FINRA Series 7Investment Information and Suitable RecommendationsHard
A high-income client subject to the alternative minimum tax (AMT) is considering purchasing a municipal revenue bond issued to finance a privately operated toll road (a private activity bond). What is the most important suitability concern the representative should raise?
- AThe bond's interest is fully taxable at the federal level for all investors
- BThe bond's interest, though exempt from regular federal tax, may be a tax preference item subject to the AMT
- CThe bond cannot be purchased by individual investors, only institutions
- DThe bond's principal is not guaranteed by the U.S. government and carries default risk
Show answer & explanationAnswer & explanation
Correct answer: B. The bond's interest, though exempt from regular federal tax, may be a tax preference item subject to the AMT
Interest on private activity bonds (PABs) is exempt from regular federal income tax but is treated as a tax preference item that must be added back when calculating alternative minimum taxable income. For a client already subject to AMT, this could significantly reduce or eliminate the expected tax benefit of the municipal bond.
Why the other options are wrong
- A. Incorrect — PAB interest remains exempt from regular federal tax; it's only an AMT preference item.
- C. Incorrect — individuals can and do purchase private activity bonds.
- D. Incorrect — while default risk exists, it is not the primary concern being tested here (the AMT issue is unique to this bond type).
Private Activity Bond AMT Preference
Interest on private activity municipal bonds is exempt from regular federal income tax but counts as a tax preference item for alternative minimum tax purposes.
- Issued to finance projects benefiting private entities (e.g., airports, stadiums, toll roads)
- Interest is added back when computing AMTI for AMT calculation
- Can reduce or eliminate tax-exempt benefit for AMT-subject investors
Memory trick: Private roads, public tax trap — AMT investors beware.