- Which of the following statements regarding an investment adviser's relationship to an employer-sponsored 401(k) plan as a client is TRUE?
Answer: The adviser's client is the plan, acting through its named fiduciary, and the adviser bases recommendations on the plan's participant demographics and the employer's objectives
Under ERISA, a 401(k) plan acts through its named fiduciary, such as the plan administrator or the employer's investment committee, and the plan—through that fiduciary—is the adviser's client for the plan account; recommendations should reflect participant demographics and the employer's plan objectives. The statement that individual participants may direct the plan's fee structure is wrong because participants do not direct the plan's investment lineup or its fees. The statement that the employer bears all investment risk is wrong for a 401(k), where participants bear the investment risk in their individual accounts. The statement that a plan cannot be a client is wrong because the plan, through its fiduciaries, can enter into advisory relationships.
A state-registered adviser manages the investment portfolio of a C corporation. The corporation's president, who owns 60% of its stock, telephones the IAR and directs the IAR to sell the corporation's municipal bonds and buy common stocks. The IAR's file contains no corporate resolution or other document identifying who is authorized to transact for the corporation.
Which action is most appropriate for the IAR? Answer: Obtain a corporate resolution or similar document identifying who is authorized to transact for the corporation, and treat the corporation as the client.
Under the adviser's fiduciary duty to the corporation and standard account-authorization practice, a corporation is a separate legal person. Because the file contains no corporate resolution or similar document identifying who may transact, the IAR must obtain that documentation before acting on the president's oral direction; apparent authority alone is not sufficient documented transaction authority for a securities account. The controlling shareholder is not the client, and shareholder consent is not required for routine portfolio trades.
An IAR is managing a $2 million account for a newly formed S corporation with no C corporation history. The S corporation will retain the funds for a future factory expansion. The sole shareholder is in the highest federal income tax bracket. The IAR is comparing a municipal bond fund and a Treasury bond fund of similar duration and credit quality.
Which statement is correct for the IAR's analysis? Answer: Because the S corporation is a pass-through entity, the shareholder is taxed currently on the Treasury interest that passes through, so the IAR should make the after-tax comparison at the shareholder's marginal rate.
Under Subchapter S of the Internal Revenue Code, an S corporation generally is not a separate federal income taxpayer. Its taxable items pass through to shareholders and are reportable in the year earned, regardless of whether the corporation distributes any cash. Therefore, the IAR should compare the Treasury fund's after-tax yield with the municipal fund's tax-exempt yield using the shareholder's marginal rate, not a corporate rate. The corporate-tax statement, the deferred-until-distribution statement, and the taxes-are-irrelevant statement each misstate the pass-through rules.
- Which of the following statements regarding an investment adviser's management of an account for a manager-managed limited liability company (LLC) is TRUE?
Answer: The adviser's client is the LLC as an entity, and the LLC acts through its manager rather than through the individual members
Under state limited liability company law, a manager-managed LLC is a separate legal entity, so the investment adviser's client is the LLC itself, and the LLC acts through its manager. The statement that fiduciary duties run to each member individually is wrong because the entity, not the members, is the client; the adviser does not need each member's written consent to execute transactions. The statement that the LLC must be treated as a corporation is wrong because an LLC's tax classification depends on its structure and elections—it may be disregarded, taxed as a partnership, or elect corporate status—so it does not always file a corporate return. The statement that members are personally liable for investment losses is wrong because limited liability is a defining characteristic of an LLC.
- Which of the following statements regarding the fixed-income allocation for a tax-exempt charitable foundation is TRUE?
Answer: The foundation should generally favor taxable bonds over municipal bonds because the municipal tax exemption provides no advantage to a tax-exempt investor.
Under tax-equivalent yield analysis, a foundation exempt from federal income tax has a 0% marginal tax rate, so the municipal bond tax exemption provides no after-tax benefit. Taxable fixed-income investments generally offer higher yields and are therefore usually more appropriate than municipal bonds for the foundation's fixed-income allocation. The statement that a municipal bond's tax-equivalent yield is higher than its stated yield is wrong: with a 0% tax rate, the tax-equivalent yield equals the stated yield. Using the highest individual marginal tax rate is wrong because the foundation's marginal rate is 0%. The statement that a taxable bond's after-tax yield is lower than its stated yield is wrong because the foundation pays no federal income tax on the interest.
A client is the executor and primary beneficiary of her late father's estate. The estate's brokerage account holds common stocks, and the client asks the IAR to sell a portion of the portfolio to pay the estate's taxes; the remaining shares will be distributed to the beneficiaries as the will directs. The IAR has not yet obtained documentation of the client's authority to act for the estate.
