Tax Implications of the Business Use of Airplanes

I n post-September 11 reality, many companies are contemplating private aviation. For companies that can afford it, private aviation offers some compelling advantages, such as a better safety record in recent years than commercial airlines, and convenience and time savings.

CPAs may be called for advice on the tax implications. If a company or a client starts by chartering (as most do), there is not much to plan for, other than showing the expense is ordinary and necessary. Once the company moves to ownership, whether through buying a plane outright or entering into a joint ownership agreement or a fractional share program, a plethora of tax pitfalls and planning opportunities arise.

Proper Reporting

In Sutherland-Lumber Southwest, Inc., 255 F3d 495 (8th Cir. 2001), the Eighth Circuit sided with the taxpayer, allowing it to deduct the full cost of operating a private plane, even though executives making personal use of the plane had only the much lower standard industry fare level (SIFL)-based amount included as compensation. After years of disagreeing with courts and taxpayers over this issue, the IRS acquiesced to Sutherland in IRB 2002-6. The victory, however, could quickly turn hollow for those not properly reporting personal use of an aircraft.

This may be one of the single most important aspects of tax planning for business aircraft. Practioners can encounter resistance from business owners unaccustomed to being proactive in addressing personal-use issues. Employee personal use counts as business use for the employer only if properly included in the employee’s income. By omitting the relatively minor SIFL-calculated amounts from their employees’ and nonemployees’ compensation, companies risk losing some significant tax benefits (including deductions for plane operating expenses, depreciation and gain-deferral opportunities for the employee personal-use portion, as well as eligibility for bonus and accelerated depreciation).

Seating Capacity Rule

Employers can safely ignore personal use when employees’ personal flights ride on the coattails of regular business flights. Under the Regs. Sec. 1.61-21(g)(12)(i)(A) seating capacity rule, if an employee or his or her spouse or dependents hitches a ride on a noncommercial flight when most seats are occupied by individuals on company business, the employee rides tax free; his or her personal use is valued at zero.

Like-Kind Exchanges

Because planes (especially high-end ones) tend to hold their value over time and have a short depreciable life (see below), many companies will face a taxable gain when disposing of old planes or redeeming fractional shares. Additionally, most of the gain will likely be ordinary income due to Sec. 1245 depreciation recapture provisions. In most cases, companies can postpone the gain (including depreciation recapture) by structuring a Sec. 1031 like-kind exchange.

Even better, with the issuance of the safe-harbor provisions under Rev. Proc. 2000-37, companies can now do a reverse-Starker exchange (by purchasing replacement property first). Like-kind exchanges are another reason not to ignore personal use: technically, only the portion of the asset used for business or investment purposes is eligible for Sec. 1031 deferral. Further, if purchasing a fractional share, the purchase should be a direct interest in the aircraft (not a partnership interest, which will be ineligible for a like-kind exchange under Sec. 1031(a)(2)(D)).

Capitalization vs. Expensing

Rev. Rul. 2001-4 marked a softening in the IRS’s previous approach to capitalizing aircraft maintenance; see Letter Ruling (TAM) 9618004. Repairs that merely keep a plane in safe operating condition (i.e., incidental, not materially adding value or appreciably prolonging useful life) can be expensed immediately, as the Service now acknowledges that inspecting, testing, servicing, cleaning and repainting are repairs not subject to capitalization.

Depreciation

The Job Creation and Worker Assistance Act of 2002 favorably changed the economics of aircraft ownership. Sec. 168(k) generally allows 30% bonus depreciation on new business aircraft placed in service after Sept. 10, 2001 and before Sept. 11, 2004 or on capital expenditures incurred to recondition or rebuild acquired (or owned) property. A purchaser negotiating to buy a used aircraft should be the party to undertake any necessary renovations, as these will qualify for bonus depreciation (or perhaps not be subject to capitalization, under Rev. Rul. 2001-4). However, the same renovation done by the seller and paid for by the purchaser (by virtue of a higher purchase price) would not qualify.

Most business aircraft are in the five-year modified accelerated cost recovery system (MACRS) category; to stay in that category, the plane generally must meet a yearly 50% qualified-business-use test each year of its depreciable life. As soon as it fails, the straight-line alternative depreciation system (ADS) must be used (generally, a six-year life), with the excess ADS depreciation previously taken on the airplane recaptured into income. Assets requiring ADS depreciation are ineligible for bonus depreciation (Sec. 168(k)(2)(C)). Further, bonus depreciation will be considered excess depreciation; falling below the 50% mark after the first year of service results in recapturing both bonus and MACRS depreciation in the failure year—an extremely undesirable situation.

Listed Property Documentation Requirements

Aircraft are listed property, subject to Sec. 274’s special recordkeeping rules (on substantiation of the amount, time and place of a property’s business use). From a practical standpoint, an aircraft management company will be able to provide detailed records of the plane’s trips and passengers. A company’s focus (aside from collecting that information) should be in providing documentation for the trips’ business purpose.

State Sales, Use and Property Taxes

The sales, use and property tax implications of owning and operating a plane are downright dizzying, but companies should not ignore them. First, sellers frequently do not collect sales tax, due to the interstate nature of most aircraft sales transactions. Many businesses are unpleasantly surprised to receive a sale/use tax questionnaire in the months (or even years) following a purchase. Some revenue-hungry states actively track aircraft purchases registered to addresses within the state; the interest and penalties on unreported use tax on such big-ticket items add up.

When does a state have nexus to tax a company’s aircraft use? The answer is unclear, although most states would consider a plane taxable if it is hangared in-state or if the business is domiciled in the state. Some planes (especially those used in fractional ownership programs) are not hangared in a single location and are continuously being swapped with other planes, which further complicates an already thorny issue. At the very least, companies must understand and plan for the tax rules in their home state and in states in which aircraft is predominately hangared.

Charter Issues

Chartering a plane in its off-hours helps to defray the substantial cost of plane ownership, but brings up additional tax issues. Charter income is subjected to the 7.5% Federal transportation excise tax, plus a small segment fee, and is reported quarterly on Form 720, Quarterly Federal Excise Tax Return (but remitted, more frequently, if over $2,000 per quarter). If a company is a passthrough entity, chartering will also raise passive-activity limit issues.

Liability and the FAA

For the uninitiated, the liability stakes are high and the potential traps abound; thus, companies should consult with an aviation attorney. For instance, a company might be tempted to set up a separate limited liability company to own and operate an aircraft, to minimize liability exposure; however, this structure can actually increase exposure. Unless the new entity meets the FAA’s stringent commercial (vs. business) aviation requirements, the aircraft would actually be operating illegally—perfect fodder for corporate veil-piercing plaintiffs’ attorneys and reluctant insurance companies. In addition, a practice as seemingly innocuous as accepting employee or client trip cost reimbursements can cause a company to run afoul of FAA laws.

From Lisa O’Connor, CPA, O’Connor & Co., Cortlandt Manor, NY