This scenario is governed by MSRB Rule G-37, which addresses political contributions and prohibitions on municipal securities business. The rule is designed to prevent pay-to-play practices, where firms might make political contributions to secure underwriting business. The rule states that a broker, dealer, or municipal securities dealer is prohibited from engaging in negotiated municipal securities business with an issuer for a two-year period after the firm or one of its municipal finance professionals (MFPs) makes a contribution to an official of that issuer. An MFP is an associated person of a dealer who is primarily engaged in municipal securities representative activities, solicits municipal securities business, or is in the supervisory chain above such persons. In this case, the MFP made a contribution to an official of the issuer. The rule provides a de minimis exception, allowing an MFP to contribute up to $250 per election to an official for whom the MFP is entitled to vote, without triggering the ban. Here, the contribution of $300 exceeds the $250 limit. Furthermore, the MFP is not entitled to vote for the official, which would make even a contribution below $250 a trigger for the ban. Therefore, the contribution results in a two-year prohibition on the firm engaging in negotiated underwriting business with that specific issuer. The ban begins on the date the contribution was made. The prohibition applies specifically to negotiated business, not competitive bid underwritings.

The market discount on a municipal bond is the difference between the par value and the purchase price in the secondary market, when the purchase price is lower than par. In this scenario, the market discount is \( \$1,000 – \$960 = \$40 \). Unlike an original issue discount (OID), which is considered part of the tax-exempt interest and accretes on a tax-free basis, a market discount is treated differently for tax purposes. The accretion of a market discount is not considered tax-exempt interest. Instead, the accreted amount is taxed as ordinary income upon the sale or redemption of the bond. The investor can choose to accrete the discount annually and pay tax on it each year, or they can wait until the bond is disposed of (sold or matures) and recognize the entire discount as ordinary income at that time. The default treatment is to recognize the income at disposition. Therefore, when the bond matures, the \( \$40 \) gain attributable to the market discount is reported as taxable ordinary income. This is distinct from a capital gain, which would arise if the bond were sold for a price different from its accreted value. The coupon payments received throughout the life of the bond remain tax-exempt at the federal level. Understanding the distinction between the tax treatment of OID and market discount is critical for municipal securities professionals.

The calculation determines the annual accretion of the market discount and its tax consequence. First, calculate the total market discount: Total Market Discount = Par Value – Purchase Price Total Market Discount = \(\$5,000 – \$4,700 = \$300\) Next, calculate the annual accretion amount using the straight-line method: Annual Accretion = Total Market Discount / Years to Maturity Annual Accretion = \(\$300 / 15 = \$20\) The key aspect is the tax treatment of this accreted amount. For a municipal bond purchased in the secondary market at a discount (a market discount), the annual accreted value is treated as taxable ordinary income. This is a critical distinction from the tax treatment of an Original Issue Discount (OID) on a municipal bond, where the accretion is considered part of the tax-exempt interest. Therefore, the \(\$20\) that accretes each year increases the investor’s cost basis but is also reportable as ordinary income, subject to federal and potentially state income tax. The investor can elect to accrete and pay tax on the discount annually or defer the recognition of the income and pay tax on the entire accumulated discount as ordinary income upon the bond’s sale or maturity. The coupon interest received from the bond remains federally tax-exempt. The market discount itself does not gain tax-exempt status simply because it is associated with a municipal security. This differential tax treatment is a fundamental concept in analyzing the total return and tax liability for investors in the secondary municipal market.

The allocation of bonds is determined by the priority of orders as established in the syndicate’s Agreement Among Underwriters. The total issue size is $100,000,000. 1. Calculate allocation for Priority 1 (Presale Orders): Presale orders total $40,000,000. These are filled first in their entirety. Bonds remaining: \($100,000,000 – $40,000,000 = $60,000,000\). 2. Calculate allocation for Priority 2 (Group Net Orders): Group Net orders total $50,000,000. These are filled next. Bonds remaining: \($60,000,000 – $50,000,000 = $10,000,000\). 3. Calculate allocation for Priority 3 (Designated Orders): Designated orders total $30,000,000. However, only $10,000,000 in bonds remain. Therefore, only $10,000,000 of the designated orders can be filled. Bonds remaining: \($10,000,000 – $10,000,000 = $0\). 4. Calculate allocation for Priority 4 (Member Orders): Member orders total $20,000,000. Since no bonds remain, these orders receive no allocation. Final Allocation: Presale: $40,000,000 Group Net: $50,000,000 Designated: $10,000,000 Member: $0 In a negotiated municipal underwriting, the syndicate manager establishes the terms for distributing the new issue, including the priority for filling different types of orders. This hierarchy is crucial when an issue is oversubscribed, meaning demand exceeds the supply of bonds. The standard priority, as outlined in MSRB Rule G-11, ensures a fair and orderly allocation process. The highest priority is given to presale orders, which are commitments from customers gathered before the final terms of the bonds are set. These orders demonstrate strong initial interest and help the underwriter gauge demand. The next level of priority is for group net orders. In these orders, the profit from the sale is shared by all syndicate members on a pro-rata basis according to their participation in the account. Following group net orders are designated orders, where the customer placing the order designates which syndicate member or members should receive credit for the sale. The lowest priority is reserved for member orders, which are orders placed by a syndicate member for its own trading account or inventory. When allocating an oversubscribed issue, the syndicate manager must fill all orders at one priority level completely before moving to the next, lower level. Any orders in a priority level that cannot be filled completely are typically allocated on a pro-rata basis within that level, and all lower-priority orders will go unfilled.

This scenario involves the application of two key Municipal Securities Rulemaking Board (MSRB) rules: Rule G-23, concerning the activities of financial advisors, and Rule G-11, which governs primary offering practices. First, MSRB Rule G-23 places strict limitations on a firm acting as both a financial advisor and an underwriter for the same issuer on the same issue. A conflict of interest exists because the advisor’s duty is to help the issuer obtain the lowest possible borrowing cost, while the underwriter’s goal is to negotiate a higher yield to make the bonds easier to sell. However, the rule provides an exception. A firm may switch from a financial advisory role to an underwriting role if it terminates the financial advisory relationship in writing, the issuer provides express written consent for the change in role, and the firm discloses the potential conflict of interest. The scenario explicitly states that the advisory agreement was terminated in writing and that the issuer provided written consent, making the firm’s participation as an underwriter permissible. Second, MSRB Rule G-11 requires the senior manager of a syndicate to establish priority provisions for the allocation of securities in a new issue and to provide these provisions to syndicate members. While the exact priority can vary, a standard hierarchy is typically followed to ensure a fair and orderly distribution process. This hierarchy is: Pre-sale orders, Group Net orders, Designated orders, and finally Member orders. Furthermore, it is a common and accepted industry practice, often explicitly stated in the syndicate agreement, to give priority to retail orders over institutional orders. This practice promotes a wider distribution of the municipal bonds to the public. In this case, the syndicate agreement specifically gives priority to retail customer orders. Therefore, the retail order from the individual investor must be filled before the designated order from the institutional pension fund, even if they are for the same size.

