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Question

Difficulty: EasyGovernment, Municipal, and Corporate Bonds

An investor purchases a newly issued U.S. Treasury bill maturing in 26 weeks. Which of the following statements accurately describes the tax treatment of the interest income earned on this security?

  1. It is subject to federal income tax but exempt from state and local income taxes.Answer
  2. B
    It is exempt from federal income tax but fully subject to state and local income taxes.
  3. C
    It is completely exempt from federal, state, and local income taxes.
  4. D
    It is fully taxable at federal, state, and local income tax levels.

Answer

Interest income earned on U.S. Treasury bills is subject to federal income tax but exempt from state and local income taxes.
Interest earned on direct U.S. government obligations—including Treasury bills, Treasury notes, and Treasury bonds—is subject to federal income tax in the year earned, but is constitutionally and statutorily exempt from state and local income taxes.

Step-by-Step Solution

1
Identify the security type and issuer from the question prompt.
The security is a U.S. Treasury bill, which is a short-term direct obligation of the federal government.
Taxation rules for debt securities depend on whether the issuer is the federal government, a state/local municipality, or a corporate entity.
2
Apply the tax rules specific to U.S. Treasury debt securities.
Interest earned on Treasury securities is taxable at the federal level but exempt from state and local income taxes.
Under federal law and constitutional principles, states cannot impose income tax on interest paid by direct obligations of the federal government.

Key Concept

Taxation of U.S. Treasury Securities
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Topics

Government, Municipal, and Corporate Bonds

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