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Revenue Procedure 2010-13 Effective for Years Beginning After January 25, 2010
There are a number of good business reasons to isolate aircraft ownership and operation in stand alone entities. The benefits often include liability protection, confidentiality, sales and use tax control, and transferability of business interest. Current federal income tax benefits are rarely enhanced by using a stand alone structure; in fact, without proper planning federal tax benefits can be suspended or lost entirely based on the structure chosen. One very effective tool to accomplishing non-tax goals without a federal tax disadvantage is the concept of “grouping”.
As a general rule, each revenue generating undertaking and its related expense is separately designated as an activity. If the activity generates a profit, obviously the taxpayer has to pay tax on its results. However, if a business undertaking generates a loss, the loss will generally result in current income tax savings only if the undertaking is determined to be active, meaning that it can offset active income from other sources; if the undertaking is passive, it can only offset other passive income, which most taxpayers do not have. The potential problem here is that the taxpayer’s primary, profitable business will often be active, while the dedicated aircraft entity would, if viewed in isolation, be considered passive. In many cases, this problem can be overcome by grouping. This grouping concept is particularly helpful to many aircraft operators who hold their aircraft for the benefit of their primary business, but for valid non-tax reasons have elected to own it in a stand alone entity. Although grouping has been available to aircraft operators for many years, the Service has provided little guidance in how to properly make a grouping election, and its consequences. This changed with a new revenue procedure issued in January 2010. However, under these new rules, grouping becomes a trap for any unwary taxpayers who fail to follow the technical rules for disclosure of groupings, and therefore lose the potential advantages grouping would provide them.
A passive activity is either a rental activity, or an activity in which the taxpayer does not materially participate. If a taxpayer’s activity is deemed to be passive, his deductions are allowable only to the extent of other passive income, or upon the eventual disposition of the activity. When an activity is grouped, the determination of whether or not it is rental, or whether or not the taxpayer materially participated is determined on an aggregate basis for all the grouped activities.
The new rules provide that taxpayers must report, as part of their initial income tax return, certain changes to groupings that occur during the tax year, as well as new groupings in addition of new activities to existing groupings. Special rules apply to groupings by S corporations and partnerships.
Groupings are first made at the entity level for certain closely held C corporations, S corporations, and entities taxed as partnerships. Once entity level grouping is accomplished, a shareholder or partner may group those activities with each other, with activities conducted directly by the shareholder or partner, and with activities conducted with other flow-through entities. However, a shareholder or partner may not treat activities grouped together at the entity level as separate activities. Once a taxpayer has grouped activities they generally may not regroup them in subsequent taxable years. If the Service determines that the taxpayer’s original grouping was clearly inappropriate or a material change of facts or circumstances has occurred that makes the original grouping clearly inappropriate, the taxpayer must regroup the activities and comply with the disclosure requirements that the Commissioner may prescribe.
How To Make the Grouping Election
The entity grouping election is somewhat different than the election made at the shareholder or partner level. Generally, compliance with entity level grouping requires disclosing the entity’s groupings to the partner or shareholder by separately stating the amounts of income and loss for each grouping conducted by the entity on attachments to the entities annual K1. The partner or shareholder is not required to make separate disclosure of groupings disclosed by the entity unless the partner or shareholder 1) groups together any of the activities that the entity does not group together, 2) groups the entity’s activities with activities conducted directly by the partner or shareholder, or 3) groups the entity’s activities with activities conducted through other flow through entities. Final rules for S corporation and partnership groupings have not yet been published, but are expected in the 2010 IRS Form 1065 and 1120S instructions.
At the shareholder or partner level, a taxpayer files a written statement with its original income tax return for the first taxable year in which two or more trade or business activities or rental activities are originally grouped as a single activity. This statement must identify the names, addresses, and employer identification numbers, if applicable, for the trade or business activities or rental activities that are being grouped as a single activity. In addition, any statement reporting a new grouping of two or more trade or business activities or rental activities as a single activity must contain a declaration that the grouped activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of the passive activity loss rules. The rules also require similar disclosure for new trade or business activities that become part of an existing grouping for the taxable year.
If it is determined that the taxpayer’s original grouping was clearly inappropriate or a material change in the facts and circumstances has occurred that makes the original grouping clearly inappropriate, the taxpayer must regroup the activities. Once the regrouping is made, the taxpayer files a written statement with his original return for the taxable year in which the activities are regrouped. Furthermore, the statement to report a regrouping must contain an explanation of why the taxpayer’s original grouping was inappropriate. A taxpayer is not required to file a written statement reporting grouping of the trade or business activities that were in effect prior to years beginning before January 26, 2010 until the taxpayer makes a change to the grouping that requires disclosure.
Failure to Group Constitutes Election to Separate
If a taxpayer is engaged in two or more trade or business or rental undertakings and fails to report whether the undertakings have been grouped as a single activity, then each trade or business undertaking will be treated as a separate activity for purposes of applying the passive activity loss and credit limitation rules. Notwithstanding this, a timely disclosure, made prior to audit, shall be deemed to be made by the taxpayer who has filed all affected income tax returns consistent with the claimed grouping activities and makes the required disclosure on the income tax return for the year in which the failure to disclose is first discovered by the taxpayer. If the failure to disclose is first discovered by the Service, the taxpayer must also have a reasonable cause for not making the disclosure as required.
So Should You Make a Grouping Election?
When an aircraft is used in support of a primary business in which the taxpayer earns an economic profit and materially participates, he will generally want to group. This is particularly appropriate for aircraft operators who hold their aircraft in stand alone entities primarily for non-income tax reasons. Of course, there will be circumstances where an aircraft has a value substantially in excess of its adjusted basis and a taxpayer has a passive activity loss carryover; here the taxpayer may choose to treat the aircraft as passive and offset carryovers with built in gains.
Most importantly, the use of stand alone entities in aircraft ownership and operation requires careful planning. For example, an entity that employs a flight crew and owns an aircraft without any other substantial assets may provide excellent general asset protection, but would violate FAA “flight department company” rules. This is certainly an area of the law where proper planning can pay big dividends, and shortcuts can be disastrous.
Contributions to this article were made and edited by Louis M. Meiners, CPA