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IRS EXPANDS AIRCRAFT TAX EXAMS – HOW SHOULD YOU PREPARE?
The Internal Revenue Service appears to be taking increased interest in aircraft owners’ income tax returns. It may be a result of bonus depreciation, enhanced expensing, or targeting high income taxpayers; but regardless of the trigger, exams appear with increasing frequency and greater depth of review.
THE LAW AND JUDICIAL PRECEDENT GENERALLY REMAINS UNCHANGED.
Of course, an aircraft is not unlike any other business tool. Its acquisition and operating expenses are allowable provided they are ordinary, necessary, and reasonable in amount. The aircraft expenses must also be directly related to the active conduct of a trade or business, or for the production of income. Depreciation deductions are statutorily determined and are generally accelerated over a five year period regardless of the economic useful life of a particular make or model of aircraft.
HOW DOES THE SERVICE ATTACK DEDUCTIBILITY?
The Service has an arsenal of tools to challenge tax deductions of a bona fide business airplane. Some of the most common attacks relate to:
1) Is the business use properly documented – have you accounted for all of the hours – do your logbook entries contain contemporary business explanations – do hours match your maintenance records?
2) Is the primary purpose of each trip business – if there are personal guests onboard, how have they impacted the tax deductions or taxable income of the users – is the personal use entertainment, or non-entertainment?
3) If the aircraft is held in a separate entity – is that entity a business and did the owner materially participate in it – if the aircraft entity supports another entity can the two entities be grouped?
4) Does the owner have basis, and is he sufficiently “at-risk” to take income tax deductions? Should his deductions be limited either to basis or for at-risk reasons? Aircraft purchased with borrowed funds in an S corporation often encounter a basis problem because the aircraft is depreciated more quickly than the debt is amortized. This issue does generally not arise in the case of a limited liability company because debt generally passes through to basis of limited liability company members.
AND LATELY CERTAIN NEW ISSUES ARE ARISING:
5) Is the taxpayer at risk for debt that is personally guaranteed when the maker is primarily responsible? We have heard recent arguments from the Service that because the taxpayer is only secondarily liable he may not be at risk. We strongly disagree, but the battle continues.
6) Aircraft held in single-purpose entities may not be grouped with all entities they support for purposes of determining passive activities and hobby losses. Industry experts recognize there are many valid business, liability, regulatory, and tax reasons for ownership of an aircraft in a single purpose entity. However, income tax considerations often require grouping the primary business with the single purpose entity to ensure qualification as a business asset with material participation by the owner. The Service appears more willing to challenge grouping qualifications in recent examinations.
7) You could get there cheaper by using commercial transportation. Fortunately, significant pro-taxpayer judicial precedent exists in this area. Nonetheless an agent will generally be able to find an alternative commercial flight, or perhaps a bus ticket, that could get you there at a lower cost. Existing law looks to what is commercially reasonable, and that includes general aviation; however, we must remain vigilant for any potential attack in this area.
ACTION PLAN – PREPARE TO BE EXAMINED
We in the industry recognize the importance of aircraft as a business tool; but to outsiders it may not be so obvious. We would suggest you prepare to defend your cherished tax deductions through the following:
1) Keep complete records of both use of the aircraft and the business purpose of each trip.
2) When acquiring an aircraft, document the business purpose of the acquisition and how it is best suited for your business needs.
3) When acquiring the aircraft, analyze the proper ownership structure and make affirmative elections to group for purposes of passive activity and hobby loss.
4) When financing the aircraft, be certain to comply with both basis and at-risk rules.
5) Take the income tax deductions you are entitled to, particularly depreciation. The basis of your aircraft is reduced by allowable depreciation whether you choose to take it or not.
6) Seek expert advice from a lawyer who understands aviation. Regulatory and liability issues permeate business and tax issues in this area of the law; an accountant should not go it alone.
For further explanation of documentation requirements, grouping opportunities, personal use of the aircraft, and justifying business deductions, please visit www.advocatetax.com.
Contributions to this article were made and edited by Jonathan Levy, Legal Director