FINRA Series 7Investment Information and Suitable RecommendationsEasy
A registered representative recommends a corporate zero-coupon bond with a $1,000 face value maturing in 10 years, purchased for $600. The client asks how this bond is taxed each year even though no cash interest is received. Which statement is correct?
- AThe bond is tax-exempt because it does not pay periodic interest
- BNo tax is owed until the bond matures or is sold, at which point all the gain is taxed as a capital gain
- CTax is deferred until maturity, and the entire discount is then taxed as ordinary income in that final year
- DThe annual accretion of the discount is taxed each year as ordinary interest income (phantom income), and the cost basis is increased accordingly
Show answer & explanationAnswer & explanation
Correct answer: D. The annual accretion of the discount is taxed each year as ordinary interest income (phantom income), and the cost basis is increased accordingly
Original issue discount (OID) on a zero-coupon bond must be accreted and reported as taxable interest income annually, even though no cash is received (phantom income). The client's cost basis rises each year by the amount accreted, so at maturity the adjusted basis equals par, avoiding double taxation.
Why the other options are wrong
- A. Incorrect — corporate zero-coupon bonds are fully taxable (unlike municipal zeros).
- B. Incorrect — the IRS requires annual accretion to be taxed, not deferred to maturity or sale.
- C. Incorrect — tax is not deferred; it is recognized annually as it accretes.
Zero-Coupon Bond Phantom Income
The annual accreted discount on a zero-coupon bond is taxed as ordinary income each year even though no interest is actually received in cash.
- Applies to corporate and Treasury zeros (municipal zeros are tax-exempt)
- Cost basis increases each year by the accreted amount
- No cash flow to pay the tax — investor must fund it from other sources
Memory trick: 'Phantom' pays no cash, but the IRS still wants its share every year.