Which of the following must the IAR obtain before acting on the client's instructions for the estate account? Answer: Letters testamentary issued by the probate court, because they are evidence of the executor's authority to transact for the estate.
Under state probate law, an executor's authority to act for an estate is evidenced by letters testamentary issued by the probate court (or letters of administration for an administrator). The IAR must obtain this evidence before following instructions to trade in the estate account. Beneficiaries do not own estate assets while administration is pending, so neither their consent nor a written authorization from the client as an individual is sufficient. The estate's attorney cannot confer transactional authority on the executor; the estate is the account holder, and the executor acts in a fiduciary capacity.
A grandmother wants to open an account for her 10-year-old grandson under the state's Uniform Transfers to Minors Act (UTMA). Her goals are to make a present gift, to keep the assets available for the grandson's college education, and to keep the assets out of her gross estate if she dies before the account terminates. She plans to serve as custodian. Under the state's UTMA, custodial property must be distributed to the beneficiary at age 21.
Which statement about this account is CORRECT? Answer: If the grandmother dies while serving as custodian before the grandson reaches age 21, the account will be included in her gross estate.
Under the Uniform Transfers to Minors Act and the Internal Revenue Code's estate tax rules, the minor is the beneficial owner of the custodial property and the custodian is a fiduciary, not the owner. If the donor serves as custodian and dies before the custodianship terminates, the property is included in the donor's gross estate, so the grandmother's estate-exclusion goal fails if she names herself custodian. The custodian has no ownership interest to distribute to herself, the grandson cannot demand the assets at 18 because the state's UTMA sets the distribution age at 21, and custodial assets may be used for the minor's benefit generally — they are not limited to higher education and no penalty applies.
- Which of the following statements regarding a Uniform Transfers to Minors Act (UTMA) account is TRUE?
Answer: The custodian may use the assets for the minor's benefit, but the assets belong to the minor and must be turned over at the statutory age set by state law
Under the Uniform Transfers to Minors Act, the custodian has discretionary authority to spend the custodial property for the minor's support, education, and benefit, but the property belongs irrevocably to the minor and must be transferred to the minor at the age specified by state law. The statement that the custodian may change the designated beneficiary is wrong because UTMA gifts are irrevocable and the minor is the sole beneficiary. The statement that the minor gains control at age 14 is wrong; control passes only at the statutory age. The statement that the custodian may hold the account indefinitely is wrong because UTMA requires transfer at the statutory age.
- Which of the following statements regarding an investment adviser's management of an account for a decedent's estate is TRUE?
Answer: The estate's executor is the adviser's client, and the adviser must ensure the portfolio provides liquidity for estate taxes and administration expenses
Under state probate law, a decedent's estate is administered by the executor or personal representative, who directs the estate's investment account and is the adviser's client; the portfolio must provide liquidity for estate taxes, administration expenses, and specific bequests. The statement that beneficiaries must approve investment changes is wrong because beneficiary approval is not required during administration. The statement that the will's investment directives override the executor's instructions is wrong because the executor has the authority to manage the estate's assets, and wills rarely contain day-to-day investment directives. The statement that beneficiaries may demand immediate distribution is wrong because distributions are governed by the probate process and the estate's administration schedule.
Two unmarried sisters, ages 60 and 62, want to open a joint securities account. The older sister wants the entire account to pass to her sister immediately upon her death, without probate, while her personal residence and other assets are to pass to her two children under her will. The sisters will contribute equal amounts.
Which account structure best accomplishes the older sister's objectives? Answer: Joint tenancy with rights of survivorship, because the account passes to the sister by operation of law and the will governs the house and other assets.
Under state property law, a joint tenancy with rights of survivorship passes the entire account to the surviving joint tenant by operation of law, outside probate, and the decedent's will does not control the account; the will still governs the house and other assets. A tenancy in common does not carry survivorship rights, so each tenant's share is a probate asset that passes under her will. A transfer-on-death designation naming the children would give the children the account, contradicting the sister's objective, and community property is a marital property regime available only to spouses.
An IAR of a state-registered adviser is meeting with a client who owns a retail store as a sole proprietor. The client wants to open a securities account titled 'Main Street Gifts' to invest the store's cash reserves and asks how the account should be set up.
Which statement is CORRECT? Answer: The account should be treated as the client's individual account, because a sole proprietorship has no separate legal existence from its owner.
