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Business Aircraft And Taxes:
Understanding Depreciation (Part 1)


Let’s face it- acquiring and operating a business aircraft is very expensive. It can also be a highly emotional event. All too often- an executive who would never consider acquiring a company or a commercial property without first analyzing the deal from all perspectives will nevertheless succumb to the allure of a sleek private jet and make an emotional decision to purchase without conducting any detailed acquisition and operations planning.

In light of the high costs of business aviation- it is essential that any prospective aircraft owner take the time to plan the acquisition and operation to be as efficient as possible. Planning for the acquisition and operations of an aircraft should include an analysis of all the state and federal tax issues affecting the acquisition and operations. This article discusses one such tax issue - tax depreciation.

This article is presented in two parts: this month- we provide an overview of tax depreciation- and a discussion of qualified business uses of business aircraft and the effect of personal- non-business uses on depreciation; next month- we will discuss the effects on depreciation of using a single aircraft for multiple purposes (such as Part 91 business use- Part 135 commercial charter use- and entertainment- recreation and amusement purposes). We will also touch on the subject of bonus depreciation.

OVERVIEW OF TAX DEPRECIATION
Many aircraft owned and operated by businesses today are depreciable for income tax purposes under the Modified Accelerated Cost Recovery System (MACRS) of Section 168(b) of the Internal Revenue Code (the Code).

Section 168(b) is often considered to be very pro-taxpayer because it permits taxpayers with depreciable assets to accelerate the tax depreciation of those assets by allowing a greater percentage of the depreciation deductions produced by the assets to be taken during the first few years of the applicable recovery period than would result using a straight-line depreciation method. Of course- the tradeoff is that less depreciation will be available to offset income in later years.

In some cases- aircraft are depreciable for income tax purposes- but do not qualify for accelerated depreciation under the MACRS system. In such cases- the aircraft must be depreciated under the generally less favorable Alternative Depreciation System (ADS) of Section 168(g) of the Code.

Depreciation under ADS is based on a straight-line method and thus results in equal depreciation deductions each year during the applicable recovery period. Recovery periods under the ADS system also tend to be longer than recovery periods under MACRS for the same property.

Whether or not a taxpayer may depreciate an aircraft- and if so- the appropriate depreciation method and recovery period to be used- depends on several factors. Chief among these are the category of aircraft (e.g.- airplane or helicopter)- and the type of use to which the aircraft is put (e.g.- personal- business- or commercial charter air transportation).

All depreciable aircraft may be placed in one of the following asset classes:

1. Aircraft- other than helicopters- used in commercial or contract carrying of passengers and freight by air (e.g.- typical Part 135 operations). Aircraft in this category generally may be depreciated under MACRS over a recovery period of seven years- or under ADS over a recovery period of twelve years.

2. Aircraft used for qualified business purposes or for the production of income (e.g.- typical business-use Part 91 operations)- and helicopters used in commercial or contract carrying of passengers and freight by air. Aircraft in this category generally may be depreciated under MACRS over a recovery period of five years- or under ADS over a recovery period of six years.

3. Aircraft held as inventory or stock in trade- and aircraft used for purposes not constituting either qualified business use- use for the production of income- or use in the commercial or contract carrying of passengers or freight (i.e.- typical personal-use Part 91 operations). Aircraft in this category generally may not be depreciated.

QUALIFIED BUSINESS USE
If an aircraft is used during a taxable year part of the time for a qualified business and/or commercial purpose or for the production of income (collectively “Business Uses”)- and part of the time for personal- non-business purposes (collectively “Personal Uses”)- the depreciation deduction allowable for the taxable year will be limited to a fraction of the depreciation deduction that would have been allowed for the taxable year had the aircraft been used solely for Business Uses. (As a general rule- a qualified business purpose is any use in a trade or business for which a deduction would be allowed under Section 162 of the Code- which defines deductible trade or business expenses).

The allowable depreciation deduction for such taxable year will be the fraction of the otherwise allowable deduction that bears the same ratio as the Business Uses of the aircraft during the taxable year bears to all the use of the aircraft during the taxable year.

