Chapter 6 - Series 66 (Sept 2011) - Client Profiles, Portfolio Strategies, & Taxation

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Accounts

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As fiduciary, if client refuses to supply suitability info, the adviser cannot open the account.
On 'Joint Account Agreement' must designate TIC or JTWROS. Joint accounts must be must be signed by all tenants. TIC - estate retains fractional interest. JTWROS - interest passes to survivor. The only types of accounts that may be opened with a TOD designation are individual accounts and JTWRrOS accounts.

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Signatures Req'd to Open an Account.

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Only 2 signatures necessary on a new account form—that of the RR/Agent introducing
the account & that of the principal accepting it but not that of the client. Although many firms do ask for a client’s signature, that is the real world and not the test world.

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Trust Accounts

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3 Parties of a Trust; Settlor (aka Grantor), Trustee, Beneficiary. For a trust to be valid, both the Settlor & Trustee must be competent parties. A trustee is an individual or other party holding legal title to property held for the benefit of another person (or persons). Beneficiary - income & remainder.

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Types of Trusts >> Simple vs. Complex

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Simple - All income earned on assets placed into a ST must be distributed during the year it is received. The trustee is not empowered to distribute the trust principal from a simple trust. Complex - may accumulate income. A complex trust is permitted deductions for distributions of net income or principal. Capital gains are deemed part of the distributable net income of a complex trust unless reinvested. Trustee may distribute trust principal according to trust terms.

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Types of Trusts >> Living vs. Testamentary

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A Living trust (aka 'Inter vivos') during the maker’s lifetime, he has complete control over the assets & manages them for the benefit of the beneficiaries. A successor trustee is always named & upon the death of the maker, the successor trustee takes over. A testamentary trust is any trust that comes into being on death through a will. Assets that pass to a TT do not avoid probate, because the validity of the will’s instructions to pass property to the trust must be substantiated in probate court.

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Trust Accounts >> Revocable Versus Irrevocable Trusts

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A revocable trust must be a living trust because only the living grantor has the power to change or revoke (undo) the trust. no estate tax benefit is available for a revocable living trust. For a trust to be considered irrevocable, the settlor must give up all incidents of ownership in property transferred into the trust. Property placed in an irrevocable trust is usually not includable in the trustor’s estate for federal estate tax purposes.

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Trust Accounts >> Irrevocable Trusts - Exceptions that can jeopardize Effectiveness of an Irrevocable Trust to Reduce Estate Taxes

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1) grantor retains a life interest, or life income; 2) grantor retains a reversionary interest in the trust that is considered more than incidental; 3) grantor retains general power to direct to whom trust property will pass; 4) grantor transfers >=1 LI policies into an ILIT while retaining certain incidents of ownership, incl the ability to make loans from policy CV &/or change beneficiaries.

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Grantor Retained Annuity Trusts (GRATs)

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Grantor transfers property into a GRAT. Term of trust specifies that Grantor will receive a FA for a period of years. At the end of the term, the remainder beneficiaries get whatever is left. If assets in trust earn > 3% (current IRS rate), any earnings > that rate goes to the beneficiary(s) free of estate and gift taxes. If Grantor dies during the term of the trust remaining assets are considered part of the deceased’s estate.

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Taxation of Trusts

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Nondistributed income taxed very harshly (i.e. top rate of 35% for $11K of income). Distributable Net Income (DNI) determines the amount of income that may be taxable to beneficiaries. Tax-exempt interest from municipal bonds remains tax exempt to trust beneficiaries.

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Trust Accounts >> Bypass Trust

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Utilizes one spouses Unified Credit by funding a Trust for benefit of kids, instead of wasting it on spouse who then has a double-whammy tax bill at death. If done properly, can also provide income to spouse for life then pass to kids.

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Trust Accounts >> Generation Skipping Trust (GST)

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When BT funded, the amount calculated as having been given away is present value of gift, thus making highly appreciating gifts suitable property for a BT. 'Direct skip' refers to a skip of >= 2 generation. If a 'direct skip,' the donor or the donor’s estate via the executor pays the GST Tax.

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Estate Account(s)

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An estate account is a custodial account that, like a trust account, is directed by an executor on behalf of the beneficiary or beneficiaries of an estate. The executor makes the invest- ment, management, and distribution decisions for the account. The taxation on undistributed income of an estate is the same as that of trusts just described, and the tax is computed on form 1041.

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Suitability Issues Inherent in Trusts

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1) Trust doct spells out objectives & they must be followed. 2) In the case of an estate, the will must be followed; 3) If the IA is managing the portfolio, in addition to the normal fiduciary responsibility assumed by all investment advisers, there are the formal reqt's of the prudent investor rule.

