What Is a Loophole?

A loophole is a technicality that allows a person or business to avoid the scope of a law or restriction without directly violating the law. Used often in discussions of taxes and their avoidance, loopholes provide ways for individuals and companies to remove income or assets from taxable situations into ones with lower taxes or none at all.

Loopholes are most prevalent in complex business deals involving tax issues, political issues, and legal statutes. They can be found within contract details, building codes and tax codes, among others.

Key Takeaways

  • Loopholes are basically a technicality allowing escape from violating the law.
  • Common loopholes are found in taxes and avoiding taxes, as well as political issues.
  • Most loopholes are closed over time.

How a Loophole Works

A person or company utilizing a loophole isn't considered to be breaking the law but circumventing it in a way that was not intended by the regulators or legislators that put the law or restriction into place. The ability to circumvent the law is due to a flaw or defect in the legislation, often one that wasn’t obvious to those who originally drafted said law.

Most loopholes will close in time, as those who have the power to do so rewrite the rules to cut off the opportunity for loophole advantage. Some tax loopholes exist perennially, especially in nations like the United States where the intricate tax code amounts to tens of thousands of pages, which can lead to many opportunities for those seeking to exploit it.

Example of a Loophole

For example, in the United States, federal law requires that commercial gun sales be subject to a background check. When a consumer wishes to buy a firearm from a commercial retailer, he or she must submit his or her information to the National Instant Criminal Background Check System, which compares the buyer’s name and birthdate against a database of individuals not allowed to buy a firearm.

However, an exception is made for private sales; under federal law, any private individual can sell any other private individual a gun without the need for a background check. This private sale exception has created what is known as the gun show loophole, which allows individuals in many states to purchase guns from gun shows, or through other private sales, without the need for a background check. As long as state law doesn’t require a background check for private gun sales (which it does in some states), neither buyer nor purchaser has broken the law.

Wallstreet Example of a Loophole

If there's a loophole that involves large sums of money in the world of banking and finance, count on Wall Street, with all those sharp lawyers and accountants, to exploit it to the max and keep it going year after year. A prime example is the carried interest provision that allows private equity managers, venture capital investors, hedge fund managers, and real estate investors to pay a capital gains tax rate, presently 20%, instead of the higher ordinary income tax rate on the income earned from their day-to-day work activity.

This loophole has saved hundreds of millions in taxes for financiers such as Stephen Schwarzman, a public face of the private equity sector, and others like him who generously support their patrons in Washington, particularly if key leaders there happen to come from the real estate industry. For Wall Street, a lucrative loophole is nothing more than "you scratch my back, and I'll scratch yours."