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Taxes & Business Consulting Blog

Our Complex Tax Code Is Crippling America

On the presidential campaign trail, the candidates seem far apart on tax policy. The Democrats favor tax hikes on high earners, and the Republicans favor tax cuts all around. But with voters currently struggling with tax-return filing, all the candidates should be addressing the tax code’s appalling complexity.

Donald Trump did complain that his tax return “would literally probably be 10 feet high if I put them together, it is so complicated and so terrible.” Most people have smaller returns, but federal tax-code compliance overall consumes more than 6 billion hours of time each year, which is like having a “tax army” of 3 million people just filling out tax returns year-round.

The problem is getting worse. Federal tax rules span about 75,000 pages today, which is three times more than when President Jimmy Carter called the code “a disgrace to the human race.” The problem is that Congress micromanages us with ever more tax credits, deductions and exemptions for education, energy, health care, saving, working and other activities.

The latest layer of complexity was added by the Affordable Care Act, which manipulates our health choices through the tax system. If you don’t have health insurance, you calculate how much you get penalized. If you do have individual insurance, you calculate the tax credits you receive. If you get advance credits during the year, then you recalculate your benefits when you file. And so on.

You can try to figure all this out by looking at the IRS’s 24-page Affordable Care Act overview, its 19-page guide for penalties and its 71-page guide for credits. Or you can go to a tax practitioner who is familiar with the thousands of pages of related regulations.

The Affordable Care Act has become a tax-filing nightmare, but so have other parts of the code, such as the earned income tax credit. The IRS guide for the earned income tax credit is 37 pages long, and the rules are so complicated that the credit’s error rate is 27%, according to the IRS. That amounts to $18 billion of mistakes every year for just for this one credit.

These days, most people get their returns done by tax-preparation firms, but that doesn’t solve the complexity problem—indeed, the pros make many errors as well. A 2014 investigation by the Government Accountability Office of 19 paid tax preparers found that most of them calculated incorrect refund amounts on sample returns. Furthermore, expert tax preparation costs money—last year the average charge for 1040 return prep was $273.

In addition to the monetary costs, the tax code’s complexity:

1. Increases avoidance and evasion. The earned income tax credit’s complexity has spawned an industry of fraudulent return filing, which costs billions of dollars a year. There is a similar problem with large corporations. We have the highest-rate and most complex corporate tax code in the world, which has created a breeding ground for widespread tax avoidance.

2. Undermines financial planning. For families, the tax code complicates decisions about retirement savings, paying for education and other life events. For businesses, the tax effects of hiring workers, investing in capital equipment, and other decisions are constantly changing as new laws and regulations are imposed. The IRS Taxpayer Advocate counted 4,428 federal tax rule changes over a 10-year period.

3. Creates “horizontal inequity.” People with similar incomes pay different amounts of tax because of all the special breaks. Homeowners, for example, can have a tax advantage of thousands of dollars a year over renters. Such inequities violate the principle of equality under the law.

Thankfully, some presidential candidates are promising to simplify the tax code. It will be a challenge because members of Congress love to add narrow breaks. The number of “tax expenditures,” or official breaks, under the income tax increased from 125 in the 1990s to about 200 today, according to the Joint Committee on Taxation. Each break has separate tax forms, instructions, regulations and other paperwork.

The best solution would be to rip out the individual income tax and replace it with a flat tax that has no deductions or credits. That would vastly simplify financial planning, reduce tax avoidance and boost the economy. Both taxpayers and the government would win as administrative costs plunged.

No president has pulled off a major tax overhaul since Ronald Reagan in 1986. But the next president will have an ace in his hole, and that is the Speaker of the House, Paul Ryan. Ryan is committed to tax restructuring, and he proposed major reforms in his past position on the House Budget Committee.

Reagan kicked off his drive for tax reform with an impassioned speech to the nation in May 1985: “We must…transform a system that’s become an endless source of confusion and resentment into one that is clear, simple, and fair for all—a tax code that no longer runs roughshod over Main Street America but ensures your families and firms incentives and rewards for hard work and risk-taking in an American future of strong economic growth.”

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The Situation’s Tax Evasion Case

Since Jersey Shore ended in 2012, Mike “The Situation” Sorrentino has had several run-ins with the law. To quote his own name and catch phrase, he’s got a situation. Though he got clearance to participate in the new Jersey Shore Family Vacation, his troubles aren’t over, and by the time the season is finished, he could be facing jail time or a hefty fine. Before you GTL, catch up on his — last time I’ll say it, I swear — situation.

March 1, 2014: Mike opens his Boca Tanning Club franchise in Middletown, New Jersey.

June 11, 2014: TMZ reports that four employees at the tanning salon file a police report because their paychecks were bouncing. According to TMZ’s sources, the Situation says the problem is the result of switching payroll companies. (The tanning salon stuff isn’t related to the tax stuff; it’s just here because it’s a separate cause of turmoil for the Sitch.)

June 17, 2014: Mike is arrested for assault at the Middletown tanning salon. He tells reporters that the fight was with his brother Frank, and that “HR was not running the store correctly.” He agreed to take anger management classes as part of a deal that would downgrade his charges.

Sept. 24, 2014: Mike and his brother Marc are indicted on charges of filing false tax returns and conspiracy to commit fraud. According to the charges, they did not report income from their appearances, and the Situation did not file a 2011 return at all despite earning nearly $2 million that year. The trial is originally scheduled for 2015 but is postponed when the Situation’s lawyer leaves the case.

Feb. 2015: The tanning salon in Middletown is closed by its landlord, who claims the Situation owes thousands of dollars in rent. Meanwhile, Mike tweets out a photo proving that another of the family’s Boca locations is still open.

Dec. 18, 2015: Gregg Mark, Mike and Marc’s former accountant, pleads guilty to filing fraudulent tax returns for them for 2010 and 2011. Mark admits that the false returns defrauded the IRS somewhere between $550,000 and $1.5 million.

April 7, 2017: Mike and Mark are indicted on additional charges; Mike for tax evasion and Marc for falsifying records to obstruct an investigation. The new charges claim that the brothers underreported income, claimed fraudulent deductions, mixed business and personal income, and used business money to make personal purchases.

