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Structuring Transactions to Control Liability and FAA Limitations May Require Tax Election
There are often compelling reasons to own an aircraft outside the core business entity. These might include interests as diverse as complying with Federal Aviation Regulations, controlling liability, managing sales and use tax issues, as well as state and federal income tax issues. Regardless of the motive for the structuring, transactions that are not properly planned may result in adverse income tax consequences.
If an aircraft owner is selected for examination by the Internal Revenue Service they should anticipate a two-pronged attack. First, that the aircraft represents a hobby and not a trade or business, and second, that the aircraft activity is a passive activity and therefore generally not available to offset a taxpayer’s other deductions. The general rule provides that any deduction resulting from an undertaking of the taxpayer is considered on a standalone basis. However, in certain circumstances a taxpayer may elect to group his various undertakings for the purpose of determining both whether or not they constitute a trade or business, and whether or not they are a passive activity. Most taxpayers find that grouping their aircraft within their underlying business is much easier to defend as a trade or business in which they materially participate than the treating of the aircraft as a separate for-profit enterprise in which they materially participate.
Schumacher v. Commissioner (TCS 2003-96)
Gene Schumacher owns 90% of the shares of Pro Flight Center, Inc., an FBO located in Beaver Falls, Pennsylvania. Because he had a minority partner who did not have sufficient capital for the additional aircraft purchases, he acquired them separately. Upon examination the Internal Revenue Service asserted that the aircraft leasing business was separate and apart from the FBO business, and Mr. Schumacher’s loss in the rental business was passive. Mr. Schumacher asserted, that in considering his undertaking of leasing the aircraft to his undertaking of operating a fixed base operation, he should be allowed to group the two as a single activity. The Tax Court sided with Mr. Schumacher finding the most significant fact to be that he created the leasing activity solely to benefit the FBO activity.
Rabinowitz v. Commissioner (TC Memo 2005-188)
Leonard Rabinowitz worked in the high-end women’s clothing industry throughout California. He and his partner established a second company to acquire a Mitsubishi Diamond Jet. His business advisors recommended that he not acquire the aircraft in his clothing business due to the impact it would have on his debt/equity ratio. He ultimately traded the Diamond for a Falcon 200 and his principal use of the aircraft shifted to charter. The Tax Court refused to allow the taxpayer to group his activities under the “Hobby Loss” rules because they lacked an economic interrelationship. The Court found that the clothing company was a mere charter customer, as were numerous other third parties. Although Rabinowitz prevailed in his trade or business argument, he was required to prove it without the benefit of grouping.
Misko v. Commissioner (TC Memo 2005-166)
Fred Misko was a trial attorney who operated out of a C corporation which focused on class action lawsuits. In connection with these lawsuits he requires the most modern computer graphics and videotape equipment. His accountant advised him that he should acquire the equipment in a separate entity to help control Medicare tax on his wages. Mr. Misko attempted to group his C corporation and his leasing activity to show that the leasing company was operated for profit. The Tax Court acknowledged that a C corporation cannot be grouped with an individual; grouping is limited to flow-through entities.
Nonetheless, for purposes of determining if the taxpayer had a profit objective, you look to his law firm earnings because the use of the equipment was integral to his practice. His salary was considered even though his C corporation earnings were not. The passive activity limitations did not present a problem because the rent was incidental to his law practice. Mr. Misko succeeded because he could show sufficient interrelationship between the two activities.
One of the factors in determining whether an undertaking is a trade or business, or a hobby, is the potential to derive personal pleasure from the activity. I have had the opportunity to meet many aircraft owners that love their work; but none that love their work more than they love their airplane.
Contributions to this article were made and edited by Louis M. Meiners, Jr., CPA