Taxation of Corporate and Government Securities

Question 1

In January, 20XX a customer buys 100 shares of ABC stock at $50 per share and pays a $2 commission per share. The customer receives $1 in cash dividends during the year. The customer’s cost basis in the stock is:

A. $49 per share
B. $50 per share
C. $52 per share
D. $53 per share

Answer 1

The best answer is C.

When the stock is purchased, any commission paid is not deductible - it is part of the cost basis of the shares. Thus, the cost basis for tax purposes is $50 + $2 commission = $52 per share. The $1 dividend received is included in taxable income for this year, and is not part of the stock’s cost basis.

Question 2

A corporation declares a cash dividend on Wednesday, December 1st. The record date is set at Tuesday, December 21st, with the dividend payable on Friday, December 31st. Based on this information, the ex date is set at Friday, December 17th. The “tax event” occurs on:

A. Wednesday, December 1st
B. Friday, December 17th
C. Tuesday, December 21st
D. Friday, December 31st

Answer 2

The best answer is D.

For tax purposes, payments by issuers to securities holders are considered to be received as of the date the issuer sends the check. In this case, the check is sent on Friday, December 31st (payable date), therefore the income is taxable as of this date.

Question 3

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

A. December 6th
B. December 26th
C. December 30th
D. January 6th

Answer 3

The best answer is D.

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

Question 4

Which of the following is (are) taxable in the year of receipt?

I Interest earned from investments
II Cash dividends from investments
III Stock dividends from investments
IV Stock splits on investments

A. I only
B. I and II
C. III and IV
D. I, II, III, IV

Answer 4

The best answer is B.

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

Question 5

An investor holds shares of a stock that declares a 10% stock dividend. Which of the following statements are TRUE regarding the stock position after the dividend is paid?

I The cost basis per share is adjusted
II The cost basis per share remains the same
III The distribution is taxable
IV The distribution is not taxable

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 5

The best answer is B.

Under IRS rules, stock dividends are not taxable at the time of receipt. The stock dividend results in the cost basis per share being reduced, with the number of shares held increased proportionately. In aggregate, the customer’s cost basis remains the same.

Question 6

Which of the following is (are) taxable in the year of receipt?

I Interest earned from investments
II Cash dividends from investments
III Stock dividends from investments

A. I only
B. II only
C. I and II
D. I, II, III

Answer 6

The best answer is C.

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

Question 7

A customer has purchased 1,000 shares of ABC stock at $30 per share, paying a commission of $1 per share for the transaction. ABC stock declares a 5% stock dividend. When the dividend is paid, the tax status of the investment is:

A. 1,000 shares held at a cost basis of $30 per share
B. 1,000 shares held at a cost basis of $31 per share
C. 1,050 shares held at a cost basis of $29.52 per share
D. 1,050 shares held at a cost basis of $30 per share

Answer 7

The best answer is C.

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

Question 8

A customer has purchased 1,000 shares of ABC stock at $44 per share, paying a commission of $1.00 per share for the transaction. ABC stock declares a 20% stock dividend. When the dividend is paid, the tax status of the investment is:

A. 1,000 shares held at a cost basis of $44 per share
B. 1,000 shares held at a cost basis of $45 per share
C. 1,200 shares held at a cost basis of $36.66 per share
D. 1,200 shares held at a cost basis of $37.50 per share

Answer 8

The best answer is D.

The payment of a stock dividend increases the number of shares held by the investor and the cost basis must be reduced accordingly, since each share is theoretically worth less after the stock dividend is paid. The customer will have 1,000 shares x 1.20 = 1,200 shares after the dividend. Each share originally had a cost basis of $45 ($44 price plus $1 commission). After the dividend is paid, the cost basis is adjusted to $45/1.20 = $37.50.

Question 9

A customer has purchased 1,000 shares of ABC stock at $58 per share, paying a commission of $2 per share for the transaction. ABC stock declares a 20% stock dividend. When the dividend is paid, the tax status of the investment is:

A. 1,000 shares held at a cost basis of $58 per share
B. 1,000 shares held at a cost basis of $60 per share
C. 1,200 shares held at a cost basis of $58 per share
D. 1,200 shares held at a cost basis of $50 per share

Answer 9

The best answer is D.

