Dr. Mark Lee Levine, Professor
TAX LOOPHOLES--(How Do I Find One?)
What are Loopholes vs Tax Planning?
It appears that many folks view a “Tax Loophole” as something that is not illegal under the tax law, but it is close to the edge of illegality.
On the contrary, one might view the term “Tax Loophole” as some proper planning, not against the law, that maybe one taxpayer or his or her planner has discovered, where most folks are not aware of such planning; thus, they have not saved by employing the “tax Loophole.”
Some taxpayers would think of the Loophole as an ambiguity; others might call it a tax dodge that, again, maybe within the law, but it is “unethical.”
One quick example illustrates this point. Years ago, back in 1963, there was a case, the Alderson Case, where a taxpayer had structured a sale of his real estate. Before the scheduled closing, the taxpayer/seller learned that the transactions could properly postpone paying any income tax on the gain if the taxpayer merely provided for an exchange.
That is, assume A, with the A-1 property, contracted to sell the property to B.
In turn, when A received the cash from B on the sale, A was intending to buy property C. However, A will have some tax to pay on the gain from the sale of A-1. Thus, assume that when A realized this, A and B agreed that they would rescind the contract of sale by A to B. In turn, B would purchase the C -1 property on step one. Following this acquisition by B, B would exchange the C-1 property to A and receive from A the A-1 property. The net result would be that A would defer any gain on the A-1 property.
Is this a Loophole by A? After all, he undertook the above steps simply to structure the transaction for a better tax position by A. It was all driven by A’s tax motive to save having to pay income tax on the “sale” of A-1.
When this issue was addressed in Court, the Court held that such actions by A were perfectly acceptable, since the original contract was not completed on the proposed sale between A and B. The intent to save taxes by A apparently was not illegal; maybe it was not even a “loophole.” The action was allowed; A did not have to pay tax under the above structure.
In thinking about this issue of Tax Planning vs Tax Dodging, whether or not labeled as a Loophole, I read an interesting presentation by the Tax Foundation (TF), a non-profit group. The discussion was on what the Tax Foundation called Myths in the tax law. Below are a few of the Myths that the TF raised in this recent discussion. See, as you read, if there are any Loopholes present.
Myth: The Rich Do Not Pay Any Taxes in the U.S.
We have all read these types of headlines in the paper or on the web. If the rich do not pay taxes, how do they “get out of paying taxes”? Maybe they know some loopholes most of us do not know?
The TF explained that there is no Loophole employed to avoid taxes. Rather, the TF stated:
“When it comes to this misconception, the opposite is true. As with any progressive income tax system, U.S. taxpayers with higher incomes pay higher income tax rates. The result: half of U.S. taxpayers pay 97 percent of all income taxes.
The top 1 percent of earners alone pay over one-third of income taxes. Income taxes are only part of the story. Payroll taxes, sales taxes, and excise taxes are additional taxes, without being progressive.” So, there is no Loophole, there is only a false narrative saying that these taxpayers do not pay taxes.
You Do Not Have to Pay Taxes:
Another Myth mentioned by the TF:
“There’s no U.S. law requiring you to pay income tax.”
Maybe you do not need a Loophole to avoid paying taxes! That is, what this Myth is addressing is that maybe the U.S. has wrongly imposed this tax on us. Of course, this is a Myth and the statement saying you do not have to pay taxes is not accurate. The 16th Amendment to our U.S Constitution makes it clear that the power to levy this tax is given to the government! This dates back to 1913.
Myth to allow Deductions:
Another interesting Myth mentioned by the TF addresses the ability to deduct expenses as being a Loophole. If the taxpayer complies with the tax law and claims a deduction as allowed by Congress when it passed the provision in question and contained within the Internal Revenue Code, this is not a Loophole. If one considered a deduction for depreciation, as an example, this is certainly not a Loophole. Congress, under Code Sections 167 and 168, among other Sections, specifically allows taxpayers to reduce their taxes for qualified depreciation deductions, such as those for business equipment, office buildings for rent, business vehicles, and much more. Again, it is not a Loophole to claim a deduction for such item that the tax law (Congress) approved. The TF, in commenting on this Myth, stated:
“…expensing—the ability for companies to write off or deduct certain business expenses and investments—is a clear and intentional feature of the U.S. federal tax code ….”
Did Congress Create the Tax Confusion?
The TF mentioned many other Myths that are often stated as to the tax law. Whether the item is a “myth,” or simply a misunderstanding of what the tax law provides, it is clear that there are many confusing aspects of the tax law. Sometimes the confusion is created by crafting wording in the tax code to try and prevent taxpayers from asserting a position that might not be intended when Congress passes a given position. For example, Congress has restricted the installment sale of properties among related parties, followed by a quick resale. Thus, for example, Father, F, sells his property in an installment sale to Daughter, D, who immediately resells it for cash to X. Is this installment sale permitted? The tax law places limits on a structure along the lines noted. However, Congress must go to great lengths in many cases to make the limits clear. In this instance, who are “related parties?”
D is related to her Father is easy to see. But, if D is married, is Father related, within the above rule, to D’s husband? (See Code Section 267 for more on this issue.) But, the point is that it is not always easy to discern what Congress meant when it passed a law. Does this create a potential Loophole?
Taxpayers often work diligently to gain the most advantageous positions under the tax law. Is this a Tax Loophole or just “good” tax planning?
(For more on these issues, see Real Estate Transactions, Tax Planning, Levine, Mark Lee and Segev, Libbi Levine, Thomson/Reuters/West (2022), Chapter 40 on tax motive.)
By Professor Mark Lee Levine, University of Denver