FINRA Series 7 — All Questions

A customer buys $20,000 of Class B shares with a CDSC of 5% in year one, 4% in year two, 3% in year three, 2% in year four and 1% in year five, applied to the lesser of original cost or redemption value. The shares are worth $24,000 when sold during the third year. What is the CDSC?

• a.$800
• b.$720
• c.$600✓
• d.$1,000

During the third year the rate is 3%, applied to the lower of cost ($20,000) and value ($24,000): 3% x $20,000 = $600. Using the $24,000 value gives $720. $800 is the 4% year-two rate, and $1,000 is the 5% year-one rate.Fund prospectus (contingent deferred sales charge)

Class A shares of a fund carry a 5.75% front-end load and a 0.25% annual 12b-1 fee. Class C shares carry no load, no deferred charge and a 1.00% annual 12b-1 fee. Ignoring growth and compounding, after how many full years does Class C's cumulative cost first exceed Class A's?

• a.After 6 years
• b.After 23 years
• c.After 8 years✓
• d.After 7 years

Class A costs 5.75% + 0.25% per year and Class C costs 1.00% per year, so C overtakes A once 0.75% x n exceeds 5.75%, which is n > 7.67. At 7 years C costs 7.00% against 7.50%, and at 8 years it costs 8.00% against 7.75%. Six years divides by the full 1.00% and ignores Class A's own fee; 23 years divides by 0.25% instead of the 0.75% difference; seven years is a rounding down of 7.67.FINRA Rule 2341(d); fund prospectus share classes

A customer holds shares of Fund X in a taxable account with a cost of $8,000 and a value of $9,500. She exchanges them for shares of Fund Y in the same fund family, with no sales charge. What are the tax consequences?

• a.The full $9,500 is taxed as income because it moved between funds
• b.Only the dividends are taxed, and the gain is deferred until Fund Y is sold
• c.The exchange is tax-free because both funds belong to the same family
• d.A taxable sale occurs and she recognizes a $1,500 gain✓

An exchange between funds, even within one family, is a redemption of one fund and a purchase of another, so the $1,500 gain is recognized in a taxable account. Only exchanges inside a tax-deferred account or a qualifying insurance product escape current tax. The gain is not deferred, and only the $1,500 gain, not the whole $9,500, is taxable.IRC Section 1001; IRS Publication 550

Under FINRA's sales charge rule, what are the maximum annual asset-based sales charge and the maximum annual service fee a fund may charge, each as a percentage of average net assets?

• a.0.75% asset-based sales charge and 0.50% service fee
• b.0.75% asset-based sales charge and 0.25% service fee✓
• c.0.50% asset-based sales charge and 0.50% service fee
• d.1.00% asset-based sales charge and 0.25% service fee

Rule 2341 caps the asset-based sales charge at 0.75% of average annual net assets and the service fee at 0.25%, so total 12b-1 fees top out at 1.00%. Allowing 1.00% for the sales charge confuses the combined ceiling with the sales charge cap. A 50/50 split and a 0.50% service fee both overstate the service-fee cap.FINRA Rule 2341(d)

A fund imposes no front-end or deferred sales charge but deducts a 0.40% annual 12b-1 fee. May it describe itself as 'no-load'?

• a.Yes, because the fund has neither a front-end nor a deferred sales charge to the investor
• b.Yes, because 12b-1 fees below 0.75% of assets are permitted for no-load funds
• c.No, because its annual 12b-1 and service fees together exceed 0.25% of its net assets✓
• d.No, because a fund that has any 12b-1 plan at all cannot use the word no-load

A fund may not be called no-load if it has a front-end or deferred sales charge or if its annual charges against net assets for sales, promotion and shareholder services exceed 0.25%. At 0.40% this fund is over the line. Lacking a load is not enough on its own. The 0.75% figure is the cap for asset-based sales charges, not the no-load test, and a 12b-1 plan of 0.25% or less would still be allowed.FINRA Rule 2341(d)

An investor bought shares of a stock fund four months ago. The fund distributes $1.80 per share of capital gains it realized on securities held for several years. How is the distribution taxed to the investor?

