“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.” — Judge Learned Hand (1872-1961), U.S. Court of Appeals (Gregory v. Helvering, 2nd Cir 1934).
Just about everyone complains about tax “loopholes,” by which they usually mean “loopholes” for the “rich.” The word is routinely used by politicians and pundits to influence public opinion, always without any explanation or clarification. It’s an ideal smokescreen that obfuscates and confuses the electorate in an effort to influence them to support a particular cause or politician or tax legislation, or berate “greedy” businesspeople. It has become an all-purpose elixir, fit for whatever grievance is popular at the moment.
The New Dictionary of Cultural Literacy (Third Edition, 2002) defines tax loophole as “a provision in the laws governing taxation that allows people to reduce their taxes. The term has the connotation of an unintentional omission or obscurity in the law that allows the reduction of tax liability to a point below that intended by the framers of the law.”
In fact, one man’s (or woman’s) tax loophole may be another’s legitimate deduction.
Most people have no real understanding of what tax loopholes are and how they are created. “Loophole” implies some sinister, perhaps even illegal, manipulation of the tax laws for personal gain or advantage, although they are generally created for specific purposes.
Looking further at tax loopholes and some of the so-called “advantages” that are implied by the term, the following points are worth noting:
» Tax loopholes are created by the same politicians who employ the term for political purposes. However, they are often really just an error or oversight in the tax laws that some sharp-shooting tax adviser discovers was somehow overlooked by the legislators or the Internal Revenue Service. In other words, they are perfectly legal.
» Tax laws are an instrument of public policy. In addition to generating money for the public treasury, they are often designed to accomplish some specific social or economic purpose, such as encouraging certain industries to invest in equipment or expand in an effort to stimulate the economy. Examples of this are found in such tax deductions as the mortgage-interest deduction for homeowners, the depletion allowance for the oil and gas industries, depreciation of business equipment, rapid write-off of computers or automobiles purchased for business use.
» One legal deduction that is sometimes considered a loophole is the charitable deduction, which was created to encourage charitable giving. This includes the various types of trusts that enable taxpayers to avoid or minimize estate taxes, which many people seem to think are also loopholes.
» Most people don’t realize that the tax laws are written by Congress or the various state legislatures, not the IRS or the state tax agencies. After tax bills have been signed into law, the tax authorities define the rules (regulations) that they determine are necessary to clarify the intent of the laws and to enforce them.
» It is widely recognized that our tax laws are far too complex and burdensome, but what is not fully understood or appreciated is the fact that most loopholes are a result of complexities that are created by the efforts of tax authorities to define specific taxable events. In other words, the tax laws have become so complicated that certain legal write-offs or deductions can often be found that the authors did not foresee or intend. When tax rules are developed, the law of unintended consequences invariably rears its ugly head. The result is more complexity as they attempt to “fix” the problem or problems they themselves have created. This is one of the reasons the federal income tax laws, rules and regulations now require almost 73,000 pages to document.
An interesting example of a tax loophole that received considerable media coverage in 2007 involved The Blackstone Group, a large corporate buyout firm. The case is a good illustration of the law of unintended consequences and how it is possible to find ways to minimize income tax liability by taking advantage of the way in which certain tax laws are written and implemented.
Writing in The New York Times (July 13, 2007), David Cay Johnston noted, “The Blackstone arrangement … was a reminder of the disconnect between the tax debate in Congress and how the tax system actually operates at the highest levels of the economy. … The debate in Congress is about whether most of the compensation that fund managers earn should be taxed at the 35 percent rate that applies to other highly paid Americans, or at the 15 percent rate for capital gains.”
The issue involved had to do with the tax treatment of the sale of the goodwill of a business. There certainly was nothing illegal involved in this case, which had to do with paying taxes on $3.7 billion from selling shares of the entity to the public.
In the final analysis, tax loopholes are tax advantages that benefit others. When we — you and I — benefit from them, they are called legitimate deductions. As former Sen. Russell Long, D-La., put it, a tax loophole is “something that benefits the other guy. If it benefits you, it is tax reform.’‘
— Harris R. Sherline is a retired CPA and former chairman and CEO of Santa Ynez Valley Hospital who as lived in Santa Barbara County for more than 30 years. He stays active writing opinion columns and his blog, Opinionfest.com.