Jan. 19, 2018: Mike pleads guilty to tax evasion; Marc pleads guilty to aiding the preparation of a false tax return. Mike also admitted to concealing his income 2011 by making small cash deposits in order to evade reporting it (this is called structuring). The judge approved Mike’s trip to Miami to film Jersey Shore Family Vacation but he will be sentenced on April 25. He could face up to five years in prison and a $250,000 fine. His attorneys make a statement encouraging the judge to be lenient in sentencing: “The plea terms call for a balance between punishing the wrong committed and conditions that facilitate Mike living a productive, law-abiding life moving forward. Following through on this plea agreement, Michael intends to pay restitution before sentencing.”

Follow Eliza on Twitter.

Eliza Thompson senior entertainment editor I’m the senior entertainment editor at Cosmopolitan.com, which means my DVR is always 98 percent full.

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Current U.S. tax incentives for higher education expenses


Congress has often attempted to assist Americans in paying for higher education by using the individual income tax laws. Between 1954 and 1996, eight education-related tax benefits were added to the Internal Revenue Code. The Taxpayer Relief Act of 1997, P.L. 105-34, introduced five new education tax benefits. Recently, the American opportunity tax credit greatly expanded the prior Hope scholarship credit. Today, at least 12 income tax ­provisions are designed to provide tax benefits for the pursuit of education.1

The education-related income tax provisions can be divided into three general categories:

  1. Tax incentives to save for education;
  2. Tax relief when paying current-year education expenses; and
  3. Tax assistance with student loans.

Some of these tax provisions allow deductions for a portion or all of education expenditures. Some exclude otherwise taxable income from inclusion in the calculation of taxable income. Still others furnish tax credits that can provide a direct reduction of tax for each dollar of qualified expenditures.

It has been estimated that in 2017 the forgone tax revenue from these provisions may have exceeded $30 billion,2 yet there is reason to believe that many of them will be ineffective in accomplishing their objectives.

This article examines the requirements and limitations that taxpayers face when they seek to obtain the tax benefits of some of the most significant education-related income tax provisions.3 It then looks at the American Bar Association’s and the AICPA’s suggestions for simplification as well as the recommendations of National Taxpayer Advocate Nina Olson.

Tax incentives to save for education

Congress has enacted provisions to give parents, students, and other taxpayers a tax incentive to save for education costs. The Code provisions discussed here are:

  • Sec. 135: Income from U.S. savings bonds used to pay higher education tuition and fees;
  • Sec. 530: Coverdell education savings accounts; and
  • Sec. 529: Qualified tuition programs.

Each program is designed to encourage saving for education by excluding the earnings on those savings from tax.

Education savings bond interest exclusion

Potential income tax benefitInterest earned on U.S. savings bonds generally is taxable. Most taxpayers report the accumulated interest as income when the savings bonds are redeemed. This provision encourages taxpayers to purchase savings bonds for higher education costs by permitting the interest earned on qualifying savings bonds (up to the amount of “qualifying educational expenses”) to be excluded from taxable income. The benefit to the taxpayer is equal to the amount of income tax that would otherwise have been imposed on the savings bond interest.4

Important requirements:

  • Only certain savings bonds qualify.5
  • The owner of the bond must be 24 years old or older before the bonds are issued. As a result, bonds gifted to a person before he or she is age 24 (e.g., at birth) do not qualify.
  • Interest from other investments, including interest on other U.S. government obligations (e.g., Treasury notes, bills, and long-term bonds), does not qualify for exclusion under this provision even if the funds are used solely for education expenses.
  • The exclusion can be claimed only if the proceeds are used to pay qualified expenses for the taxpayer, the taxpayer’s spouse, or a dependent.
  • Qualifying educational expenses include tuition and required fees at eligible educational institutions but do not include expenses for room (e.g., dormitory charges) or meals. Books are not considered a qualifying expense unless a student may not attend or enroll in a course without purchasing them.
  • Qualifying educational expenses must equal or exceed redemption proceeds, not just the interest earned on the redeemed bonds. If qualifying educational expenses are less than the bond proceeds, only a portion of the interest on the redeemed bonds will be tax free.6

Income limitsThe exclusion of savings bond interest is phased out after a taxpayer’s “modified adjusted gross income” (MAGI) exceeds a threshold amount, which is adjusted each year for inflation.7 In 2018, a taxpayer who has MAGI in excess of $79,700 ($119,550 if filing a joint return) will lose a portion or all of this benefit.8

Coverdell education savings account

A Coverdell account may be established to save for the qualified education expenses of a named beneficiary. Many banks, brokerage firms, and mutual fund companies offer these accounts.

Potential income tax benefit:The earnings on amounts deposited in a Coverdell account are excluded from taxable income until the funds in the account are distributed. If distributions from a Coverdell account are equal to or less than qualified education expenses,9 earnings will be permanently excluded from tax.

Important requirements:

  • When the account is established, the beneficiary must be 18 or younger or be a special-needs beneficiary. The beneficiary does not need to be the taxpayer’s dependent.
  • Total contributions for any year cannot exceed $2,000 and (except for a special-needs beneficiary) cannot be made after the beneficiary attains age 18. The maximum lifetime contribution limit thus ordinarily would be $36,000.10
  • Qualified higher education expenses are defined differently from qualifying expenses for education savings bonds. The costs of room and board, for instance, may be a qualified expense provided the student is enrolled at least “half-time.”11
  • When determining qualified expenses, education expenses are reduced by any tax-free educational assistance received and by expenses used in determining the American opportunity or lifetime learning credits.
  • If a beneficiary receives distributions from both a Coverdell account and a qualified tuition program in the same year and the total distributions from both are more than the beneficiary’s adjusted qualified higher education expenses, those expenses must be allocated between the two distributions to determine how much of each distribution is taxable.
  • Any unused balance in a Coverdell account usually must be distributed when the beneficiary reaches age 30 even if this results in a taxable distribution.
  • An additional tax of 10% is imposed on any taxable distribution.

Income limits:

  • The maximum amount that a taxpayer is allowed to contribute in a year ($2,000) is phased out if MAGI exceeds a threshold amount. The definition of MAGI is different from the definition for purposes of the education savings bond interest exclusion.12
  • The phaseout threshold for making contributions is $95,000 ($190,000 for joint return filers) and is not adjusted for inflation.
  • If excess contributions are made, a 6% excise tax is imposed on the excess contribution every year that those excess funds remain in the account.

