All tax practitioners are aware how unyielding the tax code can be to those who lack sufficient planning and learn of the law’s arcane requirements only after the fact. One recent tax court case re-affirming this lesson is Williams v. Commissioner, TC Memo 2014-158 (August 2014), where a taxpayer lost out on deductions from his aircraft business due to his failure to provide the court with sufficient proof of his day-to-day work.
Although the Williams case involved a piston aircraft marketed through a flight school, its lessons are also relevant to aircraft owners engaged in charter or short-term rentals. The taxpayer, Scott Williams, had decades of aviation experience, although his primary profession was providing other companies with telephone-skills training. In the mid-2000s, Mr. Williams, through a company he owned, purchased a Cirrus aircraft and enlisted the help of several flight schools in selling short-term rental and instruction to members of the public.
Unsurprisingly, this aircraft rental business generated losses on his tax return. This is usually the case because the tax depreciation schedule for most general aviation aircraft lasts only five years, allowing the company to fully write-off the cost of the aircraft over this time (or even faster if certain congressional incentives, such as bonus depreciation, happen to be available). This accelerated depreciation schedule creates the false appearance, for tax purposes, that the aircraft is losing value very rapidly. When that mostly fictional plunge in value is reflected on the tax return, it usually results in the aircraft business showing a tax loss, even if, in economic reality, the business is profitable. In such cases, aircraft owners typically desire to lessen their tax bill by netting the tax losses generated by their aircraft activity against the taxable income they receive from other sources—which is exactly what Williams sought to do.
The IRS challenge to Williams’ netting of the aircraft losses against his other income involved parsing out his items of income and expenses into two categories defined in the tax code: active items versus passive items. In this taxonomy, each item of income or expense must be associated with an “activity” of the taxpayer (roughly, identifying which of the taxpayer’s business undertakings the item is associated with) and then determining for each activity whether that activity is “active” or “passive.” The significance of the active/passive distinction is that losses from passive activities cannot be netted against income from active activities—i.e., losses from passive activities cannot reduce the liability for taxes on income from active activities.
WILLIAMS’ TWO ACTIVITIES
In Williams, the taxpayer was found to be engaged in at least two distinct activities: the aircraft business, and the telephone-training business. It then fell to the tax court to determine whether each activity was active or passive, and the key test in that regard was how much time per year Williams worked in each business.
The tax code states that any business is passive with respect to all individual taxpayers who cannot show “material participation” in it, a test that involves counting up the hours that the individual dedicated to working in that business during the given year. An individual is considered to materially participate if he or she meets any of seven tests articulated in the tax regulations, with the two most relevant of those tests being (1) does the taxpayer devote more than 500 hours per year to the activity, and (2) does the taxpayer both (a) devote more than 100 hours per year to the activity, and (b) devote more time to it per year than any other individual.
In Williams, it was never in doubt that the taxpayer materially participated in the telephone-skills training business, where he worked full-time. The tax court easily held that he materially participated by dedicating more than 500 hours per year and found him to be “active” in that business. What lost the case for him, however, was his inability to show material participation in the aircraft business.
BURDEN OF PROOF MATTERS
Williams argued that, as to the aircraft, he materially participated by devoting more than 100 hours per year and devoting more time than any other individual. Unfortunately, the law places the burden of proving material participation squarely upon the taxpayer. The IRS needs to prove nothing; the government is presumed correct, and lack of clear evidence is interpreted in its favor. Williams was in the position of needing to prove, at a trial taking place years after the fact, how many hours he had devoted to the aircraft business back in 2007, the year at issue. If he had written contemporaneous notes of the time he spent, he would have stood a better chance, but he had no such records.
After emphasizing that Mr. Williams had the burden of proof stacked against him, the tax court noted that it would not accept “a ballpark guestimate” of the hours he worked, and, without the aide of any written records, such as time logs or day-planner entries, Mr. Williams was unable to persuade the court of his material participation, and therefore unable to net his losses from the aircraft business against his income from telephone-skills training, thus resulting in a significantly higher tax bill. His experience may serve as a lesson to other aircraft owners seeking to use tax losses from aircraft rental or charter structures: a few moments spent jotting down the time you work, notes sufficient to credibly jog your memory years later and corroborate your descriptions, may save your deductions upon audit.
“INVESTMENT” HOURS WEREN’T HELPFUL
Another noteworthy issue discussed in Williams is that the tax court did not allow him to count the time he spent reviewing bills as part of his material-participation hours. These hours were considered to be of an “investor” nature, and were therefore excluded. This conclusion stands as an interesting contrast with another tax court case decided this year, Tolin v. Commissioner, TC Memo 2014-65 (April 2014), where, unlike Williams, the taxpayer was allowed to count investor-type hours towards material participation. The key distinction is that, in Tolin, the court was satisfied that the individual was involved in the day-to-day management/operations of the business.
In recent years, there has debatably been a trend for the tax court to carve out more and more different types of work hours and consider them “investment” in nature. Those who are involved on a day-to-day basis in the activities claimed as active are protected from the dangers of this trend because the hours they work count towards the material-participation-hours thresholds, whether or not the hours are considered investment time. In contrast, those not involved day-to-day could see their eligible hours eroded to the point where they may be surprised to discover that they fail the material-participation tests and their activities have become passive.
This article is a brief introduction to a complex area, and does not raise or discuss all of the relevant issues, but instead attempts to single out a certain issue to provide some depth of coverage. Aircraft ownership should always be carefully evaluated with the aid of qualified advisers.
August 7, 2014
Jonathan Levy, Esq.
Jonathan Levy is a board-certified expert aviation law practitioner, and legal director Advocate Consulting Legal Group, PLLC is a law firm whose practice is limited to serving the needs of aircraft owners and operators relating to issues of income tax, sales tax, federal aviation regulations, and other related organizational and operational issues.
Tax Disclosure. We inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under federal tax laws, specifically including the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.