There is no tax due when a stock dividend is paid; instead the investor gets more shares; with each share worth proportionately less. The payment of a stock dividend increases the number of shares held by the investor and the cost basis must be reduced accordingly, since each share is theoretically worth less after the stock dividend is paid. The customer will have 1,000 shares x 1.20 = 1,200 shares after the stock dividend is paid. Each share originally had a cost basis of $60 ($58 price plus $2 commission). After the stock dividend is paid, the cost basis is adjusted to $60/1.20 = $50 per share.

Question 10

Two years ago, a customer purchased 1,000 shares of ABC stock at $45 per share. The stock has appreciated in value and is currently worth $60,000. The company announces that it is spinning off a subsidiary, DEF, to its shareholders. The value of the new company being spun off equals 5% of the old company. The customer will have:

A. $45,000 cost basis in ABC; $0 cost basis in DEF
B. $42,750 cost basis in ABC; $2,250 cost basis in DEF
C. $60,000 cost basis in ABC; $0 cost basis in DEF
D. $57,000 cost basis in ABC; $3,000 cost basis in DEF

Answer 10

The best answer is B.

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

Question 11

Many years ago, a customer bought 1,000 shares of XYZ stock at $40 per share. The company spins off a subsidiary to its shareholders, and the customer gets 100 shares of PDQ stock as a result. On the first day of trading after the spin off, PDQ closes at $20, while XYZ closes at $50. The customer will have a:

A. $40,000 cost basis in XYZ and a $2,000 cost basis in PDQ
B. $38,000 cost basis in XYZ and a $2,000 cost basis in PDQ
C. $50,000 cost basis in XYZ and a $2,000 cost basis in PDQ
D. $48,000 cost basis in XYZ and a $2,000 cost basis in P

Answer 11

The best answer is B.

The aggregate cost basis does not change in a spin-off. The original cost basis in XYZ stock is $40,000. After the spin off, the customer gets 100 shares of PDQ, with a $20 per share value = $2,000. This is the PDQ cost basis, and it comes out of the XYZ cost basis. $40,000 XYZ cost basis - $2,000 PDQ cost basis = $38,000 adjusted XYZ cost basis.

Question 12

Five years ago, a customer purchased 1,000 shares of ABC stock at $60 per share. The stock has appreciated in value and is currently worth $100,000. The company announces that it is spinning off a subsidiary, DEF, to its shareholders. The value of the new company being spun off equals 10% of the old company. The customer will have:

A. $60,000 cost basis in ABC; $0 cost basis in DEF
B. $54,000 cost basis in ABC; $6,000 cost basis in DEF
C. $100,000 cost basis in ABC; $0 cost basis in DEF
D. $90,000 cost basis in ABC; $10,000 cost basis in DEF

Answer 12

The best answer is B.

The aggregate cost basis does not change in a spin-off. The original investment in ABC stock had a cost basis of $60,000. The 10% spin off means that 10% of this value is now attributed to the newly spun-off DEF shares = $6,000. The remaining value of the ABC shares is $60,000 - $6,000 = $54,000. The current market value has nothing to do with cost basis.

Question 13

A customer has purchased 5,000 shares of ABC corporation stock in lots of 100 shares over an extended period of time at varying prices. The customer now sells 500 of the shares. Which statement is TRUE?

A. IRS rules require that First-In, First-Out (FIFO) accounting be used to identify the shares sold when computing any gain or loss
B. IRS rules require that Last-In, First-Out (LIFO) accounting be used to identify the shares sold when computing any gain or loss
C. IRS rules allow the taxpayer to specify which shares are being sold
D. IRS rules require that the method giving the largest capital gain be used

Answer 13

The best answer is C.

The IRS allows stockholders to select which shares they are selling when computing capital gains tax liability. Thus, the taxpayer can choose the higher cost shares to reduce any potential capital gain upon sale. If specific identification is not used, the shareholder must use FIFO - first in, first out - accounting.

Question 14

All of the following are reported on Form 1099-DIV EXCEPT:

A. cash dividends paid
B. qualifying cash dividends paid
C. interest paid on taxable bonds
D. capital gains distributions paid by mutual funds

Answer 14

The best answer is C.

Form 1099-DIV is the report to the IRS by issuers of cash dividends paid and capital gains distributions made by mutual funds. Dividends that “qualify” for the lower 15% (or 20% for higher earners) tax rate are reported in a separate box on the form. Interest paid on taxable bonds and tax-free bonds is reported on Form 1099-INT.