• a.As a short-term capital gain, because the fund shares were held under 12 months
• b.As a long-term gain, whatever the investor's holding period✓
• c.As a nontaxable return of capital, because it lowers the share price
• d.As ordinary dividend income, because the payment came from a fund

A capital gain distribution is always reported as long-term, because its character comes from the fund's holding period of its securities, not the investor's holding period of the fund shares. Four months of ownership therefore does not make it short-term. It is not an ordinary dividend, and it is not a return of capital, which would be a payout in excess of the fund's earnings.IRC Section 852(b)(3); IRS Topic 404

A fund sells stocks it owned for seven months at a gain and distributes the net gain. An investor who has held the fund for five years receives it. How is the distribution reported?

• a.As a long-term capital gain, because the investor held the fund over a year
• b.As an ordinary dividend, because the fund's gains were short-term✓
• c.As a return of capital that reduces the investor's basis
• d.As a long-term capital gain, because gains paid by a fund count as long-term

Only net long-term gains are passed through as capital gain distributions. Net short-term gains realized by a fund are paid out as ordinary dividends, whatever the investor's own holding period. The investor's five years of ownership does not change the character, and a payout of earnings is not a return of capital.IRC Section 852(b); IRS Publication 550

An investor buys 1,000 fund shares at an NAV of $24.00 one day before the ex-dividend date. The fund pays $1.20 per share, which is reinvested, and the NAV drops to $22.80. What is the investor's total cost basis after the reinvestment?

• a.$26,400
• b.$22,800
• c.$25,200✓
• d.$24,000

The investor paid $24,000 and owes tax on the $1,200 distribution; reinvesting it adds $1,200 of basis, giving $25,200 (about 1,052.63 shares). Leaving basis at $24,000 ignores the reinvestment. $22,800 values the shares at the post-distribution NAV, which is not what the investor paid, and $26,400 counts the distribution twice.IRS Publication 550 (reinvested distributions and basis)

An investor paid $10,000 for fund shares. The fund classifies $600 of a distribution as return of capital. What is the tax result?

• a.The $600 is ordinary income, and the basis stays at $10,000
• b.The $600 is a long-term gain, and the basis stays at $10,000
• c.The $600 is taxed now, and the basis also falls to $9,400
• d.No current tax on the $600, and the basis falls to $9,400✓

A return of capital is not taxed when received; it lowers the basis, so $10,000 becomes $9,400, and the amount is recovered later through a bigger gain or smaller loss on sale. It is not ordinary income or a gain at receipt, and the investor does not both pay tax and reduce basis, which would tax the same dollars twice.IRC Section 301(c); IRS Topic 404

An investor bought 100 fund shares at $10, another 100 at $14 and another 100 at $12, in that order. She sells 150 shares at $15 and elects average cost. What is her gain?

• a.$750
• b.$450✓
• c.$350
• d.$550

Average cost is $3,600 / 300 = $12 per share, so the sale produces $2,250 - $1,800 = $450. $550 is the first-in, first-out result (basis of $1,700), and $350 is the last-in, first-out result (basis of $1,900). $750 pairs the sale with the cheapest 150 shares at $10, which is not an average.Treas. Reg. 1.1012-1(e); IRS Publication 550

An investor sells all 200 shares of a fund at a $1,000 loss. Twelve days later, an automatic dividend reinvestment buys 8 shares of the same fund. What is the tax treatment of the loss?

• a.$960 is allowed, and $40 is disallowed and added to the basis of the 8 replacement shares✓
• b.The full $1,000 is allowed, because reinvested dividends are not purchases
• c.$40 is allowed, and $960 is disallowed because of the reinvestment
• d.The full $1,000 is disallowed, because any repurchase within 30 days voids the loss

The wash sale rule applies to replacement shares bought within 30 days, including through dividend reinvestment, but only to the extent of the shares replaced: 8 of 200 is 4%, so $40 is disallowed and carried into the new shares' basis. Treating reinvestments as exempt allows too much. Disallowing everything overstates the replacement, and allowing $40 reverses the proportions.IRC Section 1091; IRS Publication 550

A national municipal bond fund distributes $0.30 per share of exempt-interest dividends and $0.10 per share of long-term capital gains. For federal income tax purposes (ignoring AMT), what is taxable?

• a.Only the $0.10 capital gain distribution✓
• b.Only the $0.30, because interest from a fund is always taxable
• c.Both distributions, because the fund passes through taxable income
• d.Neither, because all payments from a municipal fund are exempt

Exempt-interest dividends keep their federal exemption when passed through, but a capital gain distribution from a municipal fund is taxable as a long-term gain. The fund structure does not remove the exemption on the interest, and the exemption does not extend to the gain.IRC Section 852(b)(5); IRS Publication 550

A retired customer sets up a fixed-dollar withdrawal plan of $2,000 a month from a bond fund yielding about 3%. Which statement is accurate?

