More than ever, the media, IRS and the Securities and Exchange Commission have expressed their disapproval of private aircraft use by businesses. They each hold a general perception that personal use of business aircraft is extravagant and difficult to justify. But, your purchase, lease, or charter of an aircraft by you or the corporation you own (remember if you’re married, “you” includes your spouse as well) can still create open the opportunity for significant tax benefits.
As you might imagine, the IRS does not take as kind of a view of the tax benefits of aircraft ownership as you or I might. The American Jobs Creation Act of 2004 reversed the favorable aircraft deduction strategies previously available to you as identified in a key Tax Court case (Sutherland Lumber-Southwest, Inc. v Commissioner).
An IRS notice now restricts certain aircraft deductions, requires specific treatment of business owners, and requires stricter, more detailed records of aircraft use. Even with these restrictions though, you can still increase your financial wellbeing by making the aircraft rules work for you.
Requirements for Keeping Track of Aircraft Use
Your aircraft ownership, lease, or charter is subject to the listed property rules, which, when boiled down, simply state that if you have no log of business use, you will get no deductions.
But your log cannot be in any old form or contain limited information. The IRS notice contains major changes that affect how you must keep your aircraft records. These requirements include the following.
- new rules that require you to track use by occupied seat hours or occupied seat miles;
- new treatment of business owners who own 10% or more of the business; and
- no more free rides by your spouse and family.
Example. Say you, your spouse, and one employee take a six-hour round trip to a distant city. I f you select the seat-hours method to track aircraft use for the year, you must account for 18 hours of use on this trip (three passengers times six hours).
If the round trip is 1,100 mi les and you use the seat-mi les method, you must account for 3,300 mi les on this trip (three passengers times 1,100 mi les).
Your records now must account for up to five different uses of your aircraft.
- Personal use.
- Employee use (including how you considered that use as compensation to the employee in your payroll records or received reimbursement from the employee for the cost of that use).
- Business use for other than business entertainment.
- Business use for business entertainment.
- Partnerships and corporations also need to account for personal use for personal entertainment.
Here is an example of how you classify your use can help or hurt you. Based on a technical advice memorandum, the IRS is holding that a company that used its aircraft 80% of the time for business and 20% to take customers on hunting trips could deduct only 80%. Although the hunting may have been deductible, the use of the "entertainment facility" airplane to take the hunting trip is not deductible under the entertainment-facility rules.
Do you use your aircraft for entertainment trips? If so, here is a tip. Eliminate that entertainment use or make the entertainment a secondary part of a business trip. If entertainment will occur during a day of the trip, make sure that you conduct more than four hours of business on that day so the entertainment can be just a by-product of the regular business day, deductible as entertainment associated with a business discussion (just . In other words, you want the primary purpose of that day to be business, so your aircraft use for transport to and from a business location is treated as business use.
Rules Regarding Your Spouse and Children
You’re going to really love this rule. The rules require you to account for every seat hour or seat mile used during every flight. This is required regardless of the fact that it cost you nothing to bring your family on the aircraft in otherwise open seats.
You can deduct business travel for your spouse, dependent, or other companion only when the following apply.
- that person is an employee;
- the travel is for a bona fide business purpose; and
- the travel expenses would otherwise be deductible by the traveler.
This section makes it crystal clear that to deduct travel expenses for your spouse, dependent, or other companion, that person must be your employee or an employee of your corporation or partnership.
If you want maximum deductions from your aircraft, you need to make the trips by yourself or make employees out of your spouse, dependents, and other companions.
If you operate as a proprietorship, hiring your spouse and children can work to your monetary advantage. To employ your spouse in your proprietorship without having to deal with payroll taxes, use the Section 105 medical reimbursement plan as compensation in lieu of wages. For a dependent child under the age of 18, working for you as the parent, use a W-2 payroll. The wage relationship between parent and child (or between parent as proprietor and child) is exempt from payroll taxes.
How to Avoid the Entertainment Facility Problem
When you, or your corporation, use the aircraft to get to and from business entertainment, the law treats that use as a non-deductible entertainment-facility use.
The entertainment-facility rules are brutal, often allowing a zero deduction if you have even one entertainment use of a facility. However, the rules grant a break for transportation facilities such as aircraft. That's how the taxpayers in that technical advice memorandum got a deduction for the 80% business use, even though the 20% use for hunting trips was disallowed.