Question 15

Which of the following is reported on Form 1099-DIV?

A. Cash dividends
B. Stock dividends
C. Stock splits
D. All of the above

Answer 15

The best answer is A.

Form 1099-DIV is the report to the IRS by issuers of cash dividends paid and capital gains distributions made by mutual funds. Stock splits and stock dividends are not taxable event and are not reported. However, they affect the cost basis per share, and this must be adjusted.

Question 16

If a customer does not give a broker his or her instructions, cost basis reporting on Form 1099-B for a stock holding where there have been multiple purchases at different times is done on a:

A. FIFO basis
B. LIFO basis
C. Specific identification basis
D. Random selection basis

Answer 16

The best answer is A.

Cost basis reporting to the IRS is required on Form 1099-B. The Form includes the cost basis of the security, the sale proceeds, and whether the holding period is short term or long term. If there are multiple purchases of the stock position, absent customer instructions, FIFO is used to report cost basis. If the customer gives instructions to the broker, then specific identification can be used - which is beneficial if higher cost shares are selected to either reduce capital gains or increase reported capital losses.

Question 17

Under IRS rules, if a customer selling shares of stock wishes to use specific identification instead of FIFO for cost basis reporting, the broker-dealer effecting the trade must be notified of this no later than:

A. Trade Date
B. Confirmation Date
C. Settlement Date
D. Statement Date

Answer 17

The best answer is C.

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

Question 18

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

A. 0
B. $100 capital gain
C. $100 capital loss
D. $200 capital gain

Answer 18

The best answer is B.

The accrued interest on a bond has no bearing on the capital gain or loss that results from the liquidation of a position. Rather, the accrued interest is an adjustment to interest income paid or received for that tax year. These bonds were purchased in the secondary market at 90% of $10,000 = $9,000. The bonds were sold at 91% of $10,000 = $9,100. Thus, the capital gain is $100.

The accrued interest paid when the bonds were purchased is a reduction of the investor’s investment income in that tax year; while the accrued interest received upon sale is an increase of the investor’s investment income for that year.

Also note that because the bond was held for less than 1 year, the rule requiring the annual accretion of the market discount to be taxed as ordinary income does not “kick in” because any gain or loss is short term and would be taxed at the same higher tax rate as ordinary income. The bond must be held for more than 1 year to qualify for long term capital gains treatment, and the lower tax rate that comes with it. For positions held over 1 year, the tax rate drops to 15% (or 20% for very high earning taxpayers), from a maximum rate of 37%.

Question 19

A customer buys a corporate bond in the secondary market, paying a premium over par, plus accrued interest. The customer chooses not to amortize the bond premium for tax purposes. Regarding the customer’s cost basis in the bond which of the following statements are TRUE?

I The cost basis is inclusive of any accrued interest paid by the customer
II The cost basis excludes any accrued interest paid by the customer
III The cost basis is inclusive of any mark-up or commission paid by the customer
IV The cost basis excludes any mark-up or commission paid by the customer

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 19

The best answer is C.

Accrued interest paid is not included in the customer’s cost basis in the bond. Rather it is an offset against other interest received by the customer in that tax year.

The cost basis is the price paid for the bond, inclusive of any mark-up or commission paid by the customer.

Question 20

On Thursday, June 9th, 2019, a customer buys 5 XYZ 10% convertible debentures M’ 8-01-40 at 89 5/8 plus accrued interest in a regular way trade. On January 9th, 2020, the customer sells the bonds at 90 3/8 plus accrued interest in a regular way trade. For tax year 2019, the customer’s reported interest income is:

A. $66.67
B. $183.33
C. $250.00
D. $433.33

Answer 20

The best answer is A.

For tax purposes, interest is reported as it is received on a cash basis. Thus, only interest payments actually made by the issuer in tax year 2019 are included. The customer bought the bonds on Thursday, June 9th, 2019. The customer receives the August 1st interest payment in 2019. The next payment will be made on February 1st, 2020, so only one interest payment is reported for 2019.