In view of the many limitations on the above two programs, it is fortunate that Congress has provided another ­tax-favored way to save for college — college savings plans — established under Sec. 529.13

College savings plans

College savings plan accounts may be established to save for the qualified higher education expenses of a designated beneficiary. Only states and eligible education institutions may offer these plans.

Potential income tax benefitLike Coverdell accounts, amounts invested in a college saving plan account grow tax free until distributed. If distributions from an account are equal to or less than qualified education expenses, there is also no income tax on the distributions. While there is no federal tax deduction for contributions, many states allow deductions from state income tax.

Important requirements:

  • Unlike Coverdell accounts, there is no annual limit on contributions. State and private plans do limit total contributions to each beneficiary’s account. It is often possible to fully fund a beneficiary’s higher education expenses using these plans, because the total contribution limit for many plans exceeds $300,000.14
  • After 2017, college saving plans can be used to a limited extent for elementary and secondary school expenses as well as higher education.15 Qualified higher education expenses are defined similarly for college savings plans and Coverdell accounts.
  • If a taxpayer receives a taxable distribution (i.e., one that is not used for qualified expenses), the Code generally imposes an additional tax of 10% on the amount included in income. Unlike Coverdell accounts, the balance in the account need not be distributed by a set age.

Income limitsNone.

Compared to other programs designed to provide incentives to save for education expenses, college savings plans are flexible and simple. Perhaps it is no surprise that many Americans are now using these plans to save for higher education.

Tax relief when paying current-year education expenses

Congress has also enacted provisions that provide tax relief when paying current-year education expenses. Two important Code provisions are:

  • Sec. 25A(i): American opportunity tax credit; and
  • Sec. 25A(c):Lifetime learning credit.

American opportunity tax credit

Potential income tax benefitAn annual tax credit of up to $2,500 per student. Forty percent of the American opportunity tax credit is “refundable,” meaning a taxpayer who has no U.S. tax liability may receive up to a $1,000 refund (40% of $2,500) when filing a return.

Important requirements:

  • The amount of the credit is 100% of the first $2,000 of qualified expenses and 25% of the next $2,000. Thus, a taxpayer must have $4,000 of qualified expenses during a year to obtain the full $2,500 credit.
  • Books are considered qualifying expenses, but housing and meals are not.
  • The student must be pursuing a degree or other recognized academic credential and must have been enrolled at least half-time for at least one academic period (e.g., one semester) that begins during the calendar year.
  • The credit is available only for the first four years of higher education (generally freshman through senior years).
  • The credit is denied when certain other educational incentives are used. For example, a taxpayer cannot claim this credit for any student for whom a lifetime learning credit is claimed in the same year.
  • A student cannot claim the credit if another person has claimed the student as a dependent.
  • The student cannot have had a felony conviction for possessing or distributing a controlled substance. Conviction for any other felony (e.g., fraud, kidnapping, arson) does not result in denial of the credit.

Income limitsThe credit is phased out if MAGI16 exceeds a threshold amount, which is not adjusted for inflation. The phaseout threshold is $80,000 ($160,000 if filing a joint return).

Lifetime learning credit

The lifetime learning credit is another credit available to assist with the costs of higher education. Since it typically provides less of a tax benefit, it is generally claimed only when the American opportunity tax credit is not available.

Potential income tax benefit: The provision provides for an annual tax credit of up to $2,000 per taxpayer.

Important requirements:

  • The credit is 20% of the first $10,000 of qualified expenses. Thus, a taxpayer must have $10,000 of qualified expenses during a year to obtain the full $2,000 credit.
  • As with the American opportunity tax credit, the lifetime learning credit cannot be claimed when certain other educational incentives are claimed.
  • Unlike the American opportunity credit:• None of the credit is refundable. The lifetime learning credit only provides a tax savings to the extent the taxpayer has a tax obligation equal to or greater than the credit.• Costs for books, supplies, and equipment are not qualified expenses unless they must be paid to the educational organization.• There is no degree or workload requirement, and the credit is not limited to four years of study. Thus, the credit can be claimed for continuing education expenses.• Having a felony conviction for possessing or distributing a controlled substance (or any felony conviction) will not cause the student to lose the credit.

Income limits: The credit phases out if MAGI exceeds a threshold amount. However, the threshold for the phaseout is significantly less than that under the American opportunity tax credit. In 2018, a taxpayer who had MAGI in excess of $57,000 ($114,000 if filing a joint return) would lose a portion or all of this credit.17

Tax assistance with student loans

Congress has also enacted provisions that provide tax relief for loans used for education. Sec. 221, discussed below, is one important provision.

Student loan interest deduction

Potential income tax benefitThe payment of personal interest is not generally deductible. A taxpayer may, however, be able to claim an above-the-line deduction for up to $2,500 of interest paid each year on qualified student loans.

Important requirements:

  • The loan must have been incurred solely to pay qualified higher education expenses of the taxpayer, the taxpayer’s spouse, or a dependent at the time of the loan. The definition of “dependent,” however, is not the same as the definition used for determining the availability of a dependency exemption,18 which is unavailable beginning in 2018.
  • The loan cannot be from a related person or made under a qualified employer plan.
  • The student must have been enrolled at least half-time in a program leading to a degree, certificate, or other recognized educational credential at an eligible educational institution.
  • The loan may be used for tuition, fees, books, supplies, and equipment. The cost of room and board may also qualify.
  • Only interest is deductible; however, the allocation of payments between interest and principal for tax purposes may not be the same as the allocation shown on Form 1098-E, Student Loan Interest Statement, or other statement received from the lender.19

Income limits:

  • The deduction is phased out if MAGI exceeds a threshold amount. The definition of MAGI is different from that used for the American opportunity and lifetime learning credits.20
  • In 2018, the phaseout threshold for taxpayers filing joint returns is $135,000, and the deduction is totally phased out for taxpayers with MAGI of $165,000 or more. The phaseout threshold for other taxpayers is $65,000, and the deduction is totally phased out for taxpayers with MAGI of $80,000 or more.21

Unnecessary complexity of current provisions

Albert Einstein is reported to have said, “The hardest thing in the world to understand is income taxes.”22

Our current educational income tax incentives build on that legacy. Although all were designed to assist with the costs of higher education, the provisions do not even agree as to what should be considered qualifying educational costs. Some, but not all provisions, include the costs of books and supplies. Some, but not all, include the costs of housing and meals.