The core of this problem lies in understanding the tax treatment of different municipal bonds, specifically for an investor subject to the Alternative Minimum Tax (AMT). The after-tax yield for the General Obligation (GO) bond, which is a public purpose bond, is compared to the Private Activity Bond (PAB). For an investor not subject to AMT, the taxable equivalent yield (TEY) is calculated to compare the municipal bond’s return to a taxable corporate bond. Assuming a 35% marginal federal tax bracket for the investor: TEY of GO Bond = \(\frac{\text{Tax-Exempt Yield}}{1 – \text{Marginal Tax Rate}} = \frac{3.5\%}{1 – 0.35} = \frac{3.5\%}{0.65} \approx 5.38\%\) TEY of PAB = \(\frac{4.2\%}{1 – 0.35} = \frac{4.2\%}{0.65} \approx 6.46\%\) However, the investor is subject to AMT. Interest income from certain PABs is a tax preference item, meaning it is added back to the investor’s income for AMT calculation purposes and taxed at the applicable AMT rate (e.g., 28%). The interest from the public purpose GO bond is not an AMT preference item. Therefore, the actual after-tax yield for the AMT-subject investor is different: After-Tax Yield of GO Bond = 3.5% (remains tax-exempt) After-Tax Yield of PAB = \(\text{Stated Yield} \times (1 – \text{AMT Rate}) = 4.2\% \times (1 – 0.28) = 4.2\% \times 0.72 = 3.024\%\) This calculation demonstrates that despite its higher stated coupon, the PAB provides a lower effective after-tax yield to this specific investor than the GO bond. The distinction between public purpose bonds and private activity bonds is critical for municipal securities professionals. While the interest on most municipal bonds is exempt from federal income tax, the interest on specified PABs is a preference item for the AMT. This means for high-income individuals who may be subject to AMT, the seemingly higher yield of a PAB can be misleading. The actual after-tax return may be significantly lower than that of a traditional GO or revenue bond with a lower coupon. This is a crucial suitability determination under MSRB Rule G-19, as the representative must understand the client’s tax status to make an appropriate recommendation. The higher yield on the PAB is, in part, compensation for this less favorable tax treatment for a segment of the investor population.

The first step is to determine if the market discount on the bond qualifies for the de minimis exemption. The de minimis rule states that a market discount is considered to be zero if it is less than 0.25% (or 1/4 of 1%) of the stated redemption price at maturity, multiplied by the number of full years from the date of purchase to maturity. Calculation of the de minimis threshold: \[ \text{De Minimis Threshold} = 0.0025 \times \text{Years to Maturity} \times \text{Face Value} \] \[ \text{De Minimis Threshold} = 0.0025 \times 10 \times \$10,000 = \$250 \] Calculation of the actual market discount: \[ \text{Market Discount} = \text{Face Value} – \text{Purchase Price} \] \[ \text{Market Discount} = \$10,000 – \$9,600 = \$400 \] The actual market discount of \$400 is greater than the de minimis threshold of \$250. Therefore, the discount does not qualify for the exemption and is not treated as a capital gain. When a municipal bond is purchased in the secondary market at a discount that exceeds the de minimis amount, the gain realized at maturity or upon sale is treated as taxable ordinary income. This gain is accreted over the life of the bond on a straight-line basis, or the investor can elect to use a constant yield method. If the investor holds the bond to maturity, the full amount of the market discount is recognized as ordinary income in the year of maturity. This tax treatment is distinct from that of an Original Issue Discount (OID) municipal bond, where the accreted discount is considered tax-exempt interest income. It is also different from a market discount that falls at or below the de minimis threshold, where the gain would be treated as a capital gain. In this scenario, because the \$400 discount surpasses the \$250 de minimis limit, the entire \$400 is subject to taxation as ordinary income upon the bond’s redemption.

The tax consequences are determined by calculating the accretion of the market discount and then separating the total profit into ordinary income and capital gain. 1. Calculate the total market discount: \[ \text{Market Discount} = \text{Par Value} – \text{Purchase Price} = \$10,000 – \$9,000 = \$1,000 \] 2. Calculate the annual accretion amount using the straight-line method: \[ \text{Annual Accretion} = \frac{\text{Total Market Discount}}{\text{Years to Maturity at Purchase}} = \frac{\$1,000}{10} = \$100 \text{ per year} \] 3. Calculate the total accreted discount over the holding period: \[ \text{Total Accretion} = \text{Annual Accretion} \times \text{Years Held} = \$100 \times 4 = \$400 \] This amount represents the portion of the gain that will be taxed as ordinary income. 4. Calculate the adjusted cost basis at the time of sale: \[ \text{Adjusted Cost Basis} = \text{Original Purchase Price} + \text{Total Accretion} = \$9,000 + \$400 = \$9,400 \] 5. Calculate the capital gain: \[ \text{Capital Gain} = \text{Sale Price} – \text{Adjusted Cost Basis} = \$9,800 – \$9,400 = \$400 \] Therefore, the sale results in $400 of ordinary income and $400 of long-term capital gain. When a municipal bond is purchased in the secondary market for less than its par value, and it was not originally issued at a discount, the difference is known as a market discount. The tax treatment of this market discount is a critical concept. Unlike the interest income from the bond, which is federally tax-exempt, the accreted portion of the market discount is taxable as ordinary income upon the sale or redemption of the bond. Each year the investor holds the bond, their cost basis is adjusted upward by the amount of the annual accretion. This adjustment is necessary to properly calculate any capital gain or loss when the bond is eventually sold. In this scenario, the total profit from the transaction is the sale price minus the original purchase price. This total profit must be bifurcated. The portion equivalent to the accumulated accretion over the holding period is reported as ordinary income. Any remaining profit, which is the difference between the sale price and the adjusted cost basis, is treated as a capital gain. This distinction is crucial for accurate tax reporting and for determining the true after-tax return for an investor.