One interest payment (August 1st) 10% bonds x $5,000 face amount = $500.00 annual interest income/2 = $250.00 interest payment reported on that year’s tax return. In addition, the accrued interest that the buyer paid to the seller is deducted from the reported interest income. The bonds were purchased on Thursday, June 9th, 2019, so regular way settlement takes place on Monday, June 13th. Interest accrues up to, but not including the 13th. Thus, the buyer had to pay the seller accrued interest for:

Feb: 30 days 
Mar: 30 days 
Apr: 30 days 
May: 30 days 
Jun:	12 days
Total:	132 days

132 days / 360 days per year x $100 annual interest per bond x 5 bonds = $183.33 accrued interest paid. The reported taxable interest income is $250.00 interest received less $183.33 accrued interest paid = $66.67 taxable interest income.

Note: This is a very difficult question and a minor item for the exam.

Question 21

On Tuesday, May 11th, 2019, a customer buys 5 XYZ 9% subordinated debentures M’ 8-01-40 at 89 5/8 plus accrued interest in a regular way trade. On January 13th, 2020, the customer sells the bonds at 90 3/8 plus accrued interest in a regular way trade. For tax year 2019, the customer’s reported interest income is:

A. $97.50
B. $127.50
C. $225.00
D. $351.25

Answer 21

The best answer is A.

For tax purposes, interest is reported as it is received on a cash basis. Thus, only interest payments actually made by the issuer in tax year 2019 are included. The customer bought the bonds on Tuesday, May 11th, 2019. The customer receives the August 1st interest payment in 2019. The next payment will be made on February 1st, 2020, so only one interest payment is reported for 2019.

One interest payment (August 1st) 9% bonds x $5,000 face amount = $450.00 annual interest income/2 = $225.00 interest payment reported on that year’s tax return. In addition, the accrued interest that the buyer paid to the seller is deducted from the reported interest income. The bonds were purchased on Tuesday, May 11th, 2019, so regular way settlement takes place on Thursday, May 13th. Interest accrues up to, but not including the 13th. Thus, the buyer had to pay the seller accrued interest for:

Feb: 30 days 
Mar: 30 days 
Apr: 30 days 
May: 12 days	
Total:	 102 days

102 days/360 days per year x $90 annual interest per bond x 5 bonds = $127.50 accrued interest paid. The reported taxable interest income is $225.00 interest received less $127.50 accrued interest paid = $97.50 taxable interest income.

Note: This is a very difficult question and a minor item for the exam.

Question 22

On Tuesday, June 8th, 2019, a customer buys 5 XYZZ 9 3/8% subordinated debentures M’ 8-01-39 at 89 5/8 plus accrued interest in a regular way trade. On January 13th, 2020, the customer sells the bonds at 90 3/8 plus accrued interest in a regular way trade. For tax year 2019, the customer’s reported interest income is:

A. $66.41
B. $169.97
C. $234.38
D. $401.04

Answer 22

The best answer is A.

For tax purposes, interest is reported as it is received on a cash basis. Thus, only interest payments actually made by the issuer in tax year 2019 are included. The customer bought the bonds on Tuesday, June 8th, 2019. The customer receives the August 1st interest payment in 2019. The next payment will be made on February 1st, 2020, so only one interest payment is reported for 2019.

One interest payment (August 1st) 9.375% bonds x $5,000 face amount = $468.75 annual interest income/2 = $234.375 interest payment reported on that year’s tax return. In addition, the accrued interest that the buyer paid to the seller is deducted from the reported interest income. The bonds were purchased on Tuesday, June 8th, 2019, so regular way settlement takes place on Thursday, June 10th. Interest accrues up to, but not including the 10th. Thus, the buyer had to pay the seller accrued interest for:

Feb: 30 days 
Mar: 30 days 
Apr: 30 days 
May:30 days 
Jun:	9 days
Total: 129 days

129 days/360 days per year x $93.75 annual interest per bond x 5 bonds = $167.97 accrued interest paid. The reported taxable interest income is $234.38 interest received less $167.97 accrued interest paid = $66.41 taxable interest income.

Note: This is a very difficult question and a minor item for the exam.

Question 23

Straight line accretion of a municipal bond discount will cause the:

I bond’s cost basis to be increased by equal amounts each year
II bond’s cost basis to be increased by decreasing amounts each year
III amount of any potential capital gain on sale to decrease each year
IV amount of any potential capital gain on sale to increase each year

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 23

The best answer is A.

When a bond discount is accreted, annually, the bond’s cost basis is increased by the pro-rata amount of the discount and the accretion amount is shown as an increase of interest income received for tax purposes. However, the actual dollar amount of interest received from the issuer does not change. Because the cost basis is adjusted upwards annually by the accretion amount, this reduces potential capital gain upon sale (since capital gain equals sale proceeds minus cost basis).