• a.Withdrawals above the dividend are treated as a tax-free return of capital to the investor
• b.Each withdrawal redeems shares, so it may create gains or losses and erode principal✓
• c.A new sales charge applies to each withdrawal because shares are redeemed by the plan
• d.Withdrawals are limited to the dividends and gains the fund earns, so principal is protected

A fixed-dollar plan pays the stated amount by redeeming shares as needed, so the sale of shares can trigger gains or losses and shrink the account when withdrawals exceed income. A plan that pays only income is a different design. Proceeds above the dividend are share sales, not a tax-free return of capital, and a redemption carries no new front-end charge.Fund prospectus (systematic withdrawal plan)

An interval fund has 12 million shares outstanding. Which repurchase offer size is permitted under Rule 23c-3?

• a.1,200,000 shares✓
• b.360,000 shares
• c.3,600,000 shares
• d.480,000 shares

Rule 23c-3 requires each repurchase offer to be at least 5% and no more than 25% of outstanding shares, which is 600,000 to 3,000,000 here, so 1,200,000 shares (10%) qualifies. 360,000 is 3% and 480,000 is 4%, both under the floor. 3,600,000 is 30%, above the ceiling.Investment Company Act Rule 23c-3

How does a registered tender-offer fund differ from an interval fund?

• a.It lists its shares on an exchange, so liquidity comes only from market trades
• b.It must make a repurchase offer at set intervals for 5% to 25% of outstanding shares under a fundamental policy
• c.It redeems shares at NAV on any business day an investor asks, as an open-end fund must
• d.Its board decides whether and when to make repurchase offers; no policy requires them to be made✓

A tender-offer fund repurchases at the board's discretion and is not obliged to offer liquidity on a schedule, while an interval fund commits by fundamental policy to periodic repurchase offers of 5% to 25% of outstanding shares under Rule 23c-3. Neither redeems on demand every business day, which is an open-end feature, and a tender-offer fund is not listed, so its liquidity does not come from exchange trading.Investment Company Act Section 23(c); Rule 23c-3

The index tracked by an exchange-traded note is unchanged, yet the note falls after its issuing bank's credit rating is cut. Which risk does this show?

• a.Issuer credit risk, because an ETN is an unsecured debt obligation of the issuing bank✓
• b.Active management risk, because the manager changed the note's holdings
• c.Tracking error, because the ETN holds a basket of securities that missed the index
• d.Authorized participant risk, because creation units were redeemed in kind

An ETN is an unsecured debt obligation of its issuer, so its value depends on the issuer's creditworthiness as well as on the index. It holds no basket of securities, so tracking error against holdings and creation-unit mechanics do not apply as the explanation, and the index did not move, which also rules out manager choices.Exchange-traded notes (issuer credit risk)

A closed-end fund sells shares in its IPO at $20.00 with a 4.50% underwriting charge taken from the proceeds. Ignoring other costs, what is the NAV per share right after the offering?

• a.$19.14
• b.$19.00
• c.$19.10✓
• d.$19.55

The charge comes out of the money raised, so the fund keeps $20.00 x 0.955 = $19.10 per share. $19.14 divides by 1.045 as if the charge were added on top. $19.55 takes 4.5 cents rather than 4.5% off, and $19.00 uses a 5% charge. This shortfall is one reason new closed-end shares often fall below NAV.FINRA Rule 2111; closed-end fund offering

A 2x daily leveraged ETF is worth $100. Over two days its underlying index falls 10% and then rises 10%. What is the ETF worth at the end, assuming the fund resets daily?

• a.$98.00
• b.$96.00✓
• c.$99.00
• d.$100.00

Day one: -20% leaves $80. Day two: +20% on $80 adds $16, giving $96. The index itself ends at $99 (0.90 x 1.10), so $99 describes the unlevered index. Doubling the index's two-day -1% gives $98, which ignores daily compounding, and $100 assumes the gains and losses cancel.SEC Regulatory guidance on leveraged ETFs

A customer is offered a principal-protected structured note issued by a broker-dealer's parent. What should the representative explain about the protection?

