In recent years, the number of entrepreneurs acquiring airplanes for their business operations has increased dramatically. Often the aircraft will be placed in a separate entity for legal liability protection and other reasons. Tax advisers need to be aware of the numerous federal income tax issues that pertain to airplane operations to ensure the deductibility of the related business expenses on their client’s income tax returns. This item highlights a few issues that taxpayers and their advisers should consider.
Ordinary and Necessary Test
Under Sec. 162, a deduction is allowed for all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. The first consideration in this test is the reasonableness of using a personal aircraft versus the use of an alternative means of transportation. Various court cases provide guidance to taxpayers trying to determine what is reasonable. In Kurzet, 222 F3d 830 (10th Cir. 2000), the Tenth Circuit considered the number of trips taken, the value of the taxpayer’s time, the time saved, and the cost of first-class airfare in evaluating the reasonableness of the taxpayer’s deductions for a personal aircraft. In Palo Alto Town & Country Village, Inc., 565 F2d 1388 (9th Cir. 1977), the Ninth Circuit looked at the usefulness of owning aircraft for the taxpayer’s business and compared the costs of alternative air travel arrangements in determining that the expenses were ordinary and necessary. Alternatively, the courts have found in a number of cases that there was not a substantial relationship between the aircraft use and the taxpayer’s business to establish that the costs were ordinary and necessary (Barber, 55 AFTR2d 85-765 (E.D. MO 1984); Limerick, TC Memo 1950-144; Harbor Medical Corp., TC Memo 1979-291).
Hobby Loss Rules
Larger aircraft can generate significant tax depreciation deductions. It is not uncommon for a taxpayer acquiring multiple aircraft over several years to generate tax losses for an extended period of time. In order to prevent taxpayers from taking deductions for expenses of essentially personal activities, Sec. 183, commonly referred to as the “hobby loss rules,” disallows losses from an activity if the taxpayer does not have a profit motive. Sec. 183 applies to individual taxpayers and to S corporations but not to C corporations.
Nine factors are considered when determining if a profit motive exists: (1) the manner in which the taxpayer carried on the activity, (2) the expertise of the taxpayer or his or her advisers, (3) the time and effort the taxpayer expended in carrying on the activity, (4) the expectation that the assets used in the activity may appreciate in value, (5) the taxpayer’s success in carrying on similar or dissimilar activities, (6) the taxpayer’s history of income or loss with respect to the activity, (7) the amount of occasional profit earned, if any, (8) the taxpayer’s financial status, and (9) whether the elements of personal pleasure or recreation are involved (Regs. Sec. 1.183-2(b)). The taxpayer’s threshold for proving a profit motive is relatively low. The motive does not have to be reasonable or realistic as long as it is actual and honest (Campbell, 868 F2d 833 (6th Cir. 1989), nonacq.). Also, the activity does not necessarily have to be currently profitable if there is an expectation of future profits.
Before considering the applicability of Sec. 183, the tax adviser should ascertain what taxpayer undertakings constitute an appropriate activity under Regs. Sec. 1.183-1(d)(1). To make the determination, the taxpayer should consider the organizational and economic interrelationship of the various undertakings. When appropriate, the taxpayer should group the aircraft operations with other business undertakings to constitute an appropriate activity. Proper grouping may help a taxpayer avoid the application of the hobby loss rules.
The determination of intent under Sec. 183 is fact-driven, and the courts have considered numerous cases involving aircraft. In Cornfeld, 797 F2d 1049 (DC Cir. 1986), and Campbell , 868 F2d 833 (6th Cir. 1989), nonacq., the courts found a profit motive based on the facts and circumstances. However, other taxpayers have not been able to prove a profit motive based on their facts (e.g., Worley, TC Memo 1980-51, and Baldwin, TC Memo 2002-162).
Passive Activity Rules
Sec. 469 prevents taxpayers from deducting losses from passive activities. Instead, passive losses are carried forward until the taxpayer has passive income or disposes of the passive activity. For most activities, a taxpayer must materially participate in the activity to deduct the losses. However, under Sec. 469(c)(2), any rental activity is considered passive regardless of the taxpayer’s participation. This special rule for rental activities is important for aircraft owners, because many airplanes’ operations are structured as leases for sales and use tax planning.