Question 24

Accretion of a municipal bond discount for tax purposes results in:

I no change in the bond’s cost basis
II an increase in the bond’s cost basis
III no change in the amount of interest income received
IV a decrease in the amount of interest income received

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 24

The best answer is C.

When a bond discount is accreted, annually, the bond’s cost basis is increased by the pro-rata amount of the discount and the accretion amount is shown as an increase of interest income received for tax purposes. However, the actual dollar amount of interest received from the issuer does not change. Because the cost basis is adjusted upwards annually by the accretion amount, this reduces potential capital gain upon sale (since capital gain equals sale proceeds minus cost basis).

Question 25

When a bond discount is accreted annually, all of the following statements are true EXCEPT:

A. the bond’s cost basis is increased proportionally each year
B. the bond’s accretion amount is shown as an increase of reported interest income received
C. the bond’s accretion amount is reported as a decrease to the annual reported interest
D. there will be no capital gain on the bond if held to maturity

Answer 25

The best answer is C.

When a bond discount is accreted, annually, the bond’s cost basis is increased by the pro-rata amount of the discount and the accretion amount is shown as interest income received for tax purposes. Over the life of the bond, the entire discount will be accreted, increasing the cost basis to par at maturity. Thus, there will be no capital gain or loss at maturity; and the entire discount will have been taxed as interest income over the bond’s life.

Question 26

Which statements are TRUE about accretion of bond discounts?

I Annual accretion amounts increase reported interest income
II Annual accretion amounts increase the interest amount received from the issuer
III Annual accretion amounts increase the bond’s cost basis
IV Annual accretion amounts increase potential capital gain upon sale

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 26

The best answer is A.

When a bond discount is accreted, annually, the bond’s cost basis is increased by the pro-rata amount of the discount and the accretion amount is shown as an increase of interest income received for tax purposes. However, the actual dollar amount of interest received from the issuer does not change. Because the cost basis is adjusted upwards annually by the accretion amount, this reduces potential capital gain upon sale (since capital gain equals sale proceeds minus cost basis).

Question 27

Amortization of a municipal bond premium for tax purposes results in:

I no change in the bond’s cost basis
II a decrease in the bond’s cost basis
III no change in the amount of interest income received
IV a decrease in the amount of interest income received

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 27

The best answer is C.

Municipal bond premiums must be amortized on a straight line basis over the life of the bond for tax purposes. Each year, the amortization amount reduces the bond’s cost basis, so that at maturity, the bond has a cost basis of par. Since the bond is redeemed at par, there is no capital loss (which would have been deductible for tax purposes). The annual amortization amount does not affect the amount of interest received from the issuer. This is based solely on the coupon rate placed on the issue.

Question 28

Straight line amortization of a municipal bond premium will cause the:

I bond’s cost basis to be reduced by equal amounts each year
II bond’s cost basis to be reduced by decreasing amounts each year
III amount of any potential capital gain on sale to increase each year
IV amount of any potential capital gain on sale to decrease each year

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 28

The best answer is A.

Straight line amortization is required for all municipal bonds purchased at a premium. The premium is divided by the number of years to maturity to get an annual amortization amount. Each year, the bond’s cost basis is reduced by this amount. Because the cost basis is decreasing at the same rate annually, each year the amount of any capital gain potential on sale becomes larger. The formula for determining capital gain is:

Capital Gain = Sale Proceeds - Adjusted Cost Basis

Question 29

When using straight line amortization on premium bonds:

A. the same interest income is reported each year
B. decreasing interest income is reported each year
C. increasing interest income is reported each year
D. the reported interest income is determined by the current market price of the bond

Answer 29

The best answer is A.

Straight line amortization is an equal annual “write-off” of the bond premium over the life of the bond. The annual amortization amount reduces taxable interest income on corporate bonds and non-taxable interest income on municipal bonds. Each year, the amortization amount reduces the cost basis of the bond; so that at maturity, the bond is valued at cost and no tax deductible capital loss results. For bonds with a fixed coupon rate, since the annual amortization amount is the same, the annual reported interest income is the same each year.

Question 30

When amortizing a bond premium, which of the following statements are TRUE?

I The bond’s cost basis is increased each year
II The bond’s cost basis is reduced each year
III Any potential gain of the sale of the bond increases each year
IV Any potential gain of the sale of the bond decreases each year

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 30

The best answer is C.