In addition, the provisions impose different and inconsistent requirements for a taxpayer to obtain the promised tax benefits. Just with respect to the above provisions:

  • Some require at least half-time student enrollment; others have no minimum requirement.
  • Some have age limits; some do not.
  • Some, but not all, are limited to a taxpayer, spouse, and dependents, and for those, the definition of a “dependent” varies.
  • The American opportunity tax credit is partially refundable; the lifetime learning credit is not.
  • Some, but not all, require that income be below a certain amount. The amount of income that defines “need” varies and can be almost as much as $220,000. Those provisions that have income requirements do not use a uniform definition of “income.”

Questionable effectiveness in achieving objectives

The provisions were designed to reduce income taxes for those in need to encourage the pursuit of higher education. There are significant structural reasons why the provisions may have limited effectiveness in accomplishing this goal:

Value of exclusions and deductions: When an exclusion or deduction is claimed, the tax savings are equivalent to the amount of the deduction or exclusion multiplied by the taxpayer’s marginal tax rate. A taxpayer with need often has a low marginal tax rate and, thus, will receive only a negligible tax reduction. Using exclusions and deductions to provide education benefits can in fact have the undesired effect of giving the largest tax savings to those with the highest incomes.

Lack of federal income tax ­liabilityAn inherent problem in using the U.S. income tax law to assist taxpayers is that in 2016 approximately 44% of Americans had no U.S. income tax liability.23 As a result, most of the educational tax provisions are of no value to them.24

Recommendations for change

The American Bar Association (ABA) and the AICPA tax sections have long noted the need to simplify the education tax provisions. Some of the previous recommendations were:25

  • Eliminate or standardize income ranges for eligibility of benefits;
  • Combine the education tax credits and establish a single amount of expenses eligible for the credit; and
  • Consider replacing the existing incentives with a universal deduction or credit.

National Taxpayer Advocate Nina Olson, who has served in that role since 2001, recently wrote, “If I had to distill everything I’ve learned into one sentence, it would be this: The root of all evil is the complexity of the tax code.”26 Olson has specifically noted the need to consolidate and harmonize the Code’s education provisions. In the Taxpayer Advocate Service’s 2016 annual report to Congress, she stated: “The point of a tax incentive, almost by definition, is to encourage certain types of economic behavior. However, taxpayers will only respond to incentives if they know they exist and understand them. Few, if any, taxpayers are aware of each of the education tax incentives and familiar enough with the particulars to make wise choices.”27

The recent tax overhaul legislation, P.L. 115-97, failed to fix the current state of the educational tax provisions, although early versions of the bill had proposed to consolidate the education tax credits and make other changes. Hopefully, Congress will someday heed the calls for change and provide education tax incentives that taxpayers can understand and use.

Footnotes

1Crandall-Hollick, Higher Education Tax Benefits: Brief Overview and Budgetary Effects, CRS Report R41967 (March 12, 2014). In December 2014, another provision with education tax benefits, Sec. 529A qualified ABLE programs, was signed into law.

2Estimates of tax expenditures for educational incentives vary. Estimates provided by the Joint Committee on Taxation listed total tax expenditures for these provisions of $35.4 billion for 2017 (Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2016-2020 (JCX-3-17) (Jan. 30, 2017)). Estimates provided by the Office of Management and Budget (OMB) for 2017 totaled $29.7 billion (OMB, Analytical Perspectives, Budget of the United States Government: Fiscal Year 2017, Tax Expenditures, Table 14-2B (Feb 10, 2016)). The OMB report noted that totaling the individual incentives might not reflect the potential revenue effect due to possible changes in economic behavior and the fact that tax expenditures are interdependent. The Joint Committee report also noted that it used different methodologies than OMB. See Comparisons With Treasury and Tax Expenditures Calculations Generally in that report.

3Not all of the education-related tax provisions are reviewed in this article. For the fearless, citations to many provisions not discussed are listed here. Provisions that provide incentives to save include the following: Sec. 127 (educational assistance programs); Sec. 72(t)(2)(E) (distributions from individual retirement plans for higher education expenses); and Sec. 529A (qualified ABLE programs). Provisions that assist in paying for current expenses include the following: Sec. 222 (qualified tuition and related expenses); Sec. 162 (trade or business expenses) (Regs. Sec. 1.162-5); Sec. 117(a) (qualified scholarships); and Sec. 117(d) (qualified tuition reduction). A provision that may provide tax savings upon discharge of a student loan is Sec. 108(f) (student loans).

4It should be noted that the interest rate on Series EE U.S. savings bonds issued from Nov. 1, 2017, through April 30, 2018, is only 0.10% (Treasury Direct, “May 2005 and Later (EE Bond Rates and Terms),” available at www.treasurydirect.gov.

5Series EE bonds issued after 1989 and Series I bonds (Sec. 135(c)(1)).

6IRS Publication 970, Tax Benefits for Education, p. 57 (2017).

7Sec. 135(b)(2). “Modified adjusted gross income” is defined at Sec. 135(c)(4).

8Rev. Proc. 2017-58.

9Qualifying expenses may include elementary and secondary school expenses in addition to higher education expenses (Sec. 530(b)(2)).

10While helpful, this may not be sufficient, since the average posted charges for one year of tuition, fees, room, and board at a four-year private college during 2017 to 2018 was $46,950 (College Board, Trends in College Pricing 2017, Table 1, p. 9 (October 2017)).

11Sec. 530(b)(2). See Sec. 529(e)(3)(B) and Sec. 25A(b)(3)(B).

12Sec. 530(c)(2).

13Although not discussed here, Sec. 529 also provided for the establishment of prepaid tuition plans.

14Hurley, The Best Way to Save for College, p. 44 (Saving for College LLC 2015).

15For distributions made after Dec. 31, 2017, the definition of qualified higher education expense has been expanded to include up to $10,000 per student per year for tuition in connection with enrollment or attendance at an elementary or secondary school (Sec. 529(e)(3)(A); Sec. 529(c)(7)).

16Sec. 25A(d)(3); for purpose of this provision and the lifetime learning credit, “modified adjusted gross income” means the adjusted gross income of the taxpayer for the tax year increased by any amount excluded under Sec. 911, 931, or 933.