• a.The Treasury backs the protection if the note is held to maturity
• b.FDIC insurance covers the principal up to $250,000 if the note is held to maturity
• c.SIPC coverage replaces the principal if the issuer of the note defaults
• d.It depends on the issuer's ability to pay, since the note is unsecured✓

Principal protection on a structured note is only a promise by the issuer, so the investor carries the issuer's credit risk. A note issued by a bank or broker-dealer parent is not a deposit, so FDIC insurance does not apply, SIPC protects against a failed broker-dealer holding customer assets rather than an issuer default, and the Treasury does not stand behind it.FINRA Regulatory Notice 12-03 (structured products)

Why do ETFs typically distribute fewer capital gains than comparable open-end mutual funds?

• a.ETFs are exempt from the pass-through rules that apply to other funds
• b.ETF portfolio managers must hold each security for more than a year
• c.ETF shares do not change in price between trades, so no gains arise in the portfolio
• d.Redemptions are usually in kind, so low-basis securities leave the fund without being sold✓

Authorized participants redeem creation units for baskets of securities, so the fund can deliver low-basis lots without a taxable sale. ETFs do have price changes and gains. ETFs must still follow the regulated investment company pass-through rules to avoid fund-level tax, and no rule forces a one-year holding period.SEC guidance on ETF structure (Rule 6c-11)

A unit holder in a fixed-portfolio bond UIT wants cash before the trust terminates. What is the usual way to exit?

• a.Redeem with the trustee at NAV, or sell the units to the sponsor's secondary market✓
• b.Sell the units on an exchange at a price set by the market, like an ETF share
• c.Ask the portfolio manager to remove the holder's pro rata bonds
• d.Wait until termination, since units cannot be redeemed before then

UIT units are redeemable securities, and the sponsor customarily maintains a secondary market, so an investor can redeem at NAV or sell back. UITs are not generally listed on exchanges. Units can be redeemed before the termination date, and there is no portfolio manager to carve out specific bonds.Investment Company Act Section 4(2); Section 26

A bond held in a fixed UIT portfolio is called, and the trustee receives the proceeds. What happens to the money?

• a.It is reinvested by the portfolio manager in similar bonds of the same quality
• b.It is held in cash until the trust's stated termination date
• c.It is converted into additional units for each holder in the trust
• d.It is passed to unit holders rather than reinvested in new bonds✓

A UIT holds a fixed portfolio with no manager making new investment decisions, so principal from called or maturing bonds is passed along to holders. A manager cannot reinvest because there is none, and the trust does not hold the cash or issue new units for investors.Investment Company Act Section 4(2)

During the accumulation phase of a variable annuity, an owner invests $2,500 when the accumulation unit value is $12.50 and another $3,000 when it is $15.00. Later the unit value is $16.00. What is the value of the owner's units?

• a.$6,400✓
• b.$7,040
• c.$5,866.67
• d.$5,500

The first payment buys 200 units and the second buys 200 units, a total of 400 units, and 400 x $16.00 = $6,400. $5,500 is only the total invested. $7,040 treats all $5,500 as bought at $12.50 per unit, and $5,866.67 treats all of it as bought at $15.00.Variable annuity accumulation units

A 50-year-old holds a nonqualified variable annuity with a $60,000 cost basis and a $90,000 value. He withdraws $10,000 without annuitizing. What are the tax results?

• a.The full $10,000 is ordinary income, and a 10% additional tax of $1,000 applies✓
• b.The full $10,000 is ordinary income, and no penalty applies because the account is not a retirement plan
• c.$3,333 is ordinary income and $333 is a penalty, since the withdrawal is part basis and part earnings
• d.The $10,000 is tax-free because it is under his cost basis, and no penalty applies

Withdrawals from a nonqualified deferred annuity are treated as earnings first, so the first $30,000 of withdrawals is all taxable ordinary income, and the 10% additional tax applies before age 59 1/2. A pro rata split would apply only to annuity payments, using an exclusion ratio, rather than to withdrawals. Cost basis is recovered last. Retirement plan status is not needed for the 10% tax under Section 72(q).IRC Section 72(e) and 72(q)

An investor paid $60,000 for an immediate annuity with an expected total payout of $80,000 and receives $8,000 each year. What part of each annual payment is taxable until the basis is recovered?