The entertainment-facility regulations are almost 50 years old and are therefore are so outdated that the rules are open to interpretation.
Of course it is never good practice to thing IRS will be lenient on anything, especially those deductions that are politically charged like the aircraft deductions. Here are some guidelines to help you avoid the entertainment facility disallowance rule.
- Keep your entertainment use close to zero with zero being the ideal.
- If you use the aircraft for entertainment purposes make sure to maintain a more-than-50%- business-use.
- Deduct only the business-use percentage.
What about a separate entity for your aircraft? This may not be the way to go – for more than just tax reasons!
Sometimes it seems like a good idea to stick your aircraft in a separate legal entity; for example, for additional liability protection or to create a separate leasing entity. But creating a separate legal entity for the aircraft creates special problems and unique considerations with regard to Federal Aviation Administration (FAA) rules and tax rules. This section discusses some of the special rules you trigger by using a separate entity for the aircraft.
The separate entity is going to have to collect money for aircraft use from the first entity. Collecting money runs the separate entity into the FAA rules that govern charters, air taxis, and airlines. When an entity lands in this category of the FAA regulations, the entity
- must charge and collect federal excise taxes and segment fees;
- must comply with stricter maintenance checks and requirements (meaning additional costs); and
- must pay for additional insurance.
If the business uses the plane in its business (with no separate entity involved), the business pays excise taxes at the pump when it buys fuel. Since the business is not carrying passengers for pay, it faces no segment fees. It has lower maintenance requirements and has a lower cost of insurance. This is true regardless of how you operate your business: proprietorship, partnership, or corporation.
With a separate entity owning the aircraft, you face not only the additional FAA requirements and costs but also the tax-law rules on hobby and passive activity losses. With the hobby-loss rules, you have to prove that you are in this activity for a profit. This would be particularly troublesome if you operate your main business as a corporation and the aircraft business as a proprietorship. The recreational aspects of flying, plus the burden of having only one client—a client you own—make for potential problems with the hobby-loss rules.
As if this were not trouble enough, when it's separate from the business, the aircraft entity faces the passive loss rules that apply to rentals. At a minimum, you would have to consider the passive loss rules in your rental planning.
At least there is a revenue ruling that explains how having a pilot and crew can negate the passive-loss rules.
Thus, we are not going to spend time on the pilot and crew helping you avoid the passive-loss rules. We think you are more likely to have a simple lease with no on-staff pilot, no on-staff crew and very possibly no passive-loss deductions.
You have no practical tax reason to create a separate entity for your aircraft.
We recommend that you obtain adequate insurance protection and have your existing business own and operate the aircraft. If you operate as a proprietorship and want liability protection above and beyond insurance, you can form a single-member LLC and retain proprietorship treatment for federal tax purposes. Make sure you determine how your state will treat the LLC before you form it.
With the aircraft as a regular asset in your ongoing business, you deduct the aircraft expenses against your other business income without worrying about passive-loss or hobby-loss rules. The extra cost for insurance is nothing compared to the compliance headaches of collecting excise taxes and segment fees, not to mention the headaches associated with the additional maintenance and inspection requirements (and costs).
Great options operating as a corporation.
Say you are taking your plane on a business trip to a city some distance away. You are going to be at this business location for seven days. One of your employees hears about your trip and asks if he and his wife can hitch a ride. Of course, you say "yes."
You can value the ride by the employee and his wife using the SIFL (Standard Industry Fare Level formula) cents-per-mile method. Assume that the SIFL value of this trip to the employee and his wife is $700. The rules allow you to give the employee this choice: reimburse you, his employer, $700 or have you count the $700 as compensation to him.
If you allow reimbursement from the employee, you face federal rules which requires you to collect federal excise taxes and segment fees and risk having the FAA classify your aircraft as a charter, air taxi, or other commercial carrier, for which higher maintenance and more insurance are required. Not a good option.
Alternatively, you can treat the $700 as compensation to the employee and add it to his W-2 income.
This eliminates the excise tax and FAA problems. As compensation, the tax law treats the employee use as a business use (you will see the benefits of this in the following paragraph).
