Second in a series of articles on “How to Survive an IRS Audit of your Aircraft”
There are many valid business reasons to separate aircraft ownership from the operating companies it serves. These often include liability protection, ownership differences, and managerial issues to name a few. Although it is often beneficial to segregate ownership for non-tax reasons, it is important to avoid inadvertently causing the aircraft entity to be treated on a “stand-alone” basis for passive activity income tax purposes. Simply stated, a loss from a passive activity usually cannot be used to offset income from other sources. Fortunately, the law recognized that business reasons might dictate separation and provides that a taxpayer may group his various activities for passive activity purposes. Prior to this year, the law did not mandate making a specific grouping disclosure on your tax return but recognized taxpayers’ ability to group.
Starting in 2011, individuals are required to comply with new disclosure rules for specifying their trade-or-business “activities,” and how their various companies group together to perform those activities. For individuals who use multiple companies in conjunction to carry out a single activity, failure to properly disclose may lead each company to be viewed as separate, which will likely negatively impact the ability to utilize loss deductions to reduce their personal tax liability.
Defining an “Activity” – What Business/es Are You In?
A rule of thumb to understand what is meant by a trade-or-business activity is to ask how someone might answer the question, “What business are you in?” A given person might answer with a single activity (e.g., “I sell cars” or “I practice medicine”), or by listing multiple activities (e.g., “I practice law and I also teach piano lessons”), or even with zero activities (e.g., “I’m retired”). The answer does not relate to whether the activity is carried out through a business entity (LLC or corporation), or conducted personally. A single activity may be spread out across many business entities and, likewise, a single entity could be involved in multiple activities.
The first step to making a proper disclosure is to identify the activities the individual is engaged in, and what companies (if any) each activity is performed through. Companies may be included in this picture if they are taxed as (1) S corporations, (2) partnerships, (3) certain C corporations, or (4) as part of your individual return (e.g., Schedule C). Each person who owns (directly or indirectly) a stake in an aircraft used to support another trade or business should determine if it is beneficial to group the activities, and if so, make an affirmative election to do so in their 2011 and subsequent individual returns.
Groupings that were in place prior to 2011 do not need to be disclosed. This means that if you were undertaking an activity through a particular set of companies prior to 2011, they need not be disclosed to the IRS. Any change to the grouping—e.g., addition or removal of a component—that occurs during or after 2011 does need to be disclosed.
The test for whether grouping is appropriate is whether the total group makes up a logical economic unit for measurement of gain or loss. The main factors are (1) similarities and differences in the types of trade or business grouped, (2) the extent of common ownership and control, (3) the similarity in geographical location, and (4) interdependence between the grouped entities. Many companies have numerous addresses that can be truthfully provided as their business address. Where possible, it makes sense to list the same address for multiple members of a group. As to prong (1), the “similarity” test, do not be unduly concerned that this prevents grouping of an aircraft entity with another company so long as the aircraft is used to support that company. Case law is quite favorable on this issue.
The Effects of Grouping
Two main results flow from the decision to group or not group activities. The first impact is whether components of the aggregated activity is “active” or “passive” for tax purposes. If a passive activity generates losses, those losses cannot be used to offset other active income until the passive activity is disposed of, at which time the unused losses become active.
A trade-or-business activity can become passive as to an individual in either of two ways. It is passive if (1) it is a “rental” activity (as specifically defined in the rules) or (2) the individual does not “materially participate” in the activity (special tests apply, which are generally based on the amount of time the individual devotes to the activity). Grouping can affect both “rental” characterization and material participation. Take, for example, two companies that are both owned by an individual (a physician), but that are taxed as separate taxpayers. One of the companies owns an aircraft which it rents to the other company (the medical practice) for use in that company’s business.
If the two companies are viewed separately, then one is involved in an active medical practice, while the other is a rental business. All rental businesses are passive (except for certain real estate rental), which would make the aircraft business passive. On the other hand, if the two companies are grouped together, then the aggregate formed by the two of them is in the medical business (with the aircraft company simply providing support for the other company). As a result, the aggregate is probably active. One important caveat is that, if either of the two companies is a C corporation, then the aircraft company will still be viewed as being in the rental business and still passive—grouping will not impact the rental issue.
Grouping in this case would also affect the material participation test. Perhaps the owner spends 2,000 hours per year working in the medical practice, but only 100 hours per year in the aircraft company. If the two are viewed as separate, the 100 hours may not be enough to consider the individual as materially participating in the aircraft company. In this case, the individual would be passive as to the aircraft company (due to lack of material participation). On the other hand, if the two are grouped, then the owner would be viewed as spending 2,100 hours in the collective activity, which would be enough to show material participation.
The power of grouping is that it can convert an aircraft company that, viewed in isolation would be passive, into an active business through grouping with another active business. However, there are also some risks. If the aircraft is in a situation where it would otherwise be active, but it is grouped with a passive business (real estate rental is a likely contender) that could convert the aircraft from active to passive. A further negative effect is that, if the aircraft is determined to be passive, then it is beneficial for the aircraft to be viewed separately and not as part of another grouped activity. This is because, when you “dispose of the activity,” any previously unused passive losses are converted to active and can be used against your other income. However, by broadly grouping with aircraft it becomes more difficult to dispose of the activity—i.e., it may require more than simply selling the aircraft. This is a further reason to avoid grouping the aircraft company with any passive activities.
Although most aircraft owners will find it beneficial to group for passive activity purposes, obviously that is not always the case. The new disclosure requirements mandate that those who fail to disclose new groupings will almost certainly have each entity viewed separately. Every aircraft operator who has an opportunity to group should make an careful decision on the matter, not an election to separate by default. For a suggested form for the election please visit www.advocatetax.xyz.
 A C corporation qualifies if it is either closely held or a personal services corporation. For this purpose, a corporation is “closely held” if at any time during the last half of the taxable year more than 50 percent in value of its outstanding stock was owned, directly or indirectly, by or for not more than 5 individuals. For this purpose, an individual is deemed to own shares owned by certain family members and related companies, and certain trusts, groups of trusts, and foundations are counted as “individuals.” The definition of a personal services corporation is complex, but generally relates to a C corporation for which the principal activity is performance of services that are substantially performed by employee-owners.