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Business Accounts

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All forms of biz accounts have specific suitability reqt's.
1) Sole Proprietorship; 2) Partnership (Limited Partnership); 3) LLC's 4) S Corp's; 5) C Corp's.

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Margin Accounts

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The customer signs a margin agreement, (incl the req'd credit agreement, hypothecation agreement, & an optional loan consent.)
Under NASAA policies, it is an unethical biz practice to execute any trans in a margin account without a properly executed written margin agreement promptly after the initial transaction in the account.

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Maintenance Call and House Maintenance

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Current SRO levels are 25% for long margin accounts. The BD may have a stricter req't than the 25%, typically 35%.

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Margin Balances

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Long: CMV long – debit balance = long equity
Short: Credit balance – CMV short = short equity

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Custodial Accounts >> UTMA

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UTMA account app's must contain the custodian’s name, minor’s name & SSN, & the state in which the account is reg. UTMA's must be opened & managed as cash accounts only. Not marginable. Custodian must reinvest all cash proceeds, dividends, & interest within a reasonable period of time. Investment decisions must consider a minor’s age. Covered call writing allowed. Stock subscription rights or warrants must be either exercised or sold.

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Client Personal Profile >> Financial Status

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A financial profile incl's: current expenses; Liabilities, tax status; income sources; a B/S with all assets (incl collectibles & other real property) & liabilities (incl loans from 401k's and from LI policies).

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Client Personal Profile >> Non-Financial Info

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Age, marital status, Investment experience, Attitudes & values, number & age of dependents, employment stability, employment of family members, Current & future family educational needs, Current and future family health care needs

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Risk Tolerance

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1) The client’s objectives, 2) Amount available for investing; 3) The client’s aversion to risk. Important to know How much of a loss the investor can tolerate, liquidity reqt's, tax considerations, Investment time horizon, experience, current investment holdings, return expectations, Investment temperament, tolerance of fluctuations.

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Financial Goals and Objectives

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The most commonly specified goals include capital preservation, current income, capital growth, & speculation. The objectives behind these goals may be planning for college education, retirement, death, or disability.
1st choice for preservation of capital should always be bank-insured CDs

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Appropriate Investments >> Investor Goal >> Preservation of Capital

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CDs, highly rated bonds, savings accounts, and money market funds offer the safety they seek.
As fixed income investments, they are exposed to inflation (purchasing power) risk.

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Appropriate Investments >> Investor Goal >> Current Income

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Govt bonds and notes and agency bonds; ■ corporate bonds and notes; ■ preferred stock; and ■ utility company stock.

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Appropriate Investments >> Investor Goal >> Speculation

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highly volatile stocks; ■ high-yield (junk) bonds; ■ options on stocks or stock indexes; and ■ commodity futures.

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Tax Planning >> What three strategies may be used to reduce taxes?

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1) Asset and income shifting (shifting to a dependent in a lower tax bracket)
2) Tax deferral (Qualified accounts)
3) Tax-free income (Muni-bonds)

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Strategic Asset Allocation

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1) Constant ratio plan (model kept in a particular allocation ratio)
2) Constant dollar plan (allocate specific $'s to stocks, bonds and cash)

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Business Cycles

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1) Expansion (increases in sales, manufacturing, and wages)
2) Peak (GdP increases rapidly and businesses reach their productive capacity)
3) Contraction
4) Trough (business activity stops declining and levels off)

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Sector Rotation

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Based on the theory that one sector is always going to be in play due to the economic cycle. Typically client holds 3 sectors; one sector on the rise, one at the top, and one that is starting to decline.

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Definition of 'Growth' Style

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Earnings are growing faster than most other stocks & are expected to continue to do so. Because rapid growth in earnings is often priced into the stocks, growth investment managers are likely to buy stocks that are at the high end of their 52-week price range.

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Definition of 'Value' Style

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Concentrates on undervalued or out-of-favor secs whose price is low relative to the Co’s PE or BV & whose earnings prospects are believed to be unattractive by investors. Value managers seek to buy undervalued secs before the Co. reports positive earnings surprises.

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Definitions of Different Market Cap Sizes

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Large: > $10B
Mid: $2B - $10B
Small: $300M - $2B
Micro: <$300M
It is assumed that small Co's with a short history, small product line, & ltd financial resources represent a larger degree of risk in an economic downturn. As revenues, product diversification, & financial worth increase, the relative risk the Co. carries in a weak economy diminishes.