Total Market Discount = Par Value – Purchase Price = \(\$10,000 – \$9,000 = \$1,000\) Years to Maturity at Purchase = 10 years Annual Straight-Line Accretion = Total Market Discount / Years to Maturity = \(\$1,000 / 10 = \$100\) per year Holding Period = 4 years Total Accreted Discount for Holding Period = Annual Accretion * Holding Period = \(\$100 \times 4 = \$400\) Adjusted Cost Basis at Time of Sale = Purchase Price + Total Accreted Discount = \(\$9,000 + \$400 = \$9,400\) Total Proceeds from Sale = \(\$9,700\) Total Gain on Sale = Sale Proceeds – Original Purchase Price = \(\$9,700 – \$9,000 = \$700\) The portion of the total gain that represents the accreted market discount is taxed as ordinary income. This amount is \(\$400\). The portion of the gain that is above the adjusted cost basis is treated as a capital gain. Capital Gain = Sale Proceeds – Adjusted Cost Basis = \(\$9,700 – \$9,400 = \$300\) Therefore, the \(\$700\) total gain is characterized as \(\$400\) of taxable ordinary income and \(\$300\) of a long-term capital gain. When a municipal bond is acquired in the secondary market at a price below its par value, the difference is known as a market discount. This situation is distinct from an original issue discount (OID), where the bond is first issued at a discount. The tax treatment for market discount is a critical concept. The discount must be accreted, or added to the cost basis, over the remaining life of the bond. A common method for this is the straight-line method, which allocates an equal portion of the discount to each remaining year. Upon the sale or redemption of the bond, the portion of the investor’s gain that is attributable to this accreted market discount is not treated as tax-exempt interest nor as a capital gain. Instead, it is reported and taxed as ordinary income at the investor’s marginal tax rate. Any proceeds received from the sale that exceed the adjusted cost basis (the original purchase price plus the total accreted discount) are then treated as a capital gain. If the bond is held for more than one year, this would be a long-term capital gain. This bifurcated tax treatment is crucial for investors to understand for proper tax reporting and to accurately assess the after-tax return of a municipal bond purchased at a market discount.

The first step is to determine the after-tax yield for each bond based on the investor’s specific tax situation. The investor is subject to both a 35% regular marginal federal income tax rate and a 28% Alternative Minimum Tax (AMT) rate. For the fully taxable corporate bond, the after-tax yield is calculated by reducing the nominal yield by the investor’s regular marginal tax rate. Corporate Bond After-Tax Yield = Taxable Yield × (1 – Regular Marginal Tax Rate) \[ 7.25\% \times (1 – 0.35) = 7.25\% \times 0.65 = 4.7125\% \] For the private activity municipal bond, the analysis is more complex. Interest income from private activity bonds is considered a tax preference item for the purpose of the Alternative Minimum Tax. Since the investor is subject to AMT, this interest income is not fully tax-exempt. Instead, it is taxed at the investor’s AMT rate of 28%. Private Activity Bond After-Tax Yield = Nominal Yield × (1 – AMT Rate) \[ 5.00\% \times (1 – 0.28) = 5.00\% \times 0.72 = 3.60\% \] The final step is to compare the two resulting after-tax yields. The corporate bond’s after-tax yield is 4.7125%, while the private activity bond’s effective after-tax yield for this investor is 3.60%. Comparing these two values, the corporate bond provides a higher return. This analysis highlights a critical concept for municipal securities professionals: the suitability of a municipal bond depends heavily on the investor’s specific tax status. While municipal bonds are generally federally tax-exempt, certain types, like private activity bonds, can trigger tax consequences for investors subject to the AMT. A public purpose municipal bond, by contrast, would have its interest remain exempt from both regular federal tax and the AMT. Therefore, a simple comparison of nominal yields is insufficient. A thorough suitability analysis requires calculating the true after-tax return for the specific investor, considering all relevant factors such as the AMT.

First, the total market discount is determined by subtracting the purchase price from the par value. The bond was purchased for $9,000 and has a par value of $10,000. Total Market Discount = Par Value – Purchase Price \[\$10,000 – \$9,000 = \$1,000\] Next, the annual accretion amount is calculated using the straight-line method. The total market discount is divided by the number of years remaining to maturity. Annual Accretion = Total Market Discount / Years to Maturity \[\$1,000 / 10 \text{ years} = \$100 \text{ per year}\] After the first year, the bond’s cost basis is adjusted upward by the accreted amount. Adjusted Cost Basis after Year 1 = Purchase Price + Annual Accretion \[\$9,000 + \$100 = \$9,100\] The key point is the tax treatment of this $100 of accreted market discount. For a municipal bond purchased at a discount in the secondary market, the discount is known as a market discount. The annual increase in the bond’s value due to this discount, known as accretion, is treated as taxable ordinary income at the federal level. However, this income is not recognized or reported annually as it accrues. Instead, the tax liability is deferred until the bond is sold, called, or matures. At the time of disposition, the total accreted market discount is reported as ordinary income. While the bond is held, the investor must still calculate the annual accretion amount in order to adjust the cost basis of the bond upwards each year. This adjusted cost basis is used to determine the capital gain or loss upon the eventual sale or redemption of the bond. This treatment is distinct from an Original Issue Discount (OID) on a municipal bond, where the accretion is considered part of the tax-exempt interest and is not subject to federal income tax. Therefore, for a market discount bond, no income is reported for tax purposes in a year where the bond is held for the entire period and not sold.

The core issue involves the interaction between MSRB Rule G-37 on political contributions and MSRB Rule G-23 on the activities of financial advisors. 1. Identify the relevant event: A municipal finance professional (MFP) at Keystone Advisory Partners made a political contribution to an official of the Chesapeake Port Authority. The contribution amount exceeds the de minimis exception of $250 per election for MFPs entitled to vote for that official. 2. Apply MSRB Rule G-37: This contribution triggers a two-year prohibition on the firm (Keystone) engaging in negotiated municipal securities business with the issuer (Chesapeake Port Authority). The ban begins on the date of the contribution. 3. Analyze the firm’s request: Keystone wants to switch from its role as a financial advisor (FA) to become an underwriter for a negotiated offering by the same issuer. 4. Apply MSRB Rule G-23: This rule permits a firm to switch from an FA to an underwriter for the same issue, provided it terminates the advisory relationship in writing, obtains the issuer’s consent, and makes necessary disclosures about the conflict of interest. 5. Synthesize the rules: The prohibition imposed by Rule G-37 is absolute and takes precedence. Even if Keystone complies with all the procedural requirements of Rule G-23 to switch roles, the pre-existing two-year ban on negotiated underwriting business from Rule G-37 remains in effect. The firm cannot circumvent the G-37 ban by using the role-switching provisions of G-23. Conclusion: Keystone Advisory Partners is prohibited from participating as an underwriter in the Chesapeake Port Authority’s negotiated offering for a two-year period following the contribution. MSRB Rule G-37 is designed to prevent pay-to-play practices, where firms make political contributions to secure municipal securities business. A contribution by a municipal finance professional (MFP) to an official of an issuer with whom the firm is engaging or seeking to engage in business triggers a two-year ban on negotiated underwriting business with that issuer. The only exception is a de minimis contribution of up to $250 per election, but only if the MFP is entitled to vote for that official. In this scenario, the contribution triggers the ban. Separately, MSRB Rule G-23 addresses the conflict of interest that arises when a firm acts as a financial advisor to an issuer and then wishes to underwrite that same issuer’s bonds. The rule allows for this role change under strict conditions, including written termination of the advisory agreement and express consent from the issuer. However, the prohibitions under Rule G-37 are strict and are not waived or superseded by following the procedures in Rule G-23. The ban on negotiated business is a direct consequence of the political contribution and remains in effect for the full two-year period, regardless of other circumstances or compliance with other MSRB rules.