• a.$6,000
• b.$4,000
• c.$8,000
• d.$2,000✓

The exclusion ratio is $60,000 / $80,000 = 75%, so $6,000 of each $8,000 payment is a return of cost and $2,000 is taxable. $6,000 is the excluded amount, not the taxable one. $8,000 treats the full payment as taxable, and $4,000 splits it in half.IRC Section 72(b)

A customer wants to exchange an existing contract without recognizing gain. Which exchange does Section 1035 NOT cover?

• a.A life insurance policy for a deferred annuity
• b.A deferred annuity for a life insurance policy✓
• c.A life insurance policy for another life insurance policy
• d.A deferred annuity for another deferred annuity

Section 1035 allows life insurance to be exchanged for life insurance, endowment, annuity or long-term care contracts, and an annuity for another annuity or long-term care contract. It does not allow an annuity to be exchanged for a life insurance policy, so that exchange triggers tax on the gain. The other three exchanges are permitted.IRC Section 1035(a)

A registered representative holds only a Series 7 and wants to sell variable annuities to clients. What else must she have?

• a.A Series 6 registration in addition to the Series 7 she holds
• b.A Series 24 general securities principal registration
• c.Nothing more, because a variable annuity is a security and the Series 7 covers it
• d.A state insurance license with authority to sell variable contracts✓

A variable annuity is both a security and an insurance product, so the seller needs a securities registration and a state insurance license. The Series 7 already qualifies her to sell variable contracts as securities, so a Series 6 adds nothing, and principal registration is for supervisors. Saying nothing more is needed overlooks the insurance side.FINRA Rule 1220; state insurance licensing

A customer proposes exchanging her deferred variable annuity for a new one. Which is a required consideration before the representative recommends the exchange?

• a.Whether the exchange qualifies under Section 1035, since a tax-free exchange is by itself suitable
• b.Only whether she has done another deferred variable annuity exchange in the past 12 months
• c.Whether she would face a surrender charge, start a new surrender period, or lose existing benefits such as a death benefit✓
• d.Whether she has reached age 59½, because only then may a Section 1035 exchange be recommended

Rule 2330 requires consideration of whether the customer would incur a surrender charge, be subject to a new surrender period, or lose existing contractual benefits, and the firm must also look at any other deferred variable annuity exchange in the preceding 36 months, not 12, and as one factor among several rather than the only one. A tax-free Section 1035 exchange can still be unsuitable. The age of 59½ matters for the tax on early withdrawals, not as a condition of recommending an exchange.FINRA Rule 2330(b)(1)(B)

A policyholder owns a $250,000 variable life policy. The separate account suffers heavy losses for three years. Which statement is accurate?

• a.The death benefit stays at $250,000 or more while in force; the cash value can fall✓
• b.Neither is guaranteed, and the death benefit can fall to the level of the cash value
• c.The cash value is guaranteed, but the death benefit may fall below $250,000 if the account falls
• d.Both the death benefit and the cash value are guaranteed against investment loss by the insurer

Variable life guarantees a minimum death benefit, the face amount, as long as the premiums are paid, while the cash value rises and falls with the separate account and is not guaranteed. The statement that the cash value is guaranteed reverses this. Neither value being guaranteed ignores the minimum death benefit, and guaranteeing both describes no variable product.Variable life insurance (separate account)

A variable annuity has a 7-year surrender schedule (7%, 6%, 5%, 4%, 3%, 2%, 1%) and permits an annual penalty-free withdrawal of 10% of the contract value. In the third contract year the value is $50,000 and the owner withdraws $12,000. What is the surrender charge?

• a.$420
• b.$250
• c.$350✓
• d.$600

The free amount is 10% of $50,000, or $5,000, so $7,000 is subject to the third-year charge of 5%, giving $350. $600 applies 5% to the whole withdrawal. $250 applies 5% to only the free amount. $420 uses the year-two rate of 6% on the excess.Variable annuity contract terms

A REIT has $8,000,000 of REIT taxable income for the year. What is the smallest dividend deduction that satisfies the distribution test and avoids corporate-level tax on the distributed income?

• a.$8,000,000
• b.$7,200,000✓
• c.$6,400,000
• d.$7,600,000

A REIT must pay dividends of at least 90% of its taxable income, so 90% of $8,000,000 is $7,200,000. The 95% test gives $7,600,000 and was the rule before 2001. 80% gives $6,400,000, and $8,000,000 is the amount needed to avoid all tax, which the rule does not require. The REIT is taxed on any retained income.IRC Section 857(a)(1)

A client has $20,000 of suspended passive losses from a limited partnership and receives $5,000 in dividends from a REIT. May the passive loss offset the REIT dividend?