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3 Bond Strategies

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1) Barbell strategy 2) Bullet strategy, & 3) Laddering strategy

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Taxation of Corporations

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Dividends are paid out after paying income taxes, and then that dividend is taxable to the shareholder, hence the term double taxation. Dividends paid from one Co. to another are 70% exempt from taxation.

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Examples of Regressive and Progressive Taxes

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Regressive taxes (e.g., sales, excise, payroll, property, and gasoline taxes) are levied equally regardless of income and thus represent a smaller percentage of income for wealthy taxpayers.
Progressive taxes (e.g., estate and income taxes) increase the tax rate as income increases.

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Types of Income
(1 of 3)

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Earned: Incl's salary, bonuses, and income derived from active participation in a trade or business.
Alimony: is payment made under a (divorce) court order. Generally deductible to the spouse making the payments and includable in income for tax purposes by the spouse receiving them.
Child Support: Not to be confused with child support. CS is not deductible by the parent who pays it, nor is it incl in income by the recipient

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Types of Income >> Passive
(2 of 3)

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Passive income & losses come from rental property, LP's, & enterprises (regardless of business structure) in which an individual does not actively participate. for the general partner, income from a limited partnership is earned income; for the limited partner, the income is passive. Passive losses may be used to offset only passive income.

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Types of Income >> Passive
(3 of 3)

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Portfolio income incl dividends, interest, & net capital gains derived from the sale of secs. Dividend income - if qualifying, then max rate of 15%, otherwise, ordinary income. Interest income - Interest on any debt security - always taxed at ordinary income rates.

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Alternative Minimum Tax
(1 of 2)

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Certain items that receive favorable tax treatment must be added back into taxable income for the AMT and incl; 1) Accelerated depreciation on property placed in service after 1986 2) Certain costs associated with LP programs, such as R&D costs & excess intangible drilling costs. 3) Local tax and interest on investments that do not generate income

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Alternative Minimum Tax
(2 of 2)

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4) Tax-exempt interest on private purpose municipal bonds issued after August 7, 1986; 5) ISO's to the extent that the FMV of the employer’s stock is in excess the strike price of the option

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Determining Which Shares to Sell

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Investor may choose; 1) FIFO 2) Specific ID or 3) Average cost.
If the investor fails to choose, the IRS assumes the investor liquidates shares on a FIFO basis.

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Wash Sales

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An investor may not use capital losses to offset gains or income if the taxpayer sells a security at a loss & purchases the same or a substantially identical security <= 30 days before or after the trade date est the loss. The loss that was disallowed, however, is added to the repurchased shares’ cost basis. IRS compares 3 qualities of debt secs in determining whether they are substantially identical: the maturity, coupon, and issuer.

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Donated (Gifted) Securities

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Gifts. When a donor makes a gift of secs, the cost basis to the recipient (the donee) is the donor’s cost basis. This describes carryover basis.

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Inherited Securities

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Inherited Securities. when a person dies and leaves securities to heirs, the cost basis to the recipients is usually the fair market value on the date of the owner’s death. In other words, the cost basis steps up to the date of death value.

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Sale of a Primary Residence

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Special tax benefits for selling primary residence (as long as it has been lived in as the primary residence for at least 2 of past 5). For a couple, the first $500K in profit is excl from capital gains taxation; for a single person, it is the first $250K

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Estate Tax >> Gross Vs. Taxable Estate
(1 of 2)

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The gross estate incl all interests in property held by an individual at the time of death. Although amounts of property transferred to a spouse or a charity will generally not be subject to federal estate tax, such amounts are includable in calculating the gross estate. Adjusted Gross Estate (AGE) arrived by deducting funeral expenses, charitable contributions, & debts of the decedent.

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Estate Tax >> Gross Vs. Taxable Estate
(2 of 2)

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Once the amount of the AGE is determined, the unlimited marital and charitable deduc- tions are subtracted to arrive at the taxable estate. Estate taxes are due NLT 9 months after the date of death.

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Estate Tax >> Alternative Valuation Date

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The IRC provides that the executor of an estate may choose to value the assets in the estate as of date of death or, alternatively, 6 months later.

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Taxation of Foreign Securities

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Dividend & interest income received from foreign securities is normally subject to withholding tax, typically about 15%, by the issuer’s country of domicile. Current US tax law allows many investors to reclaim the withheld tax as a credit against taxes owed on their tax returns.

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Formula for Distributable Net Income (DNI)

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DNI = dividends and interest plus capital gains that have not been reinvested back into the trust.