You give the employee compensation based on the SIFL rates. Your business is going to deduct actual expenses. You put all your expenses into a big pot and divide that pot by the number of seat hours for the year. Say the seat cost allocable to this employee's trip with his wife is $5,900. That's what you deduct. When you do your taxes, you realize the $5,900 deduction, with $5,200 as the net aircraft cost and $700 as W-2 compensation. Both you and the employee win. Your employee received a tax-free fringe benefit of $5,200. You deducted all your costs.
This might not be true if you were that employee. The favorable SIFL cents-per-mile rates are not available to the employee-owner who uses the aircraft for entertainment.
For example, if you and your spouse take a trip on your S corporation's aircraft, your corporation has the following happen.
- It considers $700 as your SIFL cost if you and your spouse use the corporate aircraft to attend a funeral or other nonentertainment activity; or
- It considers the entire $5,900 as your cost if you and your spouse use the corporate aircraft for personal entertainment, recreation, or amusement.
As you can see, the employee-owner is penalized for using the aircraft for entertainment purposes.
On the corporation books (just as for a non-owner employee) you have two solutions: reimburse the $700 or $5,900 to the corporation and trigger the excise taxes and FAA issues mentioned above, or have your corporation consider the $700 or $5,900 as W-2 income to you. And just as we recommended above, we recommend the W-2 approach to keep this easy, and to avoid the excise taxes and FAA rules on charters and air taxis.
How to Get Maximum Benefits When You Buy an Aircraft
When you buy an aircraft for business use, you have a number of things to consider. For example:
- Do you want to take steps to avoid the sales tax?
- Does the purchase price include pilot and/or mechanic training?
- Will the aircraft land in the five-year or the seven-year depreciation class?
- What does the five- or seven-year class mean to the time period during which you must keep records and worry about recapture?
- Will you claim section 179 expensing?
Answering these questions correctly is the key to maximizing your benefits when you purchase an aircraft.
State sales- and use-tax laws often contain special rules for aircraft. Here is a quick review of how these taxes work, before we apply the special rules.
The sales tax generally applies to assets you buy in your state for delivery in your state. When you buy out of state for delivery in your state, the sales tax does not apply.
To prevent citizens from buying out of state and not paying taxes, most states have a use tax that applies to assets you buy out of state for delivery in state. If a state has an 8% sales tax, it probably has an 8% use tax.
Aircraft often face special rules. For example, a strategy that works in one state is to buy and store the aircraft out of state for more than 90 days. After that period expires, you can bring the aircraft into this state without application of the use tax.
Montana and New Hampshire have no sales tax, and many states have very low sales taxes. Say you bought a $1,000,000 airplane in a no-tax state and then brought that aircraft to an 8% tax state under the more-than-90-day rule (or under another exception to the use tax). Presto: You keep $80,000 of your hard-earned cash in your bank account.
When you buy a new aircraft, your purchase price might include pilot and mechanic training. You want to unbundle these as training costs so you get immediate deductions that are not subject to recapture.
Consider the asset class when you are deciding what type of aircraft you are going to buy and how you are going to use it. In general, you will depreciate your aircraft using the modified accelerated cost- recovery system (MACRS). If your business use of the aircraft drops to 50% or less during the alternative depreciation system (ADS) life of the asset, the law requires that you redo your depreciation using the straight-line depreciation method from the first date you placed the aircraft in service and recapture any excess depreciation and section 179 deductions. You then depreciate the recapture amount over the new straight-line life, beginning in the year you made your mistake. Don't let this happen to you; it will make you mad.
Your aircraft will fall into one of these two classes:
- Airplanes, except those used in commercial or contract carrying of passengers or freight, and all helicopters: 5 years MACRS; 6 years ADS.
- Assets, except helicopters, used in commercial and contract carrying of passengers and freight by air: 7 years MACRS; 12 years ADS.
If you place your aircraft in service in 2007, you (or your corporation) can elect to expense up to $112,000 if your total 2007 section 179 assets placed in service are $450,000 or less.9 For assets in excess of $450,000, you must reduce the $112,000 maximum section 179 deduction dollar for dollar.
Think of section 179 expensing as depreciation in advance.
When you claim section 179 expensing or MACRS depreciation on your aircraft, you make a deal with the tax law to keep your business use greater than 50%. Should your business use of the aircraft drop to 50% or lower, you violate your agreement. Violations require that you recapture your expensing and depreciation in excess of what you would have claimed with straight-line depreciation over the longer ADS life.