17Rev. Proc. 2017-58.

18Sec. 221(d)(4).

19IRS Publication 970, Tax Benefits for Education, p. 33 (2017).

20Sec. 221(b)(2)(C).

21Rev. Proc. 2017-58.

22As reported by his tax adviser, Leo Mattersdorf, in a letter to Time magazine, Feb. 22, 1963.

23Urban-Brookings Tax Policy Center, Tax Units With Zero or Negative Income Tax Under Current Law, 2011-2026, T16-0121 (July 11, 2016).

24The American opportunity tax credit is 40% refundable; however, to claim the benefit, an individual must file a U.S. tax return.

25ABA Section of Taxation, 2001 Top Simplification Recommendations, p. 6 (February 2001).

26Olson, “Complexity Is the Root of All Evil,” The Wall Street Journal, April 18, 2017, www.wsj.com.

27National Taxpayer Advocate, 2016 Annual Report to Congress, p. 322 (Jan. 11, 2017).

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EBay Tax Issues

Even if you are not running a business and only selling personal items, there are tax ramifications when selling on eBay. You should educate yourself on eBay tax issues to avoid unpleasant tax surprises from the IRS. This section goes over your income and sales tax obligations as an eBay seller. Even if you understand the issues today, there is new proposed legislation that can change everything.

eBay and Tax Reporting

The current tax laws do not require eBay or PayPal to report the sales proceeds to the Internal Revenue Service. However, in an effort to capture unreported income, the IRS is considering a proposal to classify eBay as a “broker” and require eBay to report all sales to the IRS. The logistics of doing this would be an incredibly daunting task for eBay. Sellers would need to provide eBay with a social security or federal tax ID number and report their profits to the IRS. This paperwork nightmare would likely drive many sellers away from eBay. A positive benefit is eBay seller fraud may be drastically reduced as sellers will need to verify their identity before they are allowed to sell. See internet broker tax for more information.

Currently, eBay does not provide sales tax information to any state. A 1992 Supreme court ruling declared that forcing sellers to collect sales tax in states where they don’t have a physical presence constitutes an undue burden. Imagine trying to collect sales tax for potentially 50 different states. Each state has a different sales tax rate and counties and cities within the state can have its own tax rate added in on top. It will quickly turn into a paperwork nightmare trying to keep track of it all. States are not sitting idly by watching all that sales tax revenue go untapped. In an effort to by-pass the Supreme Court ruling, several states have proposed the Streamlined Sales Tax Project. If this legislation takes hold, it will require eBay sellers to collect sales tax and pay them to each state. See eBay sales tax for more information.

Selling Personal Items

Many new eBay sellers wonder if they need to pay taxes on the items they sell. The answer is yes, but only if there is a profit on the sale. Since most used items sell for less than what they cost when they were bought new, there is no profit on the sale. If there are no profits, then there is no need to pay taxes on the sale.

If you do end up with a profit on your eBay sale, you are required to report the proceeds to the IRS. Since neither eBay nor PayPal report sales transactions to the IRS, you are on the honor system to report your eBay profits. Consider creating a business to take advantage of deductions relating to your eBay sales. This will help reduce the amount of tax you will have to pay to the IRS. See the section Create a Business for Tax Purposes below for more details. Even if you don’t set up a business, you can deduct the eBay and PayPal fees from the proceeds of your sales.

Sales Tax

Sales tax should be collected on your eBay sales if the state you live in charges a sales tax. You need to collect sales tax only from buyers that reside in the same state. You do not have to collect sales tax from buyers that live in other states. Each state has its own set of goods that are exempt from sales tax. For example, there is no sales tax on food. Some states also exempt certain types of sales transactions such as garage sales. Be sure to check with your state’s sales tax authority for more information.

When you purchase items for resale using a seller’s permit, you don’t pay sales tax on that purchase. However, when you sell the items, you need to collect sales tax. Depending on your sales volume, the collected sales tax must be paid to your state’s sales tax authority on a bi-weekly, monthly, or quarterly basis.

The question that often comes up is how will the state know about the sale if eBay does not report them? The answer is they won’t know. If you are running a business, then there is likey to be a nice paper trail to follow if the state decides to audit you. For individuals, the state will probably never know. You are on your honor system to collect the sales tax and file the necessary paperwork. Of course, most people don’t.

Create a Business for Tax Purposes

If you are going to pay taxes on your eBay profits, you should create a business so you can deduct expenses related to your eBay sales. Items that sell for a loss can be deducted from your profits. You may qualify for a home business deduction if you use part of your home exclusively for your eBay business. The camera used for photography, mileage driven to find products to sell, shipping supplies, internet access, and many other things are legitimate business expenses. Be sure to keep accurate records. At a minimum, you should use a spreadsheet to keep track of your business expenses. As your business grows, you should switch to professional accounting software such as Quickbooks.

Don’t go crazy with the deductions thinking this is a perfect tax shelter. If you don’t show a reasonable profit after a few years, the IRS could classify your business as a hobby and disallow all the business deductions you have taken. You will then be required to pay back taxes on those disallowed deductions.

For most people, setting up your business as a sole proprietorship is the best choice. Any income from the business will be treated as ordinary income on your tax return. Sole proprietors use Schedule C to file their taxes. Unfortunately, the income is subject to self employment tax. Tax preparation software can walk you through Schedule C and automatically calculate any self employment tax due.

For more information about Schedule C, see Tax Guide For Small Business, IRS Publication 334.

County/City Business Tax

Most counties and some cities require a business license in order to do business in their jurisdiction. You will then be assessed a business tax once a year. The tax is based on the value of your business property, or a percentage of your gross receipts depending on the jurisdiction. For a small business, the tax is usually less than $150. Check your county/city government website for more information.

Payroll Taxes

When your business grows to a point where you need to hire employees, you have to deal with payroll taxes. Employers must pay half of the employee’s social security and Medicare tax. The employee pays the other half. The employer is also required to withhold the employee’s federal, state, and in some cases, city income tax. Employers must contribute to federal and state unemployment funds. Depending on your payroll size, the funds collected must be deposited with state and federal agencies on a bi-weekly, monthly, or quarterly basis.

To help with the paperwork, there are several payroll services that will manage your payroll for a fee. Quickbooks sells an add-on payroll module that will handle all the calculations and generate the forms to file with the IRS. Each state has its own set of rules. Check your state’s government website for more details.