The depreciable basis of the aircraft will nevertheless be reduced by the entire amount of depreciation that would have been allowed had all the use of the aircraft during the year constituted Business Use- with the result that the portion of the depreciation deduction that is disallowed in a given taxable year as a result of Personal Use may not be deducted in any subsequent year and is therefore lost forever.

In addition- whether the depreciable portion of the aircraft may be depreciated under MACRS- or will be required to be depreciated under the generally less favorable ADS will depend on whether the Business Use or the Personal Use of the aircraft predominates. If more than 50% of the use of the aircraft during each taxable year constitutes Business Use- the predominantly business use test is satisfied and the depreciable portion of the cost basis of the aircraft generally may be depreciated under MACRS.

However- if 50% or less of the use of the aircraft during each taxable year constitutes Business Use- the predominantly business use test is not satisfied. In such event- the aircraft generally may still be depreciated to the extent of the Business Use- but that portion of the basis of the aircraft that may be depreciated must be depreciated using the straight line ADS system.

The predominant business-use test must be met during every taxable year that the aircraft is in service. The consequences of failing the test in even a single taxable year can be severe. If the test is failed during any taxable year that the aircraft is in service- the aircraft must be depreciated under the ADS system during such taxable year and all subsequent taxable years. In addition- if the aircraft had been depreciated under MACRS during any prior taxable year- the taxpayer must recapture prior depreciation to the extent that depreciation deductions taken during prior years exceed the deductions that would have been allowed under the ADS system.

In other words- the allowable deprecation must be recalculated retroactively to the date the aircraft was first placed in service- and any excess depreciation in prior years resulting from the recalculation must be recaptured and taken into income in the first taxable year in which the test was not satisfied.

Certain uses of an aircraft by a business entity that arguably may be considered qualified business uses nevertheless will not qualify as qualified business uses under certain circumstances. Specifically- any use of a business aircraft falling within any one of the following three categories will not be treated as a qualified business use for depreciation purposes unless all other qualified business uses (i.e.- all qualified business uses excluding any use falling within one of the three categories) comprise at least 25% of the total utilization of the aircraft during the applicable taxable year:

1. The leasing of the aircraft by a company to any person who owns 5% or more of the company- or to any person who is related (within the meaning of Section 267(b) of the Internal Revenue Code) to a person who owns 5% or more of the company.

2. Use of the aircraft to provide compensation (i.e.- to provide personal- non business-use flights without reimbursement at fair market rates) to any person who owns 5% or more of the company- or to any person who is related (within the meaning of Section 267(b) of the Internal Revenue Code) to a person who owns 5% or more of the company.

3. Use of the aircraft to provide compensation to any other person unless an amount is included in the gross income of such person with respect to such use of the aircraft- and any required income tax was withheld (e.g.- income is imputed under the Standard Industry Fare Level (SIFL) formula).

Put another way- if qualified business uses other than those listed in 1 through 3 above comprise at least 25% of the total utilization of the aircraft during the applicable taxable year- then any use that is for purposes listed in 1 through 3 above should be considered qualified business uses.

That said- in recent years some front-line IRS auditors have sought to disallow any uses of the types listed in 1 through 3 above for all depreciation purposes- regardless of whether the 25% standard has been satisfied- so caution is certainly advised in planning aircraft operations to be as tax-efficient as possible.

Troy A. Rolf is a business aviation and tax attorney concentrating in the areas of business aircraft transactions and operations in the law firm of GKG Law- P.C. The firm’s business aircraft practice group provides full-service tax and regulatory planning and counseling services to corporate aircraft owners- operators and managers. The group’s services include Section 1031 tax-free exchanges- federal tax and regulatory planning- state sales and use tax planning- and negotiation and preparation of all manner of transactional documents commonly used in the business aviation industry- including aircraft purchase agreements- leases- joint-ownership and joint-use agreements- management and charter agreements- and fractional program documents.

Troy manages the firm’s Minnesota office- at 700 Twelve Oaks Center Drive- Suite 700- Wayzata- MN- 55391- telephone: (952) 449-8817- facsimile (952) 449-0614- e-mail: trolf@gkglaw.com

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