Calculation: 1. Determine the total market discount: \[ \text{Par Value} – \text{Purchase Price} = \$10,000 – \$9,200 = \$800 \] 2. Calculate the annual straight-line accretion amount: \[ \frac{\text{Total Market Discount}}{\text{Years to Maturity at Purchase}} = \frac{\$800}{16 \text{ years}} = \$50 \text{ per year} \] 3. Calculate the total accreted discount over the holding period: \[ \text{Annual Accretion} \times \text{Years Held} = \$50 \times 6 \text{ years} = \$300 \] 4. Determine the adjusted cost basis at the time of sale: \[ \text{Original Cost Basis} + \text{Total Accreted Discount} = \$9,200 + \$300 = \$9,500 \] 5. Calculate the capital gain or loss on the sale: \[ \text{Sale Proceeds} – \text{Adjusted Cost Basis} = \$9,800 – \$9,500 = \$300 \] 6. Identify the tax treatment: The total accreted discount of $300 is reported as taxable ordinary income. The remaining profit of $300 is reported as a capital gain. When a municipal bond is purchased in the secondary market at a price below its par value, the difference is known as a market discount. This is distinct from an Original Issue Discount (OID), where the bond is first issued to the public at a discount. The tax treatment for these two types of discounts differs significantly. For a market discount, the discount must be accreted over the remaining life of the bond. The investor can choose to accrete annually, but for tax purposes, the accreted amount is treated as taxable ordinary income, not as tax-exempt interest. This is a critical distinction. The accretion increases the investor’s cost basis in the bond each year. In this scenario, the straight-line method is used for accretion. When the bond is subsequently sold, the sale price is compared to the adjusted cost basis, which is the original purchase price plus the total accreted market discount. Any amount received above this adjusted cost basis is treated as a capital gain. Therefore, the total profit from the transaction is bifurcated into two components for tax reporting: the portion representing the accreted market discount, which is taxable as ordinary income, and the portion representing the capital gain.

Taxable Equivalent Yield (TEY) for a non-AMT investor with a 35% marginal tax rate on a 4.5% tax-exempt yield: \[ TEY = \frac{\text{Tax-Exempt Yield}}{1 – \text{Marginal Tax Rate}} = \frac{0.045}{1 – 0.35} = 0.0692 \text{ or } 6.92\% \] After-tax yield for an investor subject to a 28% AMT rate on the same bond: \[ \text{After-Tax Yield} = \text{Stated Yield} \times (1 – \text{AMT Rate}) = 0.045 \times (1 – 0.28) = 0.0324 \text{ or } 3.24\% \] MSRB Rule G-17 establishes a general duty of fair dealing for municipal securities professionals when interacting with any person. This is a broad, principles-based rule that encompasses fairness and honesty. MSRB Rule G-47, the time-of-trade disclosure rule, operationalizes this principle by requiring dealers to disclose to customers, at or prior to the time of trade, all material information about the security and the transaction. Material information is any fact that a reasonable investor would likely consider important in making an investment decision. For a private activity bond, the fact that the interest income is a tax preference item for the Alternative Minimum Tax is a critical piece of material information. This is especially true when a representative is aware that the client is subject to the AMT, as it directly negates the primary benefit of investing in a municipal security for that client. While the fairness of the price, governed by MSRB Rule G-30, is also a key obligation, the failure to disclose the fundamental tax characteristic of the bond is a more significant breach. It undermines the suitability of the recommendation and the client’s ability to make an informed decision, directly violating the core tenets of both fair dealing and time-of-trade disclosure.

The calculation first determines if the market discount on the bond qualifies for the de minimis exception. The de minimis rule states that a market discount is considered zero if it is less than 0.25% of the stated redemption price at maturity, multiplied by the number of full years from the date of purchase to maturity. Stated Redemption Price (Par Value): $1,000 Purchase Price: $980 Market Discount: \(\$1,000 – \$980 = \$20\) Years to Maturity: 10 De Minimis Threshold Calculation: \[ \text{Threshold} = 0.0025 \times \text{Redemption Price} \times \text{Years to Maturity} \] \[ \text{Threshold} = 0.0025 \times \$1,000 \times 10 = \$25 \] The market discount of $20 is less than the calculated de minimis threshold of $25. Because the market discount is below the de minimis threshold, the investor is not required to accrete the discount annually. Instead, the entire discount is treated as a capital gain upon the sale, redemption, or maturity of the bond. The cost basis for tax purposes is the purchase price of $980. When the bond matures and the investor receives $1,000, the $20 difference will be reported as a long-term capital gain. This tax treatment is distinct from that of a market discount exceeding the de minimis amount, which would require annual accretion taxed as ordinary income. It is also different from an Original Issue Discount (OID), where the accreted amount is treated as tax-exempt interest income. The de minimis rule provides a simplified tax treatment for small market discounts, converting what would be ordinary income into a potentially more favorable capital gain. This distinction is critical for advising clients, especially those in high tax brackets, on the total after-tax return of a municipal bond purchased in the secondary market.

Total Market Discount = Par Value – Purchase Price = \(\$1,000 – \$900 = \$100\) Remaining Life at Purchase = 20 years Annual Accretion (Straight-Line) = \(\frac{\text{Total Market Discount}}{\text{Remaining Life}} = \frac{\$100}{20} = \$5\) per year Years Held = 5 years Total Accreted Discount at Sale = Annual Accretion \(\times\) Years Held = \(\$5 \times 5 = \$25\) Adjusted Cost Basis at Sale = Purchase Price + Total Accreted Discount = \(\$900 + \$25 = \$925\) Total Proceeds from Sale = \$960 Total Gain = Sale Proceeds – Purchase Price = \(\$960 – \$900 = \$60\) Taxable Interest Income Portion = Total Accreted Discount at Sale = \$25 Capital Gain Portion = Sale Proceeds – Adjusted Cost Basis = \(\$960 – \$925 = \$35\) When a municipal bond is acquired in the secondary market at a price below its par value, the difference is known as a market discount. This is distinct from an original issue discount (OID), where the bond is first sold to the public at a discount. The tax treatment for market discount is specific. While the coupon interest received from the municipal bond is typically exempt from federal income tax, the gain attributable to the market discount is not. This discount is required to be accreted over the remaining life of the bond. Upon the sale or redemption of the bond, the accreted portion of the market discount is recognized as taxable interest income. The investor’s cost basis in the bond is adjusted upward each year by the amount of the accretion. If the bond is sold for a price that exceeds this adjusted cost basis, the excess amount is treated as a capital gain. Therefore, the total profit realized from the sale is bifurcated into two components for tax purposes: the portion representing the accreted market discount, which is taxed as ordinary interest income, and the portion representing appreciation above the adjusted basis, which is taxed as a capital gain.