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

Question 31

When a bond premium is amortized annually, all of the following statements are true EXCEPT:

A. the bond’s cost basis is reduced proportionally each year
B. the bond’s amortization amount is shown as an increase of reported interest income received
C. the bond’s amortization amount is reported as a reduction to the annual reported interest
D. there will be no capital loss on the bond if held to maturity

Answer 31

The best answer is B.

When a bond premium is amortized, annually, the bond’s cost basis is reduced by the pro-rata amount of the premium and the amortization amount is shown as a reduction of interest income received for tax purposes. Over the life of the bond, the entire premium will be amortized, reducing the cost basis to par at maturity. Thus, there will be no capital gain or loss at maturity.

Question 32

Regarding corporate discount bonds, which statements are TRUE?

I Corporate original issue discount bonds must be accreted
II Corporate original issue discount bonds may be accreted
III Corporate market discount bonds must be accreted
IV Corporate market discount bonds may be accreted

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 32

The best answer is B.

The discount on original issue discount corporate and government bonds must be accreted annually - with the accretion amount being taxable annual interest income. The premium on original issue premium corporate bonds may be amortized for tax purposes; this election is beneficial to the bondholder since the annual amortization amount reduces taxable annual interest income.

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

Question 33

Regarding secondary market corporate bonds, which statements are TRUE?

I Corporate market discount bonds must be accreted
II Corporate market discount bonds may be accreted
III Corporate market premium bonds must be amortized
IV Corporate market premium bonds may be amortized

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 33

The best answer is D.

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

If a corporate or Government bond is purchased at a premium in the secondary market, the holder has the option of amortizing the premium over the bond’s life. The bondholder doesn’t have to amortize the premium, but it is in his best interest to do so because amortizing the premium reduces reported taxable interest income each year.

Question 34

Regarding original issue corporate bonds, which statements are TRUE?

I Corporate original issue discount bonds must be accreted
II Corporate original issue discount bonds may be accreted
III Corporate original issue premium bonds must be amortized
IV Corporate original issue premium bonds may be amortized

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 34

The best answer is B.

The discount on original issue discount corporate and government bonds must be accreted annually - with the accretion amount being taxable annual interest income. The premium on original issue premium corporate bonds may be amortized for tax purposes; this election is beneficial to the bondholder since the annual amortization amount reduces taxable annual interest income.

Question 35

The discount on original issue discount corporate and government bonds:

A. must be amortized annually
B. may be amortized annually
C. must be accreted annually
D. may be accreted annually

Answer 35

The best answer is C.

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

Question 36

A customer buys $10,000 of a new issue 10 year corporate bond at 92. At maturity, the customer will have:

A. no capital gain or loss
B. an $80 capital gain
C. an $800 capital gain
D. an $800 capital loss

Answer 36

The best answer is A.

The discount on all original issue discount bonds (corporate, government and municipal) must be accreted over the life of the bond. If the bond is held to maturity, the entire discount has been accreted and the adjusted cost basis is par. Since the bonds are redeemed at par, there is no capital gain or loss at maturity.

Question 37

All of the following are true regarding corporate bonds which are purchased in the secondary market at a discount and accreted EXCEPT:

A. the interest income is subject to Federal Income tax
B. the interest income is subject to State and Local tax
C. if the bond is held to maturity, there is no taxable capital gain
D. if the bond is held to maturity, there is a taxable capital gain which is taxed as ordinary income

Answer 37

The best answer is D.

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

Question 38

Which of the following statements are TRUE regarding corporate bonds purchased in the secondary market at a discount?

I The discount must be accreted
II The discount may be accreted
III The discount may be taxed as a long term capital gain if held for over 1 year
IV The discount will be taxed as ordinary income

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 38

The best answer is D.

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

Question 39

Which statements are TRUE about market discount corporate bonds?

I The discount may be taxable as a capital gain at maturity
II The discount may be accreted over the life of the bond and taxed annually as interest income
III The discount need not be accreted over the bond’s life and will be taxed as interest income earned when the bond matures or is sold

A. I and II only
B. I and III only
C. II and III only
D. None of the above

Answer 39

The best answer is C.

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

Question 40

The discount on market discount corporate and government bonds:

A. must be amortized annually
B. may be amortized annually
C. must be accreted annually
D. may be accreted annually

Answer 40

The best answer is D.

