 2023 ($6500+$1000) CAN NOT be deducted (after tax contribution), No overfunding penalty, or limit to tax deferred growth (ie..Roth Conversions) and no RMD required but income limits apply for amount of after tax deferred growth benefit. Penalties on early withdrawal if not held Roth for 5 years or under age 59 1/2.
If make equal distributions under Rule of 72, must withdraw for 5 yrs or until age 59 1/2, whichever is longer