An investor purchases a 10-year municipal bond with a par value of $1,000 in the secondary market for $950. The bond was originally issued at par. The market discount is the difference between the par value and the purchase price. Market Discount = Par Value – Purchase Price \[\$1,000 – \$950 = \$50\] This $50 discount must be accreted over the remaining life of the bond. Using the straight-line method for simplicity, the annual accretion amount is calculated. Annual Accretion = Market Discount / Years to Maturity \[\$50 / 10 \text{ years} = \$5 \text{ per year}\] Each year, the investor’s cost basis in the bond increases by $5. For example, after one year, the cost basis is $950 + $5 = $955. If the investor holds the bond to maturity, the cost basis will have accreted to the full $1,000 par value. The total accreted market discount of $50 is realized at maturity. This realized amount is subject to taxation. The tax treatment of a market discount on a municipal bond is a critical concept. Unlike the interest income from the bond, which is typically exempt from federal income tax, the gain attributable to the market discount is not considered tax-exempt interest. Instead, the accreted market discount is treated as taxable interest income, more commonly referred to as ordinary income, for federal tax purposes. This tax liability is realized when the bond is sold, called, or matures. This differs significantly from an Original Issue Discount (OID) municipal bond, where the accreted discount is considered part of the tax-exempt interest. For a market discount bond, the investor’s cost basis is adjusted upward each year by the amount of the accretion. This adjustment prevents the accreted discount from being taxed as a capital gain. Upon disposition of the bond, the difference between the sale proceeds (or par value at maturity) and the adjusted cost basis, up to the total accreted discount, is reported as ordinary income. Any amount received above the par value would be treated as a capital gain.

The determination of whether Bedrock Securities can act as an underwriter involves analyzing two key MSRB rules: Rule G-37 on political contributions and Rule G-23 on the activities of financial advisors. First, we assess the impact of MSRB Rule G-37. This rule is designed to prevent “pay-to-play” practices. It prohibits a dealer from engaging in municipal securities business, specifically negotiated underwritings, with an issuer for a period of two years after the dealer, its municipal finance professionals (MFPs), or its political action committee (PAC) makes a contribution to an official of that issuer. An MFP is an associated person of a dealer who is primarily engaged in municipal securities activities. In this scenario, an MFP of Bedrock Securities made a $500 contribution to the mayor of the City of Veridia. The de minimis exception, which allows contributions up to $250 per election, only applies if the MFP is entitled to vote for that official. Since the MFP is not a resident and cannot vote for the mayor, the de minimis exception does not apply. Therefore, the $500 contribution constitutes a violation, triggering a two-year ban on Bedrock Securities conducting any negotiated underwriting business with the City of Veridia. Second, we assess MSRB Rule G-23. This rule addresses the conflict of interest that arises when a firm acts as both a financial advisor and an underwriter for the same issuer on the same issue. The rule generally prohibits this dual role. The rule’s prohibitions extend to firms that are under common control with the financial advisor. Since Apex Advisory and Bedrock Securities are subsidiaries of the same parent company, they are considered affiliates. Thus, because Apex acted as the financial advisor, Bedrock is presumptively barred from underwriting the same bond issue. While there are specific exemptions to this rule, such as terminating the advisory relationship and obtaining written consent from the issuer after full disclosure, the existence of the G-37 violation creates an independent and overriding prohibition. The G-37 ban is absolute for the two-year period and cannot be waived by the issuer. Therefore, the political contribution is the dispositive factor that prohibits the business relationship.

The core issue revolves around MSRB Rule G-37, which governs political contributions and their impact on a dealer’s ability to conduct municipal securities business. The rule establishes a two-year prohibition on a dealer engaging in negotiated municipal securities business with an issuer if the dealer or one of its Municipal Finance Professionals (MFPs) makes a contribution to an official of that issuer. Anika, as a managing director in the public finance department, is unequivocally an MFP. The contribution was made to Mayor Thompson, an official of the issuer. While the rule provides a de minimis exception for contributions of up to \( \$250 \) per election, this exception is strictly conditional. It only applies if the MFP making the contribution is entitled to vote for the official receiving it. In this scenario, the critical fact is that Anika is not entitled to vote for Mayor Thompson. Therefore, the de minimis exception is not available to her. Because the exception does not apply, her \( \$250 \) contribution constitutes a violation of Rule G-37. The consequence of this violation is that her employer, the dealer firm, is banned from engaging in any negotiated municipal securities business with the city for a period of two years, commencing on the date the contribution was made. The underwriting awarded to the firm falls squarely within this two-year prohibition period, making the firm ineligible to participate. The ban is on the entire firm, not just the individual MFP.

First, calculate the total market discount. This is the difference between the par value and the purchase price in the secondary market. \[ \text{Total Market Discount} = \text{Par Value} – \text{Purchase Price} \] \[ \$10,000 – \$9,200 = \$800 \] Next, determine the annual accretion amount using the straight-line method. This spreads the discount evenly over the remaining life of the bond. \[ \text{Annual Accretion} = \frac{\text{Total Market Discount}}{\text{Years to Maturity at Purchase}} \] \[ \frac{\$800}{8} = \$100 \text{ per year} \] Each year, the investor’s cost basis in the bond increases by the annual accretion amount. When the bond is held to maturity, the total accreted discount is the full $800. The adjusted cost basis at maturity is the original purchase price plus the total accretion. \[ \text{Adjusted Cost Basis at Maturity} = \text{Original Purchase Price} + \text{Total Accretion} \] \[ \$9,200 + \$800 = \$10,000 \] At maturity, the investor receives the par value of $10,000. The capital gain or loss is the difference between the proceeds and the adjusted cost basis. \[ \text{Capital Gain/Loss} = \text{Maturity Value} – \text{Adjusted Cost Basis} \] \[ \$10,000 – \$10,000 = \$0 \] The tax consequence of the market discount must be determined. For municipal bonds, the accreted market discount is not treated as tax-exempt interest or as a capital gain. Instead, it is reported as fully taxable interest income at the investor’s ordinary income tax rate. Therefore, the entire $800 of accreted market discount is recognized as taxable interest income in the year the bond matures. When a municipal security is purchased in the secondary market for a price below its par value, the difference is known as a market discount. This is distinct from an Original Issue Discount (OID), where the bond is first sold to the public at a discount. The tax treatment for these two types of discounts is critically different. While the accreted portion of an OID on a municipal bond is generally considered tax-exempt interest, the accreted portion of a market discount is treated as taxable interest income. This income is taxed at the investor’s ordinary income tax rate. The accretion process systematically increases the bond’s cost basis over the period it is held. Using the straight-line method, the total discount is divided by the number of years remaining to maturity to find the annual accretion amount. This annual amount increases the cost basis each year. If the bond is held to maturity, the adjusted cost basis will equal the par value. Consequently, there is no capital gain or loss upon redemption. The entire market discount that has been accreted over the life of the holding period is realized and must be reported as taxable interest income.

