Company Planes: The AJCA Extends Bonus Depreciation, but Grounds Sutherland Lumber

The American Jobs Creation Act of 2004 (AJCA) produced both good and bad news for aircraft owners: although it extended the bonus depreciation provisions in part through 2005, taxpayers may not benefit, due to the overturn of Sutherland Lumber-Southwest, Inc., 114 TC 197 (2000), affd, 255 F3d 495 (8th Cir. 2001).

Extension of Bonus Depreciation

First, the good news: qualified aircraft may remain eligible for bonus depreciation if placed in service before 2006. The Job Creation and Workers Assistance Act of 2002 created the bonus depreciation provisions, allowing taxpayers to deduct 30% or 50% of the cost of qualified property; see Sec. 168(k). Prior to the AJCA, these provisions applied to property placed in service after Sept. 10, 2001 and before 2005.

AJCA Section 336 extends 50% bonus depreciation for noncommercial aircraft placed in service before 2006, if the aircraft:

•  Is not used to transport people or property as a trade or business (other than agriculture or firefighting);

• Is purchased by the taxpayer between Sept. 10, 2001 and before 2006, but not pursuant to a written contract entered into before Sept. 11, 2001 or after 2004;

• Commences its original use with the taxpayer after Sept. 10, 2001;

• Is the subject of a nonrefundable deposit of the lesser of 10% of the cost or $100,000 made by the taxpayer on the contract date; and

• Has an estimated production period of four months and costs exceeding $200,000.

The extension applies only to aircraft, not to other property. It does not apply to new parts and labor, unless they are part of the new aircraft. Capital improvements on existing aircraft must be made and placed in service before 2005 to qualify for the bonus provisions.

Personal-Use Deductions Disallowed

Second, the bad news: AJCA Section 907 caps the deductibility of the costs to operate aircraft for personal use by certain individuals, to the amount included in the users compensation.

Under Sec. 274(a)(1), entertainment, recreation or amusement expenses are not deductible, unless a taxpayer establishes the (1) item was directly related to or associated with the active conduct of a trade or business or (2) aircraft is used in connection with the active conduct of a trade or business. Exceptions to the disallowance include costs includible in the taxable compensation of an employee (Sec. 274(e)(2)) or a nonemployee (Sec. 274(e)(9)).

Prior to the AJCA, taxpayers relied on Sutherland Lumber, in which the Eighth Circuit allowed the taxpayer to deduct all costs associated with personal use of an aircraft, despite the fact that they exceeded the amounts included in the users income. Many taxpayers used the Standard Industry Fare Level (SIFL) rates to determine the value of the personal-use flight under Regs. Sec. 1.61-21(g)(5). Usually, this resulted in an income inclusion significantly lower than the cost to operate the aircraft.

Sutherland Lumber was overturned by AJCA Section 907(a), under which aircraft costs associated with executives personal use are deductible only to the extent includible in the executives income. Thus, the mismatch of income inclusion versus deductible expense previously enjoyed by taxpayers using SIFL to value personal use may be a thing of the past. AJCA Section 907 applies to personal use by individuals subject to the requirements of Section 16(a) of the Securities and Exchange Act of 1934 with respect to the taxpayer, or would be subject if the taxpayer issued equity securities. This typically includes directors and 10%-or-greater shareholders of private and public companies.

This provision is particularly detrimental when aircraft is held by a passthrough entity. Owners of such entities (e.g., shareholders of S corporations and partners in partnerships) previously enjoyed a significant personal net deduction on personal use of company aircraft. The new law also curbs the benefits usually derived from the extension of bonus depreciation to these taxpayers, if there is a significant personal use of company-owned aircraft.

Many unanswered questions remain, including:

• How to determine costs associated with personal use; and

• How to characterize flights with both business and entertainment purposes.

AJCA Section 907 is effective for costs incurred after Oct. 22, 2004.

Advice

Although many owners of company planes have enjoyed significant benefits from Sutherland Lumber over the past four years, the new law has left many feeling grounded. To reduce the sting, strategies contemplated by aircraft owners include:

1. Electing straight-line depreciation for aircraft placed in service after the AJCA enactment date. This would presumably reduce excess personal costs disallowed. However, it would also nullify the benefit of bonus depreciation.

2. Combine business with personal use to maximize deductibility of costs associated with each use of the aircraft. Given that many questions surround the appropriate method(s) available to allocate costs between the two purposes, the success of this strategy remains to be seen.

3. Create a leasing company to hold the aircraft and lease it for both business and personal use. This may enable the leasing company to deduct all operating costs and benefit from bonus depreciation, while limiting the personal-use lease costs paid by the taxpayer. This strategy anticipates an overall net deduction in the earlier years, when depreciation would cause operating costs to exceed leasing costs.

Taxpayers should make a concerted effort now to plan for the AJCAs effects. However, it may not be possible to gauge these effects accurately until guidance is issued on computing personal-use costs.

From Shelly McGuire, CPA, Washington, DC