A tax loophole is an exploitation of a tax law that can reduce or eliminate the tax liabilities of the filer. Quite often, the original wording of a tax break is used to justify the use of a loophole. Several years ago, for example, a substantial break was offered to small companies that invested in SUVs and other heavy vehicles for their transportation fleets. Because the law allowed for 50% personal use, small business owners could upgrade their own personal vehicles to SUVs and still receive a tax credit. This exemplifies a tax loophole: the original intent is not illegal, but the definition can be exploited for personal gain.
Few legislators would ever define a tax code change as a loophole. After the changes have been adopted, savvy tax professionals and lawyers may discover flaws in the wording of the new law. Sometimes, an obvious or potentially costly problem is duly reported to lawmakers and the law is rewritten to close it. Other times, one may exist for years until a federal overseer or IRS agent discovers the mistake or exploitation.
One of the earliest tax loophole situations involved the so-called "marriage penalty." When it came to assets and income accumulated throughout a fiscal year, couples who claimed married status sometimes found themselves paying more taxes than an unmarried couple claiming the same income. Since the definition of marital status would only apply to the last day of the filing year, however, if the couple could obtain a quick legal divorce in a foreign country by December 31st, they would be considered single and avoid paying additional taxes. The couple could then remarry legally in the United States during the following year and repeat the process.
A tax loophole is usually considered a murky legal maneuver. Many legitimate business and personal deductions are already well-defined in the existing tax codes, but some individuals and corporations may feel comfortable claiming even more deductions based on the ambiguity of the language. If the filer's tax records are selected for an audit, all of these deductions can be called into question. Because of this yearly auditing process, most loopholes rarely survive more than a few years before some corrective legislative action is taken.