• a.Yes, but only if the REIT's shares are publicly traded on an exchange
• b.Yes, but only up to 50% of the dividend under the passive activity limits
• c.No, because REIT dividends are portfolio income, not passive income, for tax purposes✓
• d.Yes, for the full $5,000, because the REIT's income comes from real estate

Passive losses can only be used against passive income. Dividends from a REIT are portfolio income, so a limited partnership loss cannot shelter them, and a REIT cannot pass its own losses through to the investor either. Real estate holdings, a 50% cap, or listing status do not change the character of the dividend.IRC Section 469(e)(1)

Which fact would prevent a corporation from qualifying as a REIT?

• a.The shares are held by 150 shareholders, none owning more than 5%
• b.Five or fewer individuals own 60% of the shares in the last half of the tax year✓
• c.At least 75% of its assets are real estate, cash and government securities
• d.It distributes 92% of its taxable income to shareholders each year

A REIT must have at least 100 shareholders and cannot be closely held, meaning five or fewer individuals cannot own more than 50% of the value during the last half of the year. 150 holders satisfies the minimum. A 92% payout is above the 90% floor, and the 75% asset test is a requirement that the corporation is meeting.IRC Section 856(a)(5), (a)(6), (h)

A limited partner is allocated a $15,000 loss in a real estate program. He has $4,000 of passive income from another partnership and $90,000 of wages. How is the loss treated this year?

• a.$15,000 offsets his wages and reduces his taxable income this year
• b.$4,000 offsets passive income, and the other $11,000 is permanently lost
• c.$3,000 offsets ordinary income, and the rest is carried forward to later years
• d.$4,000 offsets passive income, and the other $11,000 is suspended and carried forward✓

A limited partner's loss is passive and can only offset passive income, so $4,000 is used this year. The unused $11,000 is suspended and carried forward to future passive income or the sale of the interest. Wages cannot be reduced by it. The $3,000 limit belongs to capital losses, and a passive loss is not forfeited.IRC Section 469

A real estate limited partnership defaults on a $2,000,000 mortgage, and the property sells for $1,500,000. The partnership has no other assets. Beyond the amount they invested, who is exposed to the $500,000 deficiency?

• a.No one, because a partnership cannot owe more than the property is worth
• b.Each limited partner, in proportion to units owned
• c.The limited partners and the general partner equally
• d.The general partner, who has unlimited liability for partnership debts✓

A general partner is personally liable for partnership obligations, so the deficiency reaches the general partner. A limited partner who does not take part in management risks only the investment, unless the offering documents call for additional contributions. A partnership can owe more than its asset value, and shared liability ignores the structure.Uniform Limited Partnership Act (liability of partners)

A limited partner paid $25,000 for units. This year he is allocated a $5,000 tax loss and receives a $3,000 cash distribution. What is his adjusted basis at year end?

• a.$17,000✓
• b.$20,000
• c.$22,000
• d.$23,000

Basis starts at $25,000. It is reduced by the $5,000 allocated loss and by the $3,000 cash distribution, which is a tax-free recovery of capital up to basis, so $25,000 - $5,000 - $3,000 = $17,000. $23,000 adds the distribution to basis. $22,000 omits the loss, and $20,000 omits the distribution.IRC Sections 705(a) and 731(a)

Before recommending a direct participation program, a representative must have reasonable grounds to believe which of the following about the customer?

• a.The customer qualifies as an accredited investor under Regulation D of the Securities Act
• b.The customer will be able to use all of the program's tax deductions in the first year
• c.The customer has a net worth of at least $1,000,000 excluding the primary residence
• d.The customer's net worth is sufficient to sustain the risks, including loss and illiquidity✓

Rule 2310(b)(2) requires reasonable grounds to believe that the participant has a fair market net worth sufficient to bear the risks, including loss of investment and illiquidity, and can realize the program's benefits. The rule sets no dollar figure. The $1,000,000 threshold belongs to the accredited investor definition, which the rule does not make a requirement, and tax deductions are not promised.FINRA Rule 2310(b)(2)

A client's net worth is $2,000,000 excluding her home, and she owns $1,200,000 in investments. A broker offers a hedge fund that relies on Section 3(c)(7). May she buy it?

