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.Back to Articles
Business Aircraft And Taxes:
Understanding Depreciation (Part 2)
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 the second of two parts. Last month we provided 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 (World Aircraft Sales Magazine- October Issue- P164- 166).
This month we 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.
MIXING BUSINESS & COMMERCIAL CHARTER USE
Many companies that own and operate business aircraft attempt to offset some of the costs of owning and operating the aircraft by holding the aircraft out- either to the public or to a few select clients- as being available for charter at times when the aircraft is not otherwise being utilized by the owner. Such mixed utilization of aircraft can affect the asset class- and hence the depreciation schedule- applicable to the aircraft.
As discussed above- aircraft other than helicopters- used in commercial or contract carrying of passengers and freight by air generally may be depreciated under MACRS over a recovery period of seven years- and aircraft used for qualified business purposes or for the production of income and helicopters used in commercial or contract carrying of passengers and freight by air generally may be depreciated under MACRS over a recovery period of five years. Consequently- when an aircraft other than a helicopter is used part of the time in commercial or contract carrying of passengers and freight by air- and part of the time for other qualified business purposes- or for the production of income- questions concerning the appropriate MACRS recovery period are likely to arise.
Treasury regulations specify that when property is used for different purposes at various times in such a manner that the property could potentially be classified into more than one asset class- the property shall be included in the asset class for the activity in which the property is primarily used. Property is to be classified according to the primary use to which the property is put- even though the activity in which the property is used is insubstantial in relation to all of the activities of the taxpayer.
In addition- the asset class of an aircraft that is subject to a lease is determined as if the aircraft were owned by the lessee.
Although not further defined in the regulations- the “primarily used” standard appears to suggest that an aircraft (other than a helicopter) will be depreciated under MACRS over a seven year recovery period if the proportion of the time it is used in commercial or contract carrying of passengers and freight by air exceeds the proportion of time that it is used for other qualified business purposes- or for the production of income- and conversely that the same aircraft will be depreciated under MACRS over a five year recovery period if the proportion of the time it is used for other qualified business purposes- or for the production of income exceeds the proportion of time that it is used in commercial or contract carrying of passengers and freight by air. The regulations do not specify a method (e.g.- total flights- total flight hours- total days of use) of measuring various types of use.
For purposes of determining the appropriate asset class for a mixed-use aircraft- it is necessary to determine the primary use of the aircraft during each taxable year that the aircraft is in service. If at any time the primary use of the Aircraft changes- it may be necessary to convert from one depreciation schedule to another.
This can result in a partial recapture event if- for example- an aircraft is used primarily for business purposes in the first year or so after being placed in service (and is therefore depreciated under MACRS over a five year recovery period)- but in later years is used primarily in commercial or contract carrying of passengers and freight by air (and therefore must be depreciated under MACRS over a seven year recovery period).
If in this example the conversion in the primary use occurred in the fourth tax year of the depreciation schedule- the aircraft owner may be required to recapture that portion of the depreciation deductions claimed in years one- two and three that are in excess of the depreciation deductions to which the aircraft owner would have been entitled had the aircraft owner depreciated the aircraft in those years- based on a seven year MACRS schedule instead of a five year MACRS schedule.
Bonus Depreciation is a special- temporary- tax depreciation deduction allowance granted to taxpayers who place certain “Qualified Property” in service in 2008 or 2009- or- in some cases- in 2010. For most Qualified Property- the allowance is 50% of the adjusted basis of the Qualified Property (i.e.- after adjustments under other sections of the IRC (e.g.- Section 179)). Congress first enacted Bonus Depreciation legislation to help boost the economy in the years immediately following the September 11th attacks on the World Trade Center and the Pentagon- but the Bonus Depreciation incentives expired a few years later.
Congress and the Bush Administration subsequently revived the Bonus Depreciation incentives- albeit for only a short time- as part of the Economic Stimulus Act of 2008 (the “2008 Act”). Congress and the Obama administration then extended certain provisions of the 2008 Act by an additional year as part of the American Recovery and Reinvestment Act of 2009 (the “2009 Act”).
We published a detailed discussion of the Bonus Depreciation provisions of the 2008 and 2009 Acts in the May 2009 edition of World Aircraft Sales Magazine- and so we will not duplicate that discussion here. For purposes of this article- we will note only that the Bonus Depreciation special allowance does not increase the total amount of depreciation a taxpayer may be entitled to claim over the depreciable life of an asset.
As a general rule- under the MACRS system- taxpayers are entitled to depreciate 100% of the cost basis of most tangible personal property assets over a period of several years- without regard to any salvage value. That basic fact does not change regardless of whether a taxpayer qualifies for Bonus Depreciation. Rather- the Bonus Depreciation special allowance simply allows taxpayers to deduct a larger portion of the cost basis of an asset in the year that the asset is placed in service than would otherwise be allowed.