See Employer’s Tax Guide, IRS Publication 15 for more information about payroll taxes.

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Getting Started With Angel Investing

What it is: Angel investors might be professionals such as doctors or lawyers, former business associates — or better yet, seasoned entrepreneurs interested in helping out the next generation. What matters is that they are wealthy and willing to invest hundreds of thousands of dollars in your business in return for a piece of the action.How it works: Generally, the angels need to meet the Securities Exchange Commission’s (SEC) definition of accredited investors.

They each need to have a net worth of at least $1 million and make $200,000 a year (or $300,000 a year jointly with a spouse). Angel investors give you money. You sell them equity in the company, filing the investment raise with the SEC. Angel investments commonly run around $600,000. Most investments rounds also involve multiple investors, thanks to the proliferations of angel groups.Related: What Angel Investors Want Now Upside: Angel investments can be perfect for businesses that are established enough that they are beyond the startup phase, but are still early enough in the game that they need capital to develop a product or fund a marketing strategy.Many businesses receiving angel investments already have some revenue, but they need some cash to kick the enterprise to the next level.

Not only can an angel investor provide this, but he or she might become an important mentor. Because their money is on the line, they will be highly motivated to see your business succeed.Downside: You could be giving away anywhere from 10 to more than 50 percent of your business. On top of that, there’s always the risk that your investors will decide that you are the business’ greatest obstacle to success, and you could get fired from the company you created.Angel investors, like venture capitalists, also like to see an end game down the road that will allow them to pocket their winnings, whether it is a public offering or your business getting acquired by another company. You might have to give up running your enterprise before you’re done having fun with it.

Related: 5 Worst Mistakes Entrepreneurs Make When Pitching Angel InvestorsHow to get it: It used to be that angel investors were wealthy people the business owner knew. Or they might be veteran entrepreneurs who were discovered through old-fashioned networking at the local Chamber of Commerce, the area Small Business Development Center, or a trusted banker, lawyer or accountant.These days, though, angel groups are proliferating, offering plenty of mentoring and coaching on top of the money provided.The Overland, Kan.-based Angel Capital Association (ACA) has an online listing of angel groups that are members in good standing, as well as organizations affiliated with the ACA. Other websites to check out include AngelList and MicroVentures.Related: 3 Things You Must Know Before Pitching Investors

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How a Small Business Investment Can Make Money

Investing in stocks of a small business is merely an extension of buying a small portion of a business run by someone else and enjoying your cut of the earnings. Small businesses sometimes are seen as wonderful gifts that, when well-nurtured, can produce a lifetime of financial independence and a standard of living much higher than average. Small business and start-up business investment opportunities often come in the form of penny stocks which can expose the investor to higher risks.

Who Invests in Small Business Stocks For the right type of person, with the right type of skill, temperament, and risk profile, small business investment can be a lucrative investment. Typically, there are only three mechanisms through which you can experience a profit in net worth from a privately held firm. Knowing these three sources of wealth generation is important because new investors are sometimes too quick to jump head-first into potential opportunities without clear ideas of how they will drive the economic engine to gain the financial benefits they desire. The Salary You Pay Yourself For many small business investors, the company never generates more than enough for them and their family to live upon from salaries taken out of the company in exchange for working on the payroll. Though this can be considered a success, the small business isn’t really an investment at this stage. Instead, the founders have essentially created a job for themselves, which includes the benefits and drawbacks of self-employment.

These payroll distributions can limit the total capital the company has to expand, which can explain why many small businesses are never able to move beyond a single location or increase sales significantly. It is isn’t unusual for more successful small businesses to begin as part-time ventures, allowing the founders to continue their day jobs until the company grows large enough to support their small business salary needs. Distributions From Profits When a small business investment has become successful, there is profit remaining for the owners above and beyond the amount taken out of the business in salaries and wages. The owners then can decide to reinvest the profits for future expansion or they can declare a dividend. In the case of a corporation, the dividend is a distribution to shareholders. This payment takes the form of a draw for a limited liability company or limited partnership.

A sole proprietorship small business may use the money in their personal lives, often to build savings, acquire other investments—such as stocks, bonds, or real estate—and paying down debt. Whether or not a small business investor reinvests his or her dividends can have an enormous effect on their ultimate net worth. There is no right or wrong answer. If you desire to live better now and give up more wealth in the future, taking dividends can be a rational course of action. If you would rather be richer in the future and are willing to risk additional capital in that pursuit, reinvesting dividends can be the more intelligent strategy. In any event, when you move beyond having a job, dividends from profits are the second most common source of wealth for small business investors. Capitalized Earnings From Selling the Firm Once a company has grown beyond the small business realm, it could become attractive enough that outside investors want to own it.

When this happens, these investors may offer to buy the company. With few exceptions, the primary source of value for an operating business that generates good returns on capital is the earnings power, not the assets on the balance sheet. For example, manufacturing plant machinery isn’t worth much when bought on the liquidation market, but when acquired as part of an on-going company that produces large profits, it is valuable. Investors will look at the earnings of the business and factor in growth, debt levels, and the economics of the industry as a whole. If things are attractive, they often apply a valuation multiple to the profit stream.

This is the equivalent of the price-to-earnings ratio you hear so much about in the stock market. Thus, a business that earns $1 million per year in profit might reasonably sell for $10 million or $15 million. That figure is the “capitalized” earnings value of the firm. Some small business owners form new ventures for the sole purpose of growing them to the point the earnings can be capitalized and the company sold. This is known in financial terms as a “liquidity event.” There are even special types of investors that focus on this niche investment strategy, such as so-called “venture capitalists” who back nascent enterprises in the hopes of someday taking them public in an IPO or selling them to an established player in a market.

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Investing As A Business: What The Tax Code Says

Some people spend enough time on their portfolios that they believe investing has become jobs or businesses.

There are tax advantages of being in the trade or business of investing, so the tax code limits who qualifies.

Retirees often earn most of their income from their investments. Interest, dividends, and capital gains pay the bulk of their expenses. Some retirees devote enough time and attention to their portfolios that they believe investing has become jobs or businesses. They ask, for tax purposes, can a retiree be in the business of investing?