• a.Yes, as long as the fund has no more than 100 investors
• b.No, because 3(c)(7) funds admit only qualified purchasers, generally those with $5,000,000 invested✓
• c.Yes, because her $2,000,000 net worth excluding her home makes her an accredited investor
• d.No, because hedge fund investors must have a net worth of at least $5,000,000

A 3(c)(7) fund may have an unlimited number of investors, but each must be a qualified purchaser, which for an individual generally means owning at least $5,000,000 in investments. Accredited status is not enough. The 100-investor cap belongs to 3(c)(1) funds, and $5,000,000 is measured in investments rather than net worth.Investment Company Act Section 3(c)(1) and 3(c)(7)

An investor places $1,000,000 in a hedge fund that charges a 2% management fee on beginning assets and a 20% incentive fee on profits after deducting the management fee. The fund earns 12% before any fees. What is the investor's net return?

• a.8.0%✓
• b.10.0%
• c.9.6%
• d.7.6%

Gross profit is $120,000. The management fee is $20,000, which leaves $100,000 of profit, and the 20% incentive fee on it is $20,000. The investor keeps $120,000 - $20,000 - $20,000 = $80,000, or 8.0%. 7.6% takes the incentive fee on the gross profit ($24,000). 9.6% omits the management fee and 10.0% omits the incentive fee.Hedge fund fee arithmetic

A retired customer wants an oil and gas direct participation program with the lowest drilling risk and with current cash distributions as the main goal. Which type is most consistent with those objectives?

• a.A combination program that puts most of its money into new exploratory wells
• b.An exploratory (wildcat) program drilling in unproven areas
• c.A developmental program drilling next to proven fields, to gain tax deductions
• d.An income program that buys interests in producing wells✓

An income program buys producing properties, so it avoids drilling risk and passes production revenue to investors as cash flow. A wildcat program carries the highest risk of dry holes, and its goal is large deductions for drilling costs rather than income. A developmental program drills near proven fields, which lowers dry-hole risk but is still drilling, and its payout is not yet producing. A combination program that leans on exploration brings the same risk as a wildcat program.FINRA Rule 2310 (direct participation programs); oil and gas program types

A Treasury note with a $50,000 face amount is quoted at 98-16. What is the price?

• a.$49,080
• b.$49,500
• c.$49,250✓
• d.$49,125

A Treasury quote of 98-16 means 98 and 16/32, which is 98.50% of par, so $50,000 x 0.985 = $49,250. $49,080 reads the 16 as a decimal (98.16%). $49,500 rounds the quote up to 99. $49,125 reads the fraction as sixty-fourths.Treasury note and bond quotations (32nds)

A 26-week (182-day) Treasury bill with a $10,000 face value is bought at $9,700. Using the 360-day bank discount method, what is the discount yield?

• a.5.93%✓
• b.6.20%
• c.3.00%
• d.6.00%

The discount is $300 on a face value of $10,000, or 3.00%. Annualized on a 360-day year over 182 days, that is 3.00% x 360/182 = 5.93%. 6.20% is the investment (bond-equivalent) yield, which divides by the $9,700 price and uses 365 days. 3.00% is the return for the period, and 6.00% simply doubles it.Treasury bill discount yield (31 CFR Part 356, Appendix B)

A Treasury note with a 4% coupon, $100,000 face and January 15 / July 15 interest dates settles on March 15 of a non-leap year, which is 59 days after the last coupon date. There are 181 days between those dates. What is the accrued interest?

• a.$666.67
• b.$655.56
• c.$646.58
• d.$651.93✓

Treasury accrued interest uses the actual number of days elapsed over the actual days in the coupon period. The semiannual coupon is $2,000, so $2,000 x 59/181 = $651.93. $666.67 uses the 30/360 corporate method (60/180). $646.58 applies the annual coupon over 365 days, and $655.56 uses 59 actual days over a 180-day half-year.31 CFR Part 356, Appendix B (daily interest decimal)

An investor buys a 26-week Treasury bill for $9,700 in November. It matures at $10,000 in May of the following year. When does the investor report the $300 of interest, assuming cash-basis accounting?

