Series 7 practice questionmediumDebt Securities — Corporate Bonds — Zero-Coupon
A zero-coupon bond is purchased at $600 and matures at $1,000 in 10 years. Which of the following is TRUE?
- AThe bondholder must pay taxes annually on the imputed (phantom) interest, even though no cash is received✓ Correct answer
- BThe bondholder receives semi-annual interest payments
- CThe bond is exempt from federal income tax
- DThe issuer does not benefit from issuing zero-coupon bonds
Explanation
Why A — The bondholder must pay taxes annually on the imputed (phantom) interest, even though no cash is received
Zero-coupon bonds do not make periodic interest payments. Instead, they are sold at a deep discount and mature at par. The IRS requires the holder to recognize imputed (phantom) interest income annually, calculated using the constant yield method (original issue discount or OID). This creates a tax liability even though no cash is received until maturity, sometimes called 'phantom income.'
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