There are tax benefits when investing is your trade or business, which the IRS calls being a trader. All your investment-related expenses are deducted directly from investment income on Schedule C. You might even be able to deduct home office expenses, computers, and office supplies. Unlike most Schedule C taxpayers, the net income from trading isn’t subject to self-employment tax. But a trader can’t deduct Keogh retirement plan contributions.

A trader also can elect to mark-to-market all investment positions at the end of each year. This means you report gains and losses as though you sold each position on the last day of the year, though you haven’t. If you have a net loss on paper at the end of the year, you have a net loss for tax purposes, though you haven’t sold your positions and today’s paper losses might turn into gains next year. Under this election, you also can deduct net losses against other income without being subject to the $3,000 annual limit other taxpayers face on capital loss deductions. A disadvantage of being a trader is you don’t receive the preferential long-term capital gains rate. All net gains and losses are ordinary income or losses.

These tax rules apply only if you’re a trader under the tax code. If you’re not a trader, you’re an investor and don’t receive any special tax treatment.

Because the tax advantages of being in the trade or business of investing can be significant, the IRS and courts tightly limit who qualifies as a trader.

Whether you’re an investor or trader depends on your time perspective, your goals, the type of income you earn, and the amount of transactions you engage in.

To be a trader, your investment activity must be substantial and must be carried on with regularity and continuity. You also must seek to profit primarily from daily (or more frequent) market movements and not primarily from interest, dividends, or long-term capital gains. The IRS will examine the amount of time you devote to investing and whether you are pursuing the activity for a livelihood. But the key factors are the frequency and dollar amount of your trades during the year and the typical holding period for a security.

You must pass all the tests to be considered a trader. There have been court cases in which taxpayers engaged in more than 200 trades per year but weren’t considered traders either because their trading wasn’t considered regular or continuous or because they weren’t trying to profit from daily market movements.

Some people spend enough time on their portfolios that they believe investing has become jobs or businesses.

In a typical case, the taxpayer made 204 trades one year, 303 the next, and 1,543 the third year. The Tax Court said trading for the first year wasn’t substantial, but it was substantial for the next two years. That didn’t end the case. The taxpayer also had to show his trading was regular and continuous.

The taxpayer’s strategy was to buy stocks and then sell call options on them. The goal was to earn premiums as the options expired without the buyers exercising their rights to buy stocks from the taxpayer. The taxpayer’s options generally had terms of one to five months, and he did not trade them daily. The taxpayer executed trades on 77 days the first year and 99 and 112 days in the following two years. The court ruled the trading wasn’t frequent, continuous, or regular in any of the years.

Considering all the factors, the court said the taxpayer wasn’t a trader. (Endicott v. Commissioner, T.C. Memo 2013-199)

There’s no precise formula that will ensure you are considered a trader for tax purposes, but there are some general rules that can be developed from the cases.

To be a trader, you probably need to execute trades on at least 300 days per year and should execute more than one trade on many days. You also need to trade for short-term profits, so your strategy and goals matter. Your average holding period should be measured in hours, days or perhaps weeks, not months or years. You’re more likely to be considered a trader if you trade options or futures contracts instead of stocks, bonds, ETFs, or mutual funds.

Also, you can be an investor for some of your holdings and a trader for others. If you’re trying to qualify only part of your activities as trading, you should use a separate brokerage account for those transactions.

You’ll have to spend much of your days watching the markets and making trades to qualify as a trader, but you might find the tax benefits are attractive enough to warrant spending your time that way.

“Some people spend enough time on their portfolios that they believe investing has become jobs or businesses. There are tax advantages of being in the trade or business of investing, so the tax code limits who qualifies. Retirees often earn most of their income from their investments. Interest, dividends, and capital gains pay the bulk of their expenses. Some retirees devote enough time and attention to their portfolios that they believe investing has become jobs or businesses. They ask, for tax purposes, can a retiree be in the business of investing? There are tax benefits when investing is your trade or business, which the IRS calls being a trader. All your investment-related expenses are deducted directly from investment income on Schedule C. You might even be able to deduct home office expenses, computers, and office supplies. Unlike most Schedule C taxpayers, the net income from trading isn’t subject to self-employment tax. But a trader can’t deduct Keogh retirement plan contributions.

A trader also can elect to mark-to-market all investment positions at the end of each year. This means you report gains and losses as though you sold each position on the last day of the year, though you haven’t. If you have a net loss on paper at the end of the year, you have a net loss for tax purposes, though you haven’t sold your positions and today’s paper losses might turn into gains next year. Under this election, you also can deduct net losses against other income without being subject to the $3,000 annual limit other taxpayers face on capital loss deductions. A disadvantage of being a trader is you don’t receive the preferential long-term capital gains rate. All net gains and losses are ordinary income or losses. These tax rules apply only if you’re a trader under the tax code. If you’re not a trader, you’re an investor and don’t receive any special tax treatment. Because the tax advantages of being in the trade or business of investing can be significant, the IRS and courts tightly limit who qualifies as a trader.

Whether you’re an investor or trader depends on your time perspective, your goals, the type of income you earn, and the amount of transactions you engage in. To be a trader, your investment activity must be substantial and must be carried on with regularity and continuity. You also must seek to profit primarily from daily (or more frequent) market movements and not primarily from interest, dividends, or long-term capital gains. The IRS will examine the amount of time you devote to investing and whether you are pursuing the activity for a livelihood. But the key factors are the frequency and dollar amount of your trades during the year and the typical holding period for a security. You must pass all the tests to be considered a trader.

There have been court cases in which taxpayers engaged in more than 200 trades per year but weren’t considered traders either because their trading wasn’t considered regular or continuous or because they weren’t trying to profit from daily market movements. Some people spend enough time on their portfolios that they believe investing has become jobs or businesses. In a typical case, the taxpayer made 204 trades one year, 303 the next, and 1,543 the third year. The Tax Court said trading for the first year wasn’t substantial, but it was substantial for the next two years.

That didn’t end the case. The taxpayer also had to show his trading was regular and continuous. The taxpayer’s strategy was to buy stocks and then sell call options on them. The goal was to earn premiums as the options expired without the buyers exercising their rights to buy stocks from the taxpayer. The taxpayer’s options generally had terms of one to five months, and he did not trade them daily. The taxpayer executed trades on 77 days the first year and 99 and 112 days in the following two years. The court ruled the trading wasn’t frequent, continuous, or regular in any of the years. Considering all the factors, the court said the taxpayer wasn’t a trader. (Endicott v. Commissioner, T.C. Memo 2013-199) There’s no precise formula that will ensure you are considered a trader for tax purposes, but there are some general rules that can be developed from the cases. To be a trader, you probably need to execute trades on at least 300 days per year and should execute more than one trade on many days.