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

Question 41

A customer buys a $100,000 - 30 year U.S. Government bond with 10 years left to maturity in the secondary market at 80. The customer does not elect to accrete the discount annually. At maturity, the customer will have:

A. no capital gain or loss
B. a $20,000 taxable capital gain
C. $20,000 of taxable interest income
D. a $20,000 capital loss

Answer 41

The best answer is C.

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

Question 42

A customer buys $10,000 of 30 year corporate bonds with 10 years left to maturity at 92. The customer elects not to accrete the discount annually. At maturity, the customer will have:

A. no capital gain or loss
B. an $800 taxable capital gain
C. $800 of taxable interest income
D. a $9,200 taxable capital gain

Answer 42

The best answer is C.

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

Question 43

A $10,000 par corporate bond is purchased in the secondary market with a .30 mark-down. If the bond is held to maturity, the tax consequence is:

A. $30 capital gain
B. $30 taxable interest income
C. $300 capital gain
D. $300 taxable interest income

Answer 43

The best answer is B.

If a corporate bond is purchased in the secondary market for less than par, the market discount is treated as “taxable interest income.” The holder has the choice of accreting the market discount annually and paying tax each year, or waiting until maturity or sale to pay the tax (the better option).

This bond is purchased at $10,000 less a .30 mark-down, which is a mark-down of .30% of $10,000 = $30. The bond is purchased for $9,970. If the bond is held to maturity, the $30 gain is taxable interest income.

Question 44

Which statements are TRUE about amortization of corporate bond premiums?

I New issue corporate bonds purchased at a premium must be amortized over the life of the bond
II New issue corporate bonds purchased at a premium may be amortized over the life of the bond
III Secondary market corporate bonds purchased at a premium must be amortized over the life of the bond
IV Secondary market corporate bonds purchased at a premium may be amortized over the life of the bond

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 44

The best answer is D.

If a corporate or Government bond is issued at a premium or if the bond is purchased at a premium in the secondary market, the holder has the option of amortizing the premium over the bond’s life. The bondholder doesn’t have to amortize the premium, but it is in his best interest to do so because amortizing the premium reduces reported taxable interest income each year.

Question 45

In 2019, a customer buys a 3% U.S. Government bond maturing in 2023 at 102. The customer elects to amortize the bond premium for tax purposes. If the bond is sold after 2 years, its cost basis at that time is:

A. 101-16
B. 101
C. 100-24
D. 100-16

Answer 45

The best answer is B.

Both Government and corporate bond premiums may be amortized, if elected by the owner - and this is the best choice for the owner because the annual amortization reduces the taxable interest income received from the bond. This Government bond cost 102, for a premium of 2 points. Since the bond has 4 years to maturity, the annual amortization amount is 2 points divided by 4 years = 1/2 point per year. If the bond is sold after 2 years, 1 point of the premium will have been amortized. Thus, the bond’s adjusted cost basis is 102 - 1 = 101.

Question 46

A customer makes an investment in a CMO. In a given year, she receives $24,000 of payments, of which $6,000 is principal and $18,000 is interest. Which statement is TRUE about the taxation of the payments received?

A. Only the principal amount received is taxable
B. Only the interest amount received is taxable
C. Both the principal and interest amounts received are taxable
D. Neither the principal nor the interest amount received is taxable

Answer 46

The best answer is B.

A CMO (Collateralized Mortgage Obligation) passes-through the monthly mortgage payments to the certificate holders. The monthly mortgage payment is a combined payment of principal and interest, and the principal received reduces the outstanding principal (debt) amount. Only the interest component received is taxable; the principal component is a return of original investment.

Question 47

A customer has invested $100,000 in a CMO. In the first year, the customer receives $12,000 of payments, which consist of $9,000 of interest and $3,000 of principal. Which statement is TRUE?

A. All $12,000 received is taxable
B. All $12,000 received is not taxable
C. The $3,000 of principal is not taxable and the $9,000 of interest is taxable
D. The $3,000 of principal is taxable and the $9,000 of interest is not taxable

Answer 47

The best answer is C.

A CMO (Collateralized Mortgage Obligation) passes-through the monthly mortgage payments to the certificate holders. The monthly mortgage payment is a combined payment of principal and interest, and the principal received reduces the outstanding principal (debt) amount. Only the interest component received is taxable; the principal component is a return of original investment.