To attempt to defray fixed operating costs, and in some cases to earn profit, business aircraft owners commonly allow their aircraft to be chartered to the public. Because charter is a commercial operation, the aircraft must be added to the operating specifications of an air carrier certified to operate under Part 135 of the Federal Aviation Regulations (FAR).Back to Articles
To attempt to defray fixed operating costs, and in some cases to earn profit, business aircraft owners commonly allow their aircraft to be chartered to the public. Because charter is a commercial operation, the aircraft must be added to the operating specifications of an air carrier certified to operate under Part 135 of the Federal Aviation Regulations (FAR).
The aircraft must be maintained and, when chartered, operated by the air carrier under FAR Part 135. This arrangement requires an agreement between the owner and the air carrier that allows the air carrier to take exclusive possession, command and control of the aircraft when it is operated under FAR Part 135. If the agreement is a lease of the aircraft to the air carrier, the owner and the air carrier might be unnecessarily subjecting themselves to potentially significant tax burdens. This could cost the owner money, and the air carrier its managed owner(s).
Under a typical charter lease, the air carrier collects the charter revenue from customers and remits to the owner a certain amount denominated as ârentâ. The amount remitted is normally 85% to 90% of the gross charter revenue. In states that impose a sales tax on the sale of tangible personal property (e.g., an aircraft), a lease almost always constitutes a âsaleâ, and rents thereunder are subject to the sales tax. This requires the owner to charge the air carrier for the sales tax, and to report and remit the tax.
If, as is usually the case, the charter lease calls for the owner to reimburse the air carrier for sales and use taxes associated with the aircraft, the net charter revenue remittance to the owner is effectively reduced. If the sales tax is not properly collected, reported and remitted by the owner, the air carrier could become subject to collection, and the aircraft could become subject to a tax lien.
Net Investment Income Tax
Beginning in 2013, the 2010 national health care law (a.k.a. Obama Care) imposes a tax (the âNIITâ) on the investment income of certain individuals, estates and trusts. For individuals, the NIIT is 3.8% percent of the lesser of: (1) the individualâs net investment income (NII); or (2) the excess of the individualâs modified adjusted gross income over the threshold amount. The threshold amount is based on filing status:
Married filing jointly or Qualifying widow(er) $250,000
Married filing separately $125,000
Single or Head of Household $200,000
NII is defined as the sum of three categories of income. One of the categories of NII is gross income from rents, other than rental income derived in the ordinary course of a trade or business that is not a passive activity (within the meaning of Internal Revenue Code (IRC) Section 469) with respect to the taxpayer. NIIT applies rents received by an individual owning an aircraft directly or through certain C-corporations, an S-corporation, a partnership (including a limited liability company) or a trust.
Thus, whether rental income from an aircraft leasing activity (e.g., a charter lease) is subject to the NIIT is a 4-part inquiry: (1) is the income gross income from rents; (2) are such rents derived in a trade or business; (3) are the rents derived in the ordinary course of such trade or business; and (4) is such trade or business a non-passive activity with respect to the taxpayer? Failure to answer affirmatively to all four questions means the rental income is NII. Answering each of these questions is a highly nuanced undertaking based on potentially changing facts, circumstances and legal interpretations.
Passive Loss Rules
Owing principally to accelerated depreciation deductions, including bonus depreciation, aircraft more often than not produce after-tax losses. These losses translate to valuable income tax benefits, but only if the losses can be used - preferably currently - to offset income.
If the activity of owning and operating an aircraft is deemed âpassiveâ under IRC 469, losses therefrom may be used only to offset passive income. Passive losses may not be used currently to offset non-passive trade or business income (e.g., employment, business profits and allocations), or portfolio income (e.g., interest, dividends).
Cumulative passive losses from an activity may be used to offset non-passive income when the passive activity is disposed of in a taxable transaction. An activity is passive to an individual taxpayer in a taxable year if (1) the individual does not âmaterially participateâ in the activity, or (2) it is a rental activity. The passive loss rules apply to individuals who own an interest in an activity directly or through certain C-corporations, an S-corporation, a partnership (including a limited liability company) or a trust.
There are seven (7) separate facts and circumstances tests for determining whether an individual materially participates in an activity. However, even if a taxpayer materially participates in an activity, the activity will generally be passive if it is a rental activity. Although there are some tax planning strategies potentially available to attempt to avoid the treatment of a rental activity as passive, it is preferable to avoid unnecessarily entering into a lease agreement in the first place unless passive treatment is desired.
FAR Part 135 requires that in order to conduct charter flights, the air carrier must have exclusive possession, command and control of the aircraft when it is operated under FAR Part 135. Many air carriers have long attempted to fulfill the âpossessionâ requirement by putting in place a charter lease with the owner. However suitable a lease agreement might be for this purpose, it is not required. For aircraft not owned by the air carrier, Section (d)(2)(b) of OpSpec A008, Appendix B, states that the air carrier satisfies the possession requirement if the aircraft is ââ¦(b) Leased â¦or otherwise in the legal custody of the [air carrier] and remains in the [air carrierâs] exclusive possession or custody during all of its Part 135 flights.â [Emphasis supplied.]
With careful consideration of FAR Part 135 and the indicia of what constitutes a lease under applicable tax law, an experienced aviation tax specialist should be able to craft a form of agreement which transfers to the air carrier FAR-sufficient possession of the aircraft and which meets other Part 135 requirements relating to exclusive command and control and other relevant matters, but which does not constitute a lease for tax purposes. We have successfully accomplished this to the satisfaction of numerous charter companies, large and small.