If the airplane activity would be considered a passive rental activity, the taxpayer should consider grouping the rental activity with another trade or business activity under Regs. Sec. 1.469-4. If each owner of a trade or business activity has the same proportionate ownership of a rental activity and the two activities form an appropriate economic unit, the rental activity may be combined with the other activity to avoid the passive loss rules. Taxpayers may use any reasonable method of applying relevant facts and circumstances in grouping activities. Although a grouping election under Sec. 469 does not have to be filed with the taxpayer’s tax return, the preparer should maintain records in the client’s tax file showing how the taxpayer’s activities are grouped.
There are other exceptions to the general rule for rental activities under Sec. 469. Under Temp. Regs. Sec. 1.469-1T(e)(3)(ii), an activity involving the use of tangible property is not a rental activity if the average period of customer use is seven days or less. Although each flight is for a limited period, one should be wary of a recurring right to use the airplane. If the customer has a recurring right to use the property, the rental period is considered to be the entire time that the right exists (Regs. Sec. 1.469-1(e)(3)(iii)(D)). Another exception is the provision of extraordinary personal services. The burden of proof may be difficult under this exception, because the use of the property must be incidental to the services being provided (Temp. Regs. Sec. 1.469-1T(e)(3)(v)).
If the taxpayer leases the plane on a short-term basis (an average of seven days or less) or provides extraordinary services, he or she must still materially participate in the activity. Temp. Regs. Sec. 1.469-5T provides seven tests for material participation: (1) the individual participates in the activity for more than 500 hours during such year; (2) the individual’s participation in the activity for the tax year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year; (3) the individual participates in the activity for more than 100 hours during the tax year, and such individual’s participation is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year; (4) the activity is a significant participation activity for the tax year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours; (5) the individual materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year; (6) the activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or (7) based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year.
In addition to determining the overall deductibility of losses generated by the aircraft, the taxpayer and his or her adviser will need to consider restrictions on tax deductions under Secs. 274 and 280F. Sec. 274(a) disallows a deduction for any activity considered to be entertainment, amusement, or recreation unless there is a direct relation or association with the active conduct of the taxpayer’s trade or business. Sec. 274(e)(2) provides an exception if the entertainment, amusement, or recreation is treated as compensation to the employee. Thus, for most employees, an employer is not limited on deductibility of the aircraft expenses if the value of the benefit (for the nonbusiness use of the aircraft) is included in the employee’s compensation. The American Jobs Creation Act of 2004 changed the rules for certain individuals defined in Sec. 274(e)(2)(B). For these individuals, the employer’s deduction is limited to the amount included in the individual’s compensation, plus the amount that the individual reimburses the employer. On June 15, 2007, the IRS issued proposed regulations relating to the use of corporate aircraft for entertainment. Prop. Regs. Sec. 1.274-10 provides guidance on how to determine the expenses and how to allocate expenses to specific flights considered to be entertainment. (These proposed regulations will be covered in the November 2007 Tax Clinic.)
Sec. 280F(d)(4)(A)(ii) limits the depreciation a taxpayer can claim on certain types of listed property, including aircraft. Specifically, when listed property is not predominantly used in qualified business use for any tax year, depreciation must be determined under Sec. 168(g), which relates to the alternative depreciation system (Sec. 280F(b)(1)). Qualified business use does not include leasing property to a 5% owner or related person (Sec. 280F(d)(6)(C)(i)). However, in an exception specifically for aircraft, this rule does not apply if at least 25% of the total use in the year consists of other types of qualified use under Sec. 280F(d)(6)(C)(ii).
Another consideration is the applicability of Sec. 4261, which imposes a 7.5% excise tax on taxable transportation of persons by air. There are numerous exceptions, including “dry leases” in which the pilot is not provided by the lessor (Rev. Rul. 2005-64), certain flights from rural airports, and certain types of flights for certain industries such as oil and mineral exploration, logging operations, air ambulances, seaplanes, and skydiving. As this item is written, the tax is set to expire on September 30, 2007, and the Senate Finance Committee held a hearing on the tax on July 12, 2007 (see www.senate.gov/~finance/sitepages/hearing071207.htm).
The income tax aspects of airplane ownership can be complex. Tax advisers should spend time with their clients to review the various rules affecting the deductibility of expenses related to aircraft. By properly planning at the beginning of the airplane operations, the adviser can help clients ensure the deductibility of the related expenses for tax purposes. In addition to the income tax issues mentioned above, taxpayers must also consider the applicability of state property and sales taxes.
Joel E. Ackerman, CPA, MST is with Holtz Rubenstein Reminick LLP, DFK International/USA Melville, NY.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.
If you would like additional information about these items, contact Mr. Ackerman at (631) 752-7400 x262 or firstname.lastname@example.org.