Here's another point to keep in mind: You must keep your business/personal use log for the entire ADS period (13 years in the example above). Actually, because of repairs, fuel costs, and other operating expenses of your aircraft, you must keep the log every year if you want to deduct anything for tax purposes. Therefore, the longer ADS life is not a recordkeeping issue, but it definitely is a recapture issue if business use drops to 50% or less.
Don't allow recapture to get you. Keep your business use above 50%.
Here's a summary of the steps you can take to protect your bank account:
- Consider the possibility of avoiding sales and use taxes.
- Unbundle training costs embedded in the purchase contract.
- Keep your business use above 50% during the entire ADS period.
By following these easy steps, you accelerate the flow of money into your bank account.
How to Realize Maximum Benefits While You Own the Aircraft
To get maximum benefits during ownership and operation, you want;
- all deductible business use and no non-deductible personal use, and
- all fix-ups classed as repairs and none as depreciable capital items.
There are two types of personal use, and they reduce your deductions in two totally different ways. First, your use of the aircraft for personal entertainment requires a dollar-for-dollar allocation to personal use. This is true even for your section 179 expensing. Say you have 10% personal entertainment use and also claim $200,000 in section 179 expensing—presto, kiss goodbye $20,000 of your section 179 expensing deduction (10% x $200,000).
If this 10% personal use were not for entertainment, you could use the SIFL rates to value your personal use, and you might lose only $500 total. (The actual amount will vary widely, but you can bet it will be significantly less than the entertainment disallowance.)
Keep personal use, particularly personal use for entertainment, to a minimum.
Never “improve” your aircraft; only “repair” it. The repair produces a tax deduction— the tax benefits of which you get to keep. The improvement produces depreciation deductions that take place over time; when you sell the aircraft, you must pay a recapture tax on the gain attributable to your depreciation deductions. In other words, the tax benefits of an improvement act more like a loan and payback of deductions.
To your bank account, the financial difference between a repair and an improvement is substantial.
The classic repair-versus-capital-improvement gray areas and planning opportunities apply to aircraft just as they apply to your rental properties and other assets. In general, a repair keeps the property in operating condition, whereas an improvement makes it worth more money or enables it to last longer. We liken the repair to putting the property back into the condition you thought it was in before it needed the repair.
The IRS analyzes three different kinds of work done on aircraft and states whether such work is a repair or an improvement. The IRS concludes that you should do the following.
- Deduct heavy maintenance as a repair;
- Capitalize and depreciate any heavy maintenance that adds value, prolongs life, or adapts the airframe (non-engine parts) to a new or different use; and
- Capitalize and depreciate activity that is part of a plan of improvement.
Consider this question. If you spend $2 million fixing up a $15 million aircraft, is the $2 million a repair or an improvement? In a 2001 revenue ruling the expenditure of $2 million in repairs on a $15 million airframe (body of the aircraft) was addressed by example. The IRS considered none of the $2 million a capital expenditure, even though the repairs involved putting in new
- antiskid materials and stops on floors, pedals, and stairways floorboards
When this $2 million repair was completed, the IRS concluded that the life of the airframe had not been extended beyond its 25-year anticipated life when it was acquired. Thus, the $2 million repair was immediately deductible—a highly favorable result.
Had the repair been a capital expenditure, it would first be depreciated and then probably recaptured as ordinary income when the aircraft was sold—a highly undesirable result.
Plan, plan and plan some more…
Just as you create a flight plan for your aircraft before you take off, use this article as the basis for a flight plan to find your best cash results.
With this strategy in place, the execution to get your benefits is easy.
The first thing you need is a log of seat hours or seat miles by type of use. When your spouse or children occupy a seat, it's as though you are sitting in that seat.
You want to avoid entertainment, especially the use of your aircraft for your personal entertainment.
You complicate your life under both IRS and FAA rules when you hold your airplane in a separate legal entity. It's not that you can't do it, it's just that you need to pay close attention to avoid problems. And there are some problems you cannot avoid with the separate entity.
Use the SIFL rates to value personal use by your employees. Also, if you operate as a corporation, use SIFL rates to value non-entertainment personal use by you. This generally produces maximum aircraft deductions.
When you buy the aircraft, consider planning to avoid the sales and use tax. Make sure you have the seller unbundle any training costs included in the purchase price. Then plan how you are going to use section 179 expensing.
During ownership of the aircraft, try to make repairs rather than improvements.
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