Logical Deduction Process: 1. Identify the primary governing rule: MSRB Rule G-23, Activities of Financial Advisors, directly addresses the scenario where a firm wishes to switch from a financial advisor (FA) role to an underwriter role for the same issuer and issue. 2. Recognize the inherent conflict of interest: An FA has a fiduciary duty to the issuer, requiring them to act in the issuer’s best interest. An underwriter in a negotiated sale has an arm’s-length relationship, seeking to purchase the bonds from the issuer at the lowest reasonable price and sell them to the public at the highest reasonable price. These roles are fundamentally opposed. 3. Determine the requirements for resolving the conflict under Rule G-23: The rule does not create an absolute ban but imposes strict procedural safeguards. 4. Step A – Termination: The firm must terminate the financial advisory relationship with respect to the specific issue in writing. 5. Step B – Disclosure and Consent: The firm must obtain the issuer’s written consent to the new role. This consent must be preceded by a written disclosure from the firm that clearly explains the change in roles, the fact that the firm is no longer a fiduciary but is acting for its own account, and the estimated amount of underwriting compensation. 6. Conclude the necessary actions: The combination of written termination, comprehensive written disclosure of the conflict and compensation, and the issuer’s subsequent written consent are the indispensable steps required by MSRB Rule G-23 to make the transition permissible. MSRB Rule G-23 establishes critical guidelines for municipal securities dealers who also act as financial advisors to issuers. The rule is built upon the foundational principle of MSRB Rule G-17, which requires all dealers to deal fairly with all persons. A financial advisory relationship is a fiduciary one, meaning the advisor must put the issuer’s interests first. Conversely, an underwriter in a negotiated transaction has an arm’s-length relationship with the issuer; their goal is to structure a transaction that is profitable for the underwriting syndicate. This creates a significant conflict of interest. To manage this conflict, Rule G-23 prohibits a firm that has a financial advisory relationship with an issuer from acting as an underwriter on that same issue in a negotiated sale unless specific, stringent conditions are met. The firm must formally terminate the advisory relationship in writing. Furthermore, it must provide the issuer with comprehensive written disclosures. These disclosures must detail the change in the firm’s role, explicitly state that it is no longer acting as a fiduciary, and outline the potential conflicts of interest and the nature and amount of its anticipated compensation as an underwriter. Only after receiving these disclosures can the issuer provide its informed written consent for the firm to proceed in the underwriting capacity. These steps ensure the issuer is fully aware of the change in the relationship and the new dynamics involved.

The reasoning for the correct allocation is based on the standard priority provisions for orders as stipulated by MSRB Rule G-11 for municipal syndicate accounts, particularly in a competitive underwriting. When an issue is oversubscribed, the syndicate manager must follow a strict hierarchy to ensure fair and orderly distribution. The established priority is as follows: first, Pre-sale Orders; second, Group Net Orders; third, Designated Orders; and fourth, Member Orders. Pre-sale orders are customer orders submitted to the syndicate before the syndicate has officially won the bid, and they are given the highest priority. Group net orders are placed during the order period where the takedown benefits all syndicate members pro-rata to their participation. Designated orders are placed by a customer who designates one or more syndicate members to receive the takedown. Member orders are placed by a syndicate member for its own inventory or a related account. In a situation where total orders exceed the available bonds, the manager must fill all orders in one category completely before moving to the next. Therefore, all bona fide pre-sale orders must be filled in their entirety before any group net orders are considered. Subsequently, group net orders are filled before designated orders, and designated orders are filled before any member orders. This strict sequence ensures compliance and prevents preferential treatment that would violate fair dealing practices under MSRB rules.

The analysis requires calculating the taxable equivalent yield (TEY) for both the standard general obligation bond and the private activity bond to determine which offers a superior return for an investor in a specific tax bracket who is not subject to the Alternative Minimum Tax (AMT). The formula for TEY is Tax-Exempt Yield / (1 – Marginal Tax Rate). For the standard GO bond with a 4.10% yield and a client in the 35% marginal tax bracket: TEY = \( \frac{0.0410}{1 – 0.35} = \frac{0.0410}{0.65} \approx 6.31\% \) For the private activity bond with a 4.40% yield, the interest is a tax preference item for AMT purposes. However, since the client is explicitly not subject to the AMT, this specific negative tax feature does not apply to them. For this investor, the interest is still exempt from regular federal income tax. Therefore, the TEY calculation proceeds in the same manner. TEY = \( \frac{0.0440}{1 – 0.35} = \frac{0.0440}{0.65} \approx 6.77\% \) The calculation demonstrates that the private activity bond offers a higher taxable equivalent yield for this specific investor. The key analytical point is recognizing that a bond’s tax features must be evaluated in the context of the specific investor’s tax situation. A feature like being subject to AMT, which makes a bond less attractive for one group of investors, is irrelevant to another group. For an investor not subject to AMT, the higher yield offered on the private activity bond as compensation for its AMT status represents an opportunity for a greater after-tax return compared to a standard tax-exempt bond with a lower yield. The professional’s duty is to identify this nuance and not dismiss the bond based on a general rule about AMT-subject securities.