You also need to trade for short-term profits, so your strategy and goals matter. Your average holding period should be measured in hours, days or perhaps weeks, not months or years. You’re more likely to be considered a trader if you trade options or futures contracts instead of stocks, bonds, ETFs, or mutual funds. Also, you can be an investor for some of your holdings and a trader for others. If you’re trying to qualify only part of your activities as trading, you should use a separate brokerage account for those transactions. You’ll have to spend much of your days watching the markets and making trades to qualify as a trader, but you might find the tax benefits are attractive enough to warrant spending your time that way.

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10 Business Investments to Make Now

Salaries, technology, supplies. Every day, you spend money and time on your business. But do you know which investments are giving you the most bang for your buck?

Taking a close look at what is actually helping your business grow and generate revenue can help you make wiser decisions that pay off for your company.

Here are 10 of the top investments in which business owners can get the best return for their money.

Florian and Shannon Radke of Cinnaholic

To keep their Berkeley, Calif., bakery both cool and functional, Shannon and Florian Radke, co-owners of Cinnaholic installed iPads instead of registers.

1. Publicity
Before opening upscale Berkeley, Calif., bakery, Cinnaholic, Shannon Radke launched a blog chronicling the details about location-hunting, permit challenges and difficult landlords. Within a couple of months, the frank, but funny blog was getting 15,000 hits per month and led to coverage in popular regional publications like SF Weekly and East Bay Express. The duo also invested about $3,000 dollars in a website and spends $150 a month on Facebook ads. When the bakery opened last June, there were “lines around the block,” says husband and co-founder Florian Radke.

2. Customer research
Brett Brohl spent a month and about $300 polling healthcare professionals about their preferences before launching his Minneapolis-based online scrubs and medical uniforms retailer, Scrubadoo.com. Through the online-survey service SurveyMonkey, he asked about favorite brands, buying volume and preferred media. That research helped improve his understanding of the brand-driven nature of his business and his target customers. He was then better able to make a range of decisions from inventory selection to marketing.

Brett Brohl of Scrubadoo

Before starting up, Brett Brohl, the founder of Scrubadoo.com, a medial scrubs retailer, used SurveyMonkey to poll what exactly his target audience would buy.

3. Automation
When Brohl first launched his site, he logged every transaction by hand. With tens of thousands of barcodes to manage, it took precious time away from selling to bigger accounts. A $1,500 investment in software to automate his ordering system paid for itself in three to four months, Brohl says. An added benefit: He can take a vacation. Automating features and writing out procedures for repeat tasks allows others to step in when you can’t.

4. Outsourcing
Sometimes, it pays to offload tasks that don’t need to be done in-house, says Jennifer Crews, founder of Pearl Advisory Partners, an Asbury Park, N.J., business-consulting firm. If you can generate more money in an hour spent doing these tasks than it would cost you to pay someone to do it for you, you’re losing money, she says.

5. Better book-keeping
Organizing your books is critical. Tapping a freelance bookkeeper or even just investing in accounting software, which can cost anywhere from $39.95 to $1,000 or more, can help you take advantage of early-payment discounts and avoid late-payment fees and finance charges, Crews says. You’ll also keep your credit history sterling, which can help when negotiating for better terms with vendors and rates on loans and lines of credit, she says.

Sean Clemmons of Piraeus Data

Sean Clemmons upped the training he and other execs offered Piraeus Data’s 40-person staff. That training has turned neophytes into managers in half the time.

6. Training
For those activities that you can keep in-house and delegate, training is essential, Crews says. Sean Clemmons found that to be true. He owns a 40-person business-intelligence consulting firm, Piraeus Data in Seattle. He upped internal training, spending more time with employees and offering daily feedback sessions, and productivity surged. He estimates that the time it takes a new hire to become a manager has shrunk from more than a year to just two or three months. The cost? About $1,000 in staff time per week.

7. Technology
When Radke was designing his bakery, he wanted the hip factor to carry through to point-of-sale. So, instead of buying a big, boxy cash register or computer system, which would have set him back more than $3,000, he opted for a $600 iPad equipped with Square, a free app and reader that turns iPad, iPhone, and Android devices into credit card payment systems with no contracts or merchant account required. Though cash purchases can be processed for free through the Square app, credit card transaction fees, which range from 2.75% to 3.5% plus 15 cents, still apply. “So, in addition to saving hundreds of dollars, it helps our brand, and we’ve gotten a lot of publicity because it’s unusual,” he says.

8. Sales data
Even though Clemmons and co-founder Ethan Chin run Piraeus Data, which is a data-driven company, they realized they weren’t doing a good job of tracking customers and their buying habits. To remedy the problem, they now use a customer-relationship management tool from Salesforce.com. In exchange for roughly $4,000 a year, Piraeus’ salespeople can access more comprehensive and current customer data. Clemmons says the frequency of contact with customers and prospects has gone from as long as year to no more than 90 days, which has doubled the number of client meetings. Even in 2010’s tough environment for consulting firms, he says the firm’s revenue grew 5%.

9. ‘Scope creep’ curbs
Twenty percent of Piraeus’ consulting projects were suffering from “scope creep” — a term used to describe projects that grow beyond original expectations. Although particularly problematic for consultants and their ilk, scope creep can be a challenge for many companies, as they try to keep customers satisfied. Clemmons and his team spent approximately 160 hours — about $20,000 in billable hours — analyzing and evaluating how they manage projects and finding ways to prevent scope creep, saving nearly $200,000 in uncompensated work hours for the firm. “Now, it’s the project manager’s job to say ‘I’m sorry. That’s out of scope. Let’s talk about how we can do that in Phase 2,’” he says.

10. Quality suppliers
An ideal vendor will not only work to keep your business by keeping prices reasonable and provide timely deliveries, you may even benefit from pitching their products or services. Radke says the top-of-the-line ingredients he gets from his suppliers allows him to charge $5 to $6 for cinnamon rolls, while his competitors charge about $3.50.

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