This- of course- results in reduced depreciation deductions being available in future years. For more information on Bonus Depreciation- see “The ‘2009’ Act” on page 155 of the May- 2009- edition of this publication.
USE OF THE AIRCRAFT FOR ENTERTAINMENT- RECREATION & AMUSEMENT
Depreciation deductions (as well as operating expense deductions) that are otherwise allowable under the rules discussed above- including Bonus Depreciation- may nevertheless be disallowed to the extent that the deductions are attributable to travel for entertainment- recreation and/or amusement purposes (collectively “Entertainment”).
This is a change in the law brought about by the American Jobs Creation Act of 2004 (the “2004 Act”)- signed into law by President Bush on October 22- 2004. The 2004 Act over-rode the Sutherland Lumber decision by limiting a taxpayer’s ability to deduct aircraft depreciation and operating expenses when the aircraft is used to provide transportation to certain “Specified Individuals” for Entertainment purposes. (It should be noted that “Entertainment” is not synonymous with “personal”):
The 2004 Act created a great deal of confusion in the business aviation community because- while the 2004 Act clearly limited the deduction permitted to taxpayers for the expenses associated with the provision of flights to Specified Individuals for Entertainment purposes- the 2004 Act did not provide a method for calculating the limitation- or any guidance concerning how to allocate costs for flights in many situations. In order to address these and other questions raised by the Act- the IRS published Notice 2005-45 on May 27- 2005 (“Notice 2005-45”).
Prior to enactment of the 2004 Act- the Eighth Circuit Court of Appeals held in Sutherland Lumber v. Commissioner of Internal Revenue that the limitation contained in IRC Section 274(a) (which generally denies deductions for entertainment expenses) did not apply to flights provided by a taxpayer to the taxpayer’s shareholders and employees on a company-operated aircraft for recreational purposes if the taxpayer imputed fringe benefit income to the shareholders and employees for the value of flights. Therefore- the company could deduct all the depreciation and operating expenses associated with such flights.
The 2004 Act in effect overruled the Sutherland Lumber decision by limiting the deduction permitted to taxpayers for the expenses associated with the provision of Entertainment flights to certain “Specified Individuals” to the amount imputed to the Specified Individuals as fringe benefit income for such flights. The term “Specified Individuals” includes any person who is the direct or indirect owner of more than 10% of any class of equity security of the taxpayer- and any officer or director of the taxpayer. The 2004 Act does not limit the deduction permitted to companies for the expenses associated with operating flights for entertainment- amusement- or recreational purposes for employees who are not “Specified Individuals”.
Notice 2005-45 provides interim guidance for calculating the disallowed portion of depreciation and operating expenses associated with aircraft operations- where the aircraft is used for both business and Entertainment purposes at various times during a year. The methodology specified in Notice 2005-45 for calculating the disallowance is highly (some would say overly) complicated- and cannot be fully described in this article- but may be summarized as follows:
Notice 2005-45 requires that all depreciation and expenses of operating the aircraft during a tax year be aggregated- and that a percentage of the sum of all such depreciation and operating expenses be allocated prorata to each mile (or- alternatively- each hour) flown by each individual passenger who traveled on the aircraft during the tax year. The total of all such depreciation and operating expenses that are allocated to miles (or hours) flown by Specified Individuals for Entertainment purposes is then reduced by netting out any amounts that are either imputed as fringe benefit income to the Specified Individuals for the value of the Entertainment flights- or reimbursed by the Specified Individuals to the taxpayer. The net amount thereafter remaining is disallowed as a deduction on the taxpayer’s return.
In June- 2007- the IRS published proposed regulations implementing the 2004 Act. The proposed regulations largely adopt the methodologies specified in Notice 2005-45- but also allow for an alternative- simplified method of calculating the Entertainment disallowance that is based on flight-by-flight analysis of the use of the aircraft- rather than a passenger-by-passenger analysis. Final regulations implementing the 2004 Act are still pending.
Business aviation is expensive. Business aircraft typically cost millions- or tens of millions- of dollars. Operating and maintaining a business aircraft can also cost several million dollars per year- depending on the make and model of the aircraft- and the level of utilization. Given the level of investment involved- the decision to acquire a business aircraft should (primarily at least) be a business decision- not an emotional one.
From a business perspective- the ability to fully depreciate the cost of acquiring an aircraft and to deduct all of the expenses of operating and maintaining an aircraft will help to mitigate the cost of acquiring- operating and maintaining the aircraft. There are- however- a number of complicated issues that must be addressed- and planned for- in order to maximize the tax efficiency of business aircraft acquisitions and operations.
Consequently- prior to acquiring a business aircraft- any prospective purchaser should seek the assistance of an aviation attorney or tax advisor who is familiar with the tax issues related to business aircraft acquisitions and operations. Having an experienced aviation attorney or tax advisor guide you can help to maximize the tax efficiency of your aircraft acquisition and operations structure.
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: firstname.lastname@example.org