The calculation for the tax treatment of the Original Issue Discount (OID) bond (Bond A) is as follows. The total discount is the face value minus the purchase price: \(\$10,000 – \$8,000 = \$2,000\). This discount must be accreted over the life of the bond. The annual accretion amount is the total discount divided by the years to maturity: \(\$2,000 / 10 \text{ years} = \$200\) per year. Each year, the investor’s cost basis increases by this amount. At maturity, the adjusted cost basis will be the original purchase price plus the total accreted discount: \(\$8,000 + \$2,000 = \$10,000\). When the bond matures, the investor receives the face value of \(\$10,000\). The taxable gain is the proceeds minus the adjusted cost basis: \(\$10,000 – \$10,000 = \$0\). The accreted amount is considered tax-exempt interest. For the secondary market discount bond (Bond B), the calculation of the discount is the same: \(\$10,000 – \$8,000 = \$2,000\). However, its tax treatment is different. This market discount is not part of the original issue terms. When the bond matures, the investor receives \(\$10,000\). The cost basis remains the purchase price of \(\$8,000\). The difference of \(\$2,000\) is realized and is treated as taxable ordinary income. The tax treatment of discounts on municipal bonds depends critically on whether the discount is an Original Issue Discount or a secondary market discount. For an OID bond, the discount is considered part of the bond’s total return and is treated as tax-exempt interest. The investor must accrete the discount over the bond’s life using a constant yield method, which increases the bond’s cost basis each year. At maturity, the adjusted cost basis equals the face value, resulting in no capital gain or loss. This accretion is not taxed at the federal level. In contrast, a bond purchased at a discount in the secondary market has a different tax implication. This market discount reflects changes in interest rates or credit quality since the bond was issued. The gain realized from this discount, which is the difference between the redemption value and the purchase price, is treated as taxable ordinary income in the year the bond is sold or matures. It is not considered tax-exempt interest and does not receive the same favorable tax treatment as OID. This distinction is a key factor in determining the after-tax return for an investor.

The determination of the correct procedure follows a logical analysis of MSRB Rule G-23, which governs the activities of financial advisors. 1. Identify the core issue: A firm acting as a financial advisor (FA) to a municipal issuer has an affiliate that wishes to act as an underwriter for the same bond issue in a negotiated sale. This presents a significant potential conflict of interest. 2. Reference the governing regulation: MSRB Rule G-23 directly addresses this scenario to ensure the issuer is protected and the transaction is conducted at arm’s length. 3. Outline the specific requirements under Rule G-23 for an affiliate of a financial advisor to participate in the underwriting of a negotiated offering: a. The financial advisory relationship must be formally terminated in writing. b. The broker-dealer (the underwriter) must provide the issuer with full written disclosure of the potential conflict of interest arising from the affiliate relationship. This disclosure must also detail the anticipated role and compensation of the broker-dealer as an underwriter. c. The issuer must provide its express written consent for the broker-dealer to act in the underwriting capacity after receiving the disclosures and termination notice. These three steps are mandatory to transition the relationship from a fiduciary advisory role to a principal underwriting role, ensuring the issuer makes an informed decision. MSRB Rule G-23 is designed to prevent conflicts of interest that can arise when a municipal securities professional acts as both a financial advisor and an underwriter for the same issuer. The role of a financial advisor is a fiduciary one, requiring the advisor to act in the best interests of the issuer. In contrast, the role of an underwriter in a negotiated sale is an arm’s-length, principal relationship where the underwriter is purchasing the bonds from the issuer for resale. To manage the inherent conflict, the rule establishes a clear and documented process for a financial advisor or its affiliate to switch roles. The process requires the formal written termination of the advisory relationship before the underwriting agreement is executed. Concurrently, the issuer must be given a full written disclosure of the conflict of interest and the compensation the firm will receive as an underwriter. Finally, and most critically, the issuer must give its express written consent to the arrangement. This ensures the issuer is fully aware of the change in the relationship’s nature and has explicitly agreed to proceed with the firm’s affiliate acting as an underwriter, thereby waiving the potential conflict.

Calculation of Accretion and Taxable Income: For both bonds, the total discount is the difference between the par value ($1,000) and the purchase price ($950). Total Discount = \(\$1,000 – \$950 = \$50\) The annual accretion amount using the straight-line method over 10 years is: Annual Accretion = \(\frac{\$50}{10 \text{ years}} = \$5\) per year. For the Original Issue Discount (OID) bond (Bond A): The cost basis is adjusted upward each year by the accreted amount. Cost Basis at Maturity = Purchase Price + Total Accretion = \(\$950 + \$50 = \$1,000\) Proceeds at Maturity = $1,000 Taxable Event = Proceeds – Adjusted Cost Basis = \(\$1,000 – \$1,000 = \$0\) The accreted amount is considered tax-exempt interest. For the standard bond purchased at a market discount (Bond B): The cost basis remains the original purchase price unless the investor elects to pay tax on the accretion annually. Assuming no such election, the cost basis is static. Cost Basis at Maturity = $950 Proceeds at Maturity = $1,000 Taxable Event = Proceeds – Cost Basis = \(\$1,000 – \$950 = \$50\) This $50 gain is taxed as ordinary income. The tax treatment of discounts on municipal bonds depends critically on whether the discount is an Original Issue Discount (OID) or a market discount. An OID occurs when a bond is first issued to the public at a price below its par value. This discount is considered a form of interest. For tax purposes, the OID must be accreted over the life of the bond, meaning the investor’s cost basis is adjusted upward each year. This annual accreted amount is treated as tax-exempt interest, just like the coupon payments. Consequently, when an OID municipal bond is held to maturity and redeemed at par, there is no capital gain or loss because the adjusted cost basis will equal the par value. In contrast, a market discount arises when a bond is purchased in the secondary market for a price below its current accreted value or par value. This discount is not considered tax-exempt interest. Instead, the accretion of a market discount is treated as taxable ordinary income. This income is generally recognized when the bond is sold or redeemed. The investor’s cost basis is not automatically adjusted for the accretion. Therefore, upon maturity, the difference between the redemption proceeds (par value) and the original purchase price constitutes ordinary income, which is subject to federal income tax. The de minimis rule, which would allow a small market discount to be treated as a capital gain, was specified as not applying in this case.