• a.In the year of maturity, as interest income, when the bill is paid at its face value✓
• b.In the year of maturity, but as a long-term capital gain on the bill
• c.In neither year, because the discount on a Treasury bill is not taxable
• d.In the year of purchase, since the discount is earned from the day it is bought

The difference between the discounted price and the face value received at maturity is interest income, and a cash-basis investor reports it in the year the bill is paid at maturity, here the following year. Reporting it in the year of purchase applies the accrual treatment of a stripped bond. The gain is interest, not capital gain, and Treasury interest is exempt only from state and local tax, not from federal tax.IRS Publication 550 (Treasury bills)

A resident of a state with an income tax receives $3,000 of interest from Treasury notes and $3,000 from a corporate bond. How is the interest taxed?

• a.Both are subject to federal and state income tax
• b.Both are exempt from state tax, but only the Treasury interest is federally taxed
• c.Both are subject to federal income tax, and only the corporate interest is taxed by the state✓
• d.Only the corporate interest is subject to federal tax, while the Treasury interest is fully exempt

Treasury interest is fully taxable for federal purposes but exempt from state and local income taxes, while corporate bond interest is taxed at every level. Treasury interest does not escape federal tax, which is the feature of municipal bonds. Corporate interest is not exempt from state tax.31 U.S.C. 3124 (Treasury interest exempt from state and local tax)

A customer holds a two-year Treasury floating rate note. A week after the latest 13-week bill auction, the bill's high discount rate rises. What happens to the note?

• a.The spread is raised, while the index part of the rate stays the same until maturity
• b.Nothing changes, because the rate was fixed when the note was issued at auction
• c.The rate resets only at each quarterly payment date, so it stays the same for now
• d.The index part resets weekly, so the rate rises while the spread stays fixed✓

A Treasury FRN has an interest rate equal to an index rate, based on the highest accepted discount rate of the most recent 13-week bill auction, plus a fixed spread. The index resets weekly, and interest is paid quarterly. The rate is not fixed like a regular note, the spread does not move, and resets are not tied to payment dates.TreasuryDirect: floating rate notes

A TIPS has a 2% annual coupon paid semiannually. Inflation has raised its principal from $10,000 to $10,300. What is the next interest payment?

• a.$300
• b.$100
• c.$206
• d.$103✓

Interest is the semiannual rate of 1% applied to the adjusted principal of $10,300, which is $103. $100 uses the original principal and ignores the adjustment. $206 is the annual interest on the adjusted amount, and $300 is the principal increase, which is not paid out until maturity.TreasuryDirect: TIPS interest

A $10,000 TIPS was issued when the reference CPI stood at 250. At maturity the CPI is 240. What principal is paid at maturity?

• a.$10,400
• b.$10,000✓
• c.$9,600
• d.$9,800

At maturity a TIPS pays the greater of the inflation-adjusted principal or the original principal, so the holder never receives less than $10,000 even though adjusted principal would be $9,600 (10,000 x 240/250). $10,400 reverses the index ratio, and $9,800 imagines the loss is shared with the Treasury, which the rules do not provide.TreasuryDirect: TIPS at maturity

During the year, a TIPS holder received $200 of interest, and inflation raised the principal by $300. Neither the increase nor any of the principal was paid out. What is her federal taxable income from the TIPS for the year?

• a.$300
• b.$200
• c.$0, because the increase is not received until maturity
• d.$500✓

Interest paid is taxable, and an increase in the principal of a TIPS is also taxable in the year it occurs, although it is paid only at maturity or sale, so the holder reports $200 + $300 = $500 of income. Reporting only the cash interest ignores the adjustment, and counting only the adjustment ignores the coupon. Waiting until maturity is the treatment for a Series EE bond, not a TIPS.IRS Publication 550 (TIPS); Treas. Reg. 1.1275-7

A customer buys a 10-year Treasury STRIPS at a deep discount and holds it in a taxable account. How is it taxed before maturity?

• a.The accreted discount is taxed as interest each year, though no cash is received until maturity✓
• b.Nothing is taxed until maturity, when the whole gain is taxed as a capital gain
• c.The accretion is exempt from federal income tax because the issuer is the U.S. Treasury
• d.The accretion is taxable only if the customer sells the STRIPS before maturity

A stripped bond is treated as an original issue discount instrument, so the investor includes the accreted discount in income every year as interest (phantom income) although the cash arrives at maturity. Deferral to maturity or sale is not available, the Treasury's guarantee gives no federal exemption, and the accreted amount is interest, not capital gain.IRC Section 1286 (stripped bonds)