QFC Tax Planning & Preparation 2 — Questions and Answers
Question 1: A hedge fund manager receives a $500,000 carried interest payment after a 3-year holding period. Under current US tax law, how is this typically taxed?
- As ordinary income at the manager's marginal rate
- As long-term capital gains at preferential rates (Correct answer)
- As self-employment income subject to FICA
- As qualified dividend income
Correct answer: As long-term capital gains at preferential rates
Carried interest held for more than 3 years qualifies for long-term capital gains treatment under the Tax Cuts and Jobs Act's Section 1061 rules.
Question 2: Which of the following best describes the 'wash sale' rule and its tax implication?
- Gains on securities sold within 30 days are taxed as ordinary income
- Losses are disallowed if substantially identical securities are repurchased within 30 days before or after the sale (Correct answer)
- Short sales must be held open for at least 45 days to claim a loss
- Securities sold at a loss must be held for 60 days before repurchase
Correct answer: Losses are disallowed if substantially identical securities are repurchased within 30 days before or after the sale
The wash sale rule (IRC §1091) disallows a loss deduction when substantially identical securities are purchased within 30 days before or after the sale.
Question 3: An investor in the 37% bracket holds a municipal bond yielding 4.5%. What is the approximate taxable equivalent yield?
- 4.5%
- 5.85%
- 7.14% (Correct answer)
- 6.75%
Correct answer: 7.14%
Taxable equivalent yield = tax-exempt yield / (1 - marginal rate) = 4.5% / (1 - 0.37) = 7.14%.
Question 4: Under IRC §1256, futures contracts and certain other derivatives are subject to the '60/40 rule.' What does this mean?
- 60% of gains are taxed at ordinary rates and 40% at capital gains rates
- 60% of gains are treated as long-term and 40% as short-term capital gains regardless of holding period (Correct answer)
- Losses can only offset 60% of futures gains in the current year
- 40% of open positions must be marked to market annually
Correct answer: 60% of gains are treated as long-term and 40% as short-term capital gains regardless of holding period
Section 1256 contracts are marked to market annually, with 60% of gains/losses treated as long-term and 40% as short-term, regardless of actual holding period.
Question 5: A portfolio manager wants to minimize taxes on a $2M equity portfolio. Which strategy directly harvests tax losses while maintaining market exposure?
- Rotating into tax-exempt municipal bonds
- Selling losing positions and immediately buying similar (not substantially identical) ETFs (Correct answer)
- Converting the portfolio to a deferred annuity
- Accelerating dividend recognition into the current tax year
Correct answer: Selling losing positions and immediately buying similar (not substantially identical) ETFs
Tax-loss harvesting involves selling securities at a loss and replacing them with similar (but not substantially identical) securities to maintain exposure while realizing the tax loss.
Question 6: What is the primary tax advantage of a 'step-up in basis' at death?
- Inherited assets are exempt from estate tax entirely
- Unrealized capital gains on inherited assets are permanently eliminated for income tax purposes (Correct answer)
- The holding period of inherited assets resets to zero for short-term treatment
- Inherited IRAs receive a stepped-up basis eliminating deferred income taxes
Correct answer: Unrealized capital gains on inherited assets are permanently eliminated for income tax purposes
Under IRC §1014, inherited assets receive a basis equal to fair market value at the date of death, permanently eliminating unrealized capital gains for income tax purposes.
Question 7: Which of the following correctly describes the Net Investment Income Tax (NIIT) under IRC §1411?
- A 3.8% tax on the lesser of net investment income or the amount by which MAGI exceeds the threshold ($200K single/$250K MFJ) (Correct answer)
- A 3.8% surtax on all capital gains regardless of income level
- A 5% tax on passive income from partnerships and S corporations
- A 2.9% additional Medicare tax on investment income above $500,000
Correct answer: A 3.8% tax on the lesser of net investment income or the amount by which MAGI exceeds the threshold ($200K single/$250K MFJ)
The NIIT imposes a 3.8% tax on the lesser of net investment income or the excess of MAGI over the threshold ($200K single, $250K MFJ).
QFC Tax Planning & Preparation 2
A hedge fund manager receives a $500,000 carried interest payment after a 3-year holding period.
Under current US tax law, how is this typically taxed?