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Federal Tax Considerations of Aircraft Acquisitions and Operations Law Letter, Issue 1, 2008

Although the use of an aircraft for business purposes can be very valuable from a tax perspective, there are several things that should be considered before taking those deductions on your income tax return.  A number of the federal income tax considerations include:  whether the aircraft activity is a “trade or business;”  whether the aircraft expenses are “ordinary and necessary;” the manner of depreciation of the aircraft; hobby loss rules; at-risk issues; and passive activity loss limitations.

Trade or Business
The Internal Revenue Code (Code) section 162(a) provides that “there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business....”  This section contains two components: (1) “trade or business” and (2) “ordinary and necessary.”  With regard to the so-called “trade or business” test, the issue is whether the aircraft related expenses are incurred in the furtherance of a “trade or business.”  Considerations include a demonstrated business purpose for the ownership and use of the aircraft, including business generated from the use of the aircraft.

Ordinary and necessary
Once the “trade or business” component of Code section 162(a) is addressed, you must still deal with the “ordinary and necessary” prong. The aircraft-related  expenses incurred must be both “ordinary” and “necessary.”  “Ordinary” expenses are those that are common and accepted given the particular industry or business activity involved.  “Necessary” expenses are those that are appropriate and helpful to the particular taxpayer’s business enterprise. Given the nature of air travel today and the speed at which business is conducted, it should be relatively easy to establish the “ordinary” component of this test.  The “necessary” component may be more difficult to establish.  Under Code section 162(a), the term “necessary” has been interpreted by the courts to mean “appropriate and helpful in the development of the taxpayer’s business.”  The key to demonstrating the “necessary” component of the test is to document the business nature of the trip.  On audit, the Internal Revenue Service (IRS) may attempt to limit the deduction on the basis that the aircraft was inappropriate for the specific travel (i.e., not necessary).  The IRS position would be to disallow the expense associated with the aircraft and substitute an expense equivalent to first class airfare and, therefore, limit the aircraft-related deduction.  This position can be challenged upon a showing that certain logistical constraints (e.g., location or time) made the use of the aircraft  “necessary.”

Depreciation
An aircraft used in a trade or business may be depreciated over a five-year period on a Modified Accelerated Cost Recovery System (MACRS) basis.  This presupposes that the aircraft is not engaged in common or contract carriage under certain parts of the Federal Aviation Regulation (FAR).  Aircraft covered under these FAR parts are depreciated on a seven-year MACRS schedule.  Likewise, where an aircraft is leased for charter with an on-demand charter service, under FAR, it may be subject to a seven-year depreciation schedule.  In order to depreciate your aircraft under MACRS, it must be used more than 50% of the time in your trade or business. The most efficient way to establish or meet the 50% test is to keep a log of your flight hours and document whether such flight hours were for business or pleasure.  If you fail to meet the 50% test, you may still be able to depreciate your aircraft on a straight-line basis, as opposed to an accelerated depreciation basis.  Moreover, if you had been depreciating the aircraft on an accelerated basis and for a given tax year your business use drops below 50%, you must switch to straight-line depreciation in the year of the change.  In addition, you must recapture the prior accelerated depreciation in the year you fall below 50%, which will generally result in substantial adverse income tax consequences.

An aircraft used in business less than 50% is depreciated on a straight-line basis over six years (noncommercial) or 12 years (commercial).  In addition to the potential depreciation recapture based on the 50% test, when the aircraft is sold, any gain incurred on the sale will be considered ordinary to the extent of the prior depreciation due to “depreciation recapture.”  This can be deferred if the aircraft is exchanged under Code section 1031.

Hobby Loss
Code section 183 restricts the use of aircraft-related losses against other taxable income where the aircraft-related activities are not engaged in “for profit.” As a general rule, the IRS presumes that a company that has profits in three out of every five consecutive years is a legitimate business and not a hobby.  If there are not at least three profitable years, the IRS will apply a facts and circumstances test to determine if the losses were related to a hobby.  If your aircraft-related activity is considered a “trade or business,” then all of your aircraft-related expenses will be deductible as previously discussed; however, if considered a hobby, then your aircraft-related losses may only be used to offset any income derived from such activity.  Pursuant to a Treasury Regulation, whether an activity is engaged in “for profit” requires a facts and circumstances analysis.  The Regulation indicates that no one factor is determinative, but rather a variety of factors should be taken into account when determining a “lack of profit objective.”  According to the Regulation, the factors include:  (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer and his advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) an expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer’s history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) the elements of pleasure or recreation present in the carrying on of the activity in question.  Thus, with regard to the hobby loss issue, these factors should be considered in light of the activities you undertake related to the use of an aircraft.

At Risk
Code section 465, which applies to individuals and closely-held corporations, limits a taxpayer’s deductible loss to the amount such taxpayer is actually at risk with respect to the given activity.  Put differently, the at-risk rules limit losses from aircraft-related activities to the amount that the taxpayer is financially at risk.  This includes the amount of the taxpayer’s cash investment in the business, any capital contributions, and any financing where the taxpayer has personal liability for the financed amounts.  If an aircraft is purchased outright or otherwise financed through recourse financing, then the taxpayer will be considered at risk for the entire value of the aircraft.  If the at-risk rules apply, then your losses are limited to the amount that you are at risk for the involved activity.

Passive activity loss limitations
Losses from passive activities cannot be used to offset income from non-passive activities (e.g., wages, interest or dividends).  A passive activity is defined under the Code as “any activity in which the taxpayer does not materially participate.”  If the total deductions from passive activities in a given tax year exceed the income from passive activities, then the excess deduction from the passive activities is suspended and carried forward as a deduction in future years against future passive income.  As with the at-risk rules, the passive activity loss rules apply to individuals and closely-held corporations.  For certain flow-through type entities (e.g., partnerships, limited liability companies and S-corporations), the loss limitations apply at the shareholder, partner or member level.

One way to address the passive activity loss limitations is to group similar activities.  A taxpayer may group a variety of activities involving both passive and non-passive activities for purposes of combining income and deductions.  A word of caution, however, the IRS may disallow such groupings to the extent it is abusive.

Passive activity loss limitation issues often arise when an aircraft is leased.  A leasing or rental activity is per se passive regardless of whether the taxpayer materially participates.  Although there are several exceptions to the per se rule treatment for rental activities, these exceptions may be very difficult to establish or meet.

For purposes of determining whether non-rental activities are passive, the individual owner must meet one of the material participation tests under a Temporary Treasury Regulation.  The three most likely scenarios where an individual is considered as materially participating in an activity during a given year are: (1) the taxpayer participates in the activity more than 500 hours per year; (2) the taxpayer’s participation is substantially all of the participation in the activity by all individuals; or (3) the taxpayer participates for more than 100 hours and this participation is not less than the participation of any other individual.  In order to establish “material participation,” you should keep sufficient records of the hours and time spent on the involved activity (e.g., reports, logs, calendars and narratives).

When you think about using an aircraft in your business, the preceding issues should be reviewed and considered in determining whether you may be able to deduct certain aircraft-related expenses for business purposes.

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