The tax treatment of a bond’s discount depends on whether it is an Original Issue Discount (OID) or a market discount. For the OID bond: The bond was issued at a discount to its par value. The discount is considered part of the bond’s total return and is treated as tax-exempt interest. The investor must accrete the discount annually, which means increasing the bond’s cost basis each year. Initial Cost Basis = \(\$9,200\) Par Value = \(\$10,000\) Total OID = \(\$10,000 – \$9,200 = \$800\) When the bond matures, the cost basis has been accreted to the full par value of \(\$10,000\). Adjusted Cost Basis at Maturity = Initial Cost + Total Accretion = \(\$9,200 + \$800 = \$10,000\) Proceeds at Maturity = \(\$10,000\) Capital Gain/Loss = Proceeds – Adjusted Cost Basis = \(\$10,000 – \$10,000 = \$0\) The \(\$800\) of accreted discount is considered tax-exempt interest and is not subject to federal income tax. For the market discount bond: The bond was issued at par but purchased in the secondary market at a discount. This discount resulted from changes in interest rates, not from the original issuance terms. The accreted market discount is taxed as ordinary income in the year the bond is sold or matures. Purchase Price = \(\$9,600\) Par Value = \(\$10,000\) Market Discount = \(\$10,000 – \$9,600 = \$400\) When this bond matures, the investor receives \(\$10,000\). The \(\$400\) difference between the purchase price and the maturity value is the accreted market discount. This amount must be reported as taxable ordinary income for the year of maturity. Therefore, at maturity, the OID bond results in no taxable event, while the market discount bond generates \(\$400\) of ordinary income. An Original Issue Discount (OID) on a municipal bond occurs when the bond is first issued to the public for a price that is less than its stated redemption price at maturity. The tax code treats this discount as a form of tax-exempt interest that is earned over the life of the bond. For tax purposes, the investor must increase their cost basis in the bond each year by a portion of the discount, a process known as accretion. Because the cost basis is adjusted upwards annually, by the time the bond matures, its basis will equal its par value. As a result, when the investor receives the par value at maturity, there is no capital gain to report. The entire amount of the OID is effectively received as tax-free interest. In contrast, a market discount arises when a previously issued bond is purchased in the secondary market for a price below its par value, typically because market interest rates have risen since the bond was issued. The accretion of this market discount is not considered tax-exempt interest. Instead, it is treated as taxable ordinary income, which is realized when the bond is sold, called, or matures. This distinction is critical for investors to understand as it significantly impacts the after-tax return of their investment.

First, determine if the secondary market discount on Bond A qualifies for the de minimis exemption. The de minimis threshold is calculated as 0.25% of the par value multiplied by the number of full years remaining to maturity. De minimis threshold calculation: \[0.0025 \times \$1,000 \text{ par value} \times 10 \text{ years} = \$25\] The actual market discount on Bond A is the difference between the par value and the purchase price: \[\$1,000 – \$920 = \$80\] Since the actual discount of $80 is greater than the de minimis threshold of $25, the discount is not considered de minimis. The tax treatment for the discount accretion on each bond at maturity is as follows: For Bond A (secondary market purchase), because the market discount is not de minimis, the entire accreted discount of $80 must be reported as ordinary income in the year the bond matures or is sold. It is not treated as a capital gain. For Bond B (Original Issue Discount or OID bond), the accreted discount of $80 is considered part of the bond’s tax-exempt interest. Therefore, this amount is not subject to federal income tax. For an investor in a high tax bracket, receiving $80 of tax-exempt income is significantly more valuable than receiving $80 that will be taxed at their high ordinary income tax rate. Therefore, Bond B offers a superior after-tax outcome. The distinction between an Original Issue Discount and a secondary market discount is critical for tax purposes. An OID is the difference between the stated redemption price at maturity and the public offering price at the time of original issuance. The accretion of this discount is treated as tax-exempt interest for a municipal bond. In contrast, a market discount occurs when a bond is purchased in the secondary market for a price below its par value. The tax treatment of this market discount’s accretion depends on the de minimis rule. If the discount is less than the de minimis threshold, the gain is treated as a capital gain upon disposition. However, if the discount exceeds the de minimis threshold, as in this scenario, the accreted value is taxed as ordinary income. This makes the OID bond far more attractive to an investor seeking to minimize their tax liability, as the entire return component from the discount is shielded from federal taxes.

First, the market discount is calculated as the difference between the par value and the purchase price. \[ \text{Market Discount} = \text{Par Value} – \text{Purchase Price} = \$1,000 – \$920 = \$80 \] Next, the de minimis threshold is calculated. The de minimis rule states that a market discount is considered to be zero if it is less than 0.25% (or 1/4 of 1%) of the stated redemption price at maturity, multiplied by the number of full years from the date of purchase to maturity. \[ \text{De Minimis Threshold per Year} = 0.0025 \times \$1,000 = \$2.50 \] \[ \text{Total De Minimis Threshold} = \$2.50/\text{year} \times 12 \text{ years} = \$30.00 \] The calculated market discount of $80 is then compared to the total de minimis threshold of $30. Since the market discount is greater than the de minimis threshold (\(\$80 > \$30\)), the de minimis rule does not apply. Therefore, the market discount must be accreted on a straight-line basis over the life of the bond. This annual accretion is treated as taxable ordinary income for the investor. \[ \text{Annual Accretion} = \frac{\text{Market Discount}}{\text{Years to Maturity}} = \frac{\$80}{12} \approx \$6.67 \] This amount must be reported as ordinary income each year, and it also increases the investor’s cost basis in the bond. For municipal bonds purchased in the secondary market at a discount, the tax treatment of that discount depends on whether it meets the de minimis threshold. This threshold is a specific calculation: one-quarter of one percent of the bond’s par value multiplied by the number of full years remaining until maturity. If the actual market discount is less than this calculated threshold, it is considered de minimis. In such a case, the discount is not accreted annually. Instead, it is treated as a capital gain upon the sale or redemption of the bond. However, if the market discount is equal to or greater than the de minimis threshold, the tax treatment is different. The discount must be accreted annually over the remaining life of the bond. This annual accreted amount is not tax-exempt interest, nor is it a capital gain. It is considered taxable interest income, reported as ordinary income to the IRS each year. This annual accretion also increases the investor’s cost basis in the bond, which reduces the capital gain or increases the capital loss realized upon the final disposition of the security. This distinction is critical for accurately advising clients on the tax implications of their municipal bond investments.

The analysis begins by identifying the key parties and rules. Anya is a Municipal Finance Professional (MFP) for Keystone Capital, a municipal securities dealer. The candidate for the Port Authority’s board is an “official of an issuer.” The proposed action is a $500 political contribution from the MFP to the issuer official. MSRB Rule G-37 governs political contributions and their impact on a dealer’s ability to conduct municipal securities business. The core of the rule is that a dealer is prohibited from engaging in municipal securities business with an issuer for a two-year period if the dealer or any of its MFPs make a contribution to an official of that issuer. Municipal securities business is broadly defined and explicitly includes negotiated underwriting. There is a de minimis exception to this rule. An MFP who is entitled to vote for an issuer official may contribute up to $250 per election to that official without triggering the two-year ban on business for the firm. In this scenario, Anya’s contribution is $500. This amount exceeds the $250 de minimis threshold. Therefore, the contribution is not exempt and the full force of the rule applies. The consequence is that her firm, Keystone Capital, is banned from engaging in municipal securities business, such as acting as a negotiated underwriter, with the Port Authority of the Cascades. This ban commences on the date of the contribution and lasts for two years. The firm’s prior role as a financial advisor under MSRB Rule G-23 is a separate consideration; the G-37 violation creates an independent and absolute two-year prohibition on underwriting business.