Editor: Kevin D. Anderson, CPA, J.D.
The Tax Court denied wealthy insurance salesman Michael D. Brown and his wife an $11 million bonus depreciation deduction on a $22 million private plane because the plane, while flown, was not considered placed in service during the year at issue (Brown, T.C. Memo. 2013-275).
Whether an asset has been placed in service is a question of fact. A common misconception is that use of the asset is the determinative factor. However, the regulations provide that "[p]roperty is first placed in service when first placed in a condition or state of readiness and availability for a specifically assigned function" (Regs. Sec. 1.167(a)-11(e)(1)(i)) (emphasis added).
Several cases demonstrate that putting an asset to use in some limited capacity before the end of the tax year is not enough. In Noell, 66 T.C. 718 (1976), the Tax Court held that a nearly completed airport with a gravel surface runway (but not yet paved) that had been used on a limited basis, but only in good weather, was not considered placed in service because it was not available for full service until it was paved the following year. In another case, an electric utility claimed depreciation deductions for a hydroelectric plant it had operated for two weeks until it was shut down for repairs. The Tax Court held that depreciation could not be taken until the following year, when the utility demonstrated that the plant was available for "full operation on a regular basis" and all preoperational testing had been completed (Consumers Power Co., 89 T.C. 710 (1987)).
Similarly, in another earlier case, a partnership was denied depreciation deductions for an ethanol-distillation plant in the year claimed. The plant began operations late in the tax year but could not produce the specified chemical output in volume or quality until more parts and equipment were installed after year end. The court, citing Noell, acknowledged that the regulation doesn't "require that property be free of all flaws and defects as of the time that it is first operated" but "must be operating in the fulfillment of its specifically assigned function" (Valley Natural Fuels, T.C. Memo. 1991-341).
The Brown Case
Brown was a highly successful life insurance salesman who catered to the ultra-affluent. His earnings, at times, exceeded $10 million on the sale of a single policy. Brown learned early in his career that the rich are very demanding and that missing a meeting for any reason could cause him to lose a sale. For example, a travel delay that caused him to miss a meeting with a potential client cost him an $8 million commission. Over time, he went from flying commercially to chartering jets. Ultimately, he acquired his own jet in 2001. That plane, while helpful in meeting the rigid scheduling needs of his affluent clients, was inefficient for cross-country travel, due to required refueling stops.
In 2003, Brown was having an "exceptionally good year," and with such favorable factors as low interest rates and the availability of 50% bonus depreciation, he sought to upgrade his plane. In mid-December 2003, after taking a test flight on a similar model, he signed a contract to acquire a $22 million Bombardier Challenger 604 jet. He made it clear that he needed to close the transaction by Dec. 31, 2003, for tax reasons.
While Brown was inspecting jets and taking test flights, the aviation facility operator, Midcoast Aviation, showed him several planes. One plane had a conference table where two reclining easy chairs were situated on Brown's plane. Brown insisted that his plane be modified to have a conference table. Also, he required that the standard 17-inch display screens be upgraded to 20-inch screens. The modifications cost more than $500,000. Brown testified that the two modifications were important and necessary for his business.
There was one glitch, however. Midcoast would require at least six weeks to complete the two modifications that Brown had insisted upon. To solve this dilemma, Brown and Midcoast agreed that he would take delivery of the plane by Dec. 31 and then return the plane to Midcoast to complete the modifications in early January.
On Dec. 30, Brown and his pilot flew to Portland, Ore., to take delivery of the Challenger. Brown testified at trial that the plane "was complete in every way except for two business requirements that [he] needed." Brown believed that merely taking delivery of the plane was not enough to capture the bonus depreciation he was seeking. In what the IRS referred to as "tax flights," Brown logged nearly 4,000 nautical miles in three hastily arranged flight segments-one flight from Portland to Seattle; a second from Seattle to Chicago; and the last to return to Portland from Chicago.
At trial Brown introduced into evidence two thank-you letters purportedly written by each of the two parties he met with at his two year-end trip destinations, Seattle and Chicago; however, the letters were actually written by Brown's CFO for the parties to sign after Brown's returns came under IRS examination. The court found the letters "just not believable" and gave them "zero credence."
In disallowing Brown's bonus depreciation deduction, the IRS contended that he had not placed the Challenger in service in 2003 because Midcoast had not completed the modifications Brown had requested until 2004. The court agreed. The deciding factor in the court's determination was that the Challenger was not in a state of readiness for its "specifically assigned function" absent the completion of the modifications that Brown had requested and testified at trial were required to meet his specific business needs. The court, in referring to its prior holdings, noted that "our [case law] tells us to look at whether the asset involved is ready and available for full operation on a regular basis for its specifically assigned function."
Despite losing the bonus depreciation deduction for 2003, Brown was able to avoid the IRS's imposition of a Sec. 6663(a) civil fraud penalty, primarily because the two thank-you letters, while viewed as false documents, did not exist when Brown filed his tax return. This is consistent with the well-established rule that a fraudulent intent must be present at the time the return is filed (see Gleis, 24 T.C. 941 (1955), aff'd, 245 F.2d 237 (6th Cir. 1957), and Holmes, T.C. Memo. 2012-251). However, the IRS assessed, and the court sustained, a 20% accuracy-related penalty under Sec. 6662(a) related to Brown's substantial tax underpayment.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Bethesda, Md.
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