Under state business-entity law, a sole proprietorship has no separate legal existence; the owner and the business are the same person, and the owner is personally liable for the business's obligations. The account is therefore the individual client's account. A sole proprietor is not required to incorporate to hold securities; a partnership agreement and corporate resolution are irrelevant to a sole proprietorship; and although a sole proprietor may obtain an employer identification number, the business's income is not taxed to the business as a separate taxpayer — it is reported on the owner's personal tax return.
- Which of the following statements regarding an investment adviser's fiduciary obligations when managing a portfolio for an irrevocable trust is TRUE?
Answer: The adviser's fiduciary duties run to the trustee and require the adviser to weigh the interests of the trust's income beneficiaries and remainder beneficiaries when making recommendations
Under the Uniform Prudent Investor Act, the adviser's client for an irrevocable trust is the trustee, who holds legal title and directs the trust's investments, and the adviser must balance the interests of income beneficiaries and remainder beneficiaries. The statement that duties extend to the grantor is wrong because an irrevocable trust cannot be revoked or amended by the grantor. The statement that duties run exclusively to the income beneficiaries is wrong because the remainder beneficiaries' interest in principal is also protected by the prudent investor standard. The statement that the adviser merely follows the trustee's instructions is wrong because the adviser is a fiduciary and must exercise independent professional judgment.
An IAR manages a portfolio for an irrevocable trust. The trustee is the trust department of a bank. The trust instrument names the grantor's sister as income beneficiary and a museum as remainderman; it is silent on investment authority. The sister emails the IAR and directs an immediate reallocation of the trust's portfolio from its current balanced allocation to 80% high-grade bonds and 20% equities. The bank trustee has not responded to the IAR's voicemails about the request.
What should the IAR do? Answer: Decline to act until the bank trustee confirms the reallocation, because the trustee is the party with legal authority to direct trust investments.
Under state trust law, the trustee is the authorized representative of a trust and has the legal power to direct trust investments unless the trust instrument provides otherwise. The sister's status as income beneficiary gives her an economic interest but not management authority. The museum's equitable remainder interest does not give it a power to consent to investment changes. The grantor of an irrevocable trust generally has no continuing control unless the trust reserves that power. Because the bank trustee has not confirmed the sister's direction, the IAR should not execute the reallocation.
A married couple wants to start saving for their 6-year-old granddaughter's college education. Their goals are to keep the funds under their own control, to ensure the money is used only for the granddaughter's education, and to obtain tax-free growth for qualified education expenses. The couple asks the IAR to compare a 529 plan with a custodial account under the state's UTMA; the grandchild would receive the assets at age 21.
Which statement best explains why the 529 plan is preferable to the UTMA account for this couple? Answer: As owners of the 529, the couple control distributions and may name an eligible family member as the new beneficiary; UTMA assets belong to the grandchild and are paid to her at age 21.
Under IRC § 529 and the Uniform Transfers to Minors Act, the decisive difference is ownership and control. The owner of a 529 plan controls distributions and may name another eligible family member as beneficiary; the grandchild has no right to the funds. UTMA assets are the grandchild's property and, under the stated state rule, must be distributed to her at age 21 with no requirement that they be used for education. The gift-tax statement is wrong because 529 contributions are gifts for federal gift tax purposes—they qualify for the annual exclusion rather than no-gift treatment—just as UTMA contributions are gifts. The federal-deduction statement is wrong because there is no federal income tax deduction for 529 contributions. The age-21 spending statement is wrong because a 529 plan has no age-21 distribution deadline and may be used for qualified expenses after that age.
An IAR of a state-registered investment adviser is meeting with a prospective client who serves as trustee of an irrevocable trust created by her father. The trust directs that all income be paid quarterly to the father's 72-year-old wife for life, with the principal to be distributed to the father's three adult children when she dies. The trust instrument gives the trustee full investment discretion. The trustee tells the IAR that the children want maximum long-term growth and asks for an all-equity portfolio. The income beneficiary has no role in investment decisions.
Which response by the IAR is most appropriate? Answer: Recommend a balanced portfolio of income and growth assets, because the trustee's duties run to the income beneficiary and the remainder beneficiaries.
Under the Uniform Prudent Investor Act and general trust fiduciary law, the trust is the client acting through its trustee, and the trustee owes a duty of impartiality to both the income beneficiary and the remainder beneficiaries. An all-equity growth portfolio would favor the adult children and could deprive the 72-year-old income beneficiary of current income, so a balanced portfolio is the appropriate recommendation. Full investment discretion does not permit the trustee to favor one class of beneficiaries. Following the trustee's instruction ignores that duty; the income beneficiary's consent is not required because beneficiaries generally do not control the trustee's investment decisions; and the grantor of an irrevocable trust has surrendered control over the assets, so his approval is not required.
