“"Not everything can fly. We will not install a swimming pool or a fireplace. That is not possible."”
First, some good news: aircraft ownership, while expensive, offers many tax benefits. A business jet may generate, say, $2 million of out-of-pocket costs annually, but if all of those costs are deductible against taxable income, your after-tax out-of-pocket costs might be only $1.2 million.
To achieve this kind of savings, of course, you have to be entitled to the tax deductions, and for that, you must (ignoring other sources of deduction, such as gifts to charity) employ the aircraft in a trade or business. This sometimes inspires taxpayers to try to create a business that can justify the deductions, and sometimes these "businesses" lack a genuine profit motive. If an activity is merely a hobby, the IRS won't permit deductions against income in excess of the income specifically generated by the hobby. An activity that doesn't generate gross income in excess of tax deductions for at least three out of five consecutive years will be presumed to be a hobby and not a for-profit enterprise, but it is possible (though often difficult) to overcome this presumption and still qualify as a for-profit business.
There is a common misconception that more than 50 percent of an aircraft's usage must be business-related for its expenses to be deductible. In reality, the expenses are deductible to the extent that you use the aircraft in a trade or business. In other words, you're still entitled to deduct aircraft expenses arising from use in a trade or business even if you use the aircraft principally in another activity. But, as we shall see, the percentage of non-business use may have an impact on how fast you can take depreciation on the aircraft for tax purposes.
While depreciation expense is capitalized and recognized over time, you can deduct most business-related aircraft expenses in the year you incur them. These costs include fixed expenses such as hangar, crew salaries and insurance, and the direct operating costs of flights, such as fuel and landing fees. Most maintenance expenses are also currently deductible, although the IRS may require you to capitalize maintenance expense that materially adds to the aircraft's value or prolongs its useful life.
Dealing with Depreciation
For many business aircraft buyers, the most appealing tax benefit of ownership is the ability to write off depreciation expense. Aircraft owners can be thankful that tax depreciation bears little or no relation to real depreciation.
A common assumption is that, over time, business jets depreciate at an average rate of 4 percent per year. At this rate, they would be worthless after 25 years, but most business jets remain in service far longer than that. Tax depreciation, on the other hand, occurs at an even faster rate. Assuming an aircraft is employed annually in a qualified business more than 50 percent of the time, you can write it off in only six years (eight if you use it mostly in commercial operations, including charter flights) on a schedule that is heavily front-loaded. The IRS calls this "accelerated depreciation," and indeed it is. On an accelerated schedule, a two-year-old noncommercial aircraft that is still under warranty and that the marketplace regards as almost new will have only 48 percent of its tax life remaining.
If this seems like a windfall, it is worth remembering that Congress in 2002 and again in 2003 further accelerated depreciation deductions for aircraft by enacting "bonus depreciation" rules. Under the 2003 legislation, the buyer of a factory-new aircraft could actually write off 60 percent of the cost in the first year.
Though bonus depreciation is no longer available, regular accelerated depreciation remains a siren song for many airplane buyers. You might think the way to optimize the benefit of tax depreciation would be to make your purchase on December 31, and thereby get a whole year's depreciation even though the aircraft is in service for only one day that first year. But the IRS decided that, instead of looking to see exactly when during the year an asset such as an aircraft is placed in service, it would simply assume that it is placed in service halfway through the year. This is known as the half-year convention. A second convention-the mid-quarter convention-says that if more than 40 percent of the aggregate basis of assets placed in service that year are placed in service during the fourth quarter, the assets will be deemed to be placed in service midway through that quarter. Consequently, if you buy the aircraft on December 31, and (as is often the case) it's the major asset placed in service that year, the most you are entitled to is one eighth of the first-year depreciation percentage, not 50 percent.
Making Tax-Free Exchanges
The effect of tax depreciation is dramatic: if you buy a $20 million aircraft, you can shelter $20 million of income from tax over six years (a savings of $8 million at a 40-percent tax rate). But this is really an interest-free loan from the government, not an outright savings. The value of tax depreciation is that you have the temporary use of funds you would otherwise pay in taxes. Meanwhile, the tax basis of the aircraft is reduced over time to zero. When you sell it, it is time to pay off the "loan," and consequently, any proceeds from the sale will be taxable, a chastening phenomenon known as depreciation recapture. These days, when aircraft owners sometimes sell airplanes for more than they paid for them, it's important to remember that the portion of the sale proceeds in excess of original cost represents taxable capital gain.
A sure-fire way to avoid recapture is to die before you sell your aircraft. Your estate will then get a tax-free step-up in basis of the aircraft to fair market value. A more attractive strategy from the owner's standpoint, though less attractive from a tax standpoint, is to postpone depreciation recapture further by doing a tax-free or "like-kind" exchange.
Suppose you purchase a Hawker 800XP for $10 million. Under accelerated depreciation schedules, its tax basis after six years is zero. If you then sell the jet for $8 million, you'll have $8 million of taxable income. Alternatively, if you use the Hawker to make a tax-free exchange for a $22 million Challenger 604, there will be no recapture of any income on its sale. The quid pro quo is that your tax basis in the Challenger will be reduced by $8 million, so that your tax basis for depreciation in the Challenger going forward will be $14 million.
Section 1031 of the Internal Revenue Code sanctions tax-free exchanges, and for that reason they are often called "1031 exchanges." The key to complying with Section 1031 is to avoid two independent transactions: the sale of the existing aircraft and the purchase of the new one. Instead, you basically need to exchange one aircraft for another. In some cases, this is easy-for example, when trading in an aircraft to a manufacturer for a new model. More often, though, owners sell an existing aircraft to one party and purchase the new aircraft from another. To transform such transactions into an exchange, you will probably want to retain a professional exchange company to act as an intermediary. Section 1031 permits you to wait 180 days after selling your aircraft to take title to the replacement, though you are required to identify the replacement aircraft with some specificity within 45 days after the sale. A policy published by the IRS in 2000 also permits this process to work in reverse: you can acquire the new aircraft first through an intermediary as long as you sell the existing aircraft within 180 days.
Paying for Personal Use
Business executives sometimes use corporate jets for non-business flights. The treatment of these flights for tax purposes has been a subject of great controversy in recent years.
Personal use involves two main tax issues: recognition of income for the executive and deduction of expenses for the company operating the aircraft. Let's consider these in turn.
If you take a free personal flight on the company aircraft, the IRS considers that you have received a taxable fringe benefit. You could eliminate this benefit by paying for the flight, but because of one of the more notorious disjunctions between FAA regulations and IRS requirements, you may find it difficult (without violating FAA rules) to pay an amount sufficient to wipe out all, or even any, of the fringe benefit. Fortunately, in lieu of paying fair value for the flight, IRS regulations permit you to receive imputed income for it, using an attractive valuation formula called SIFL. The SIFL rules, which are based on first-class airfare, generally result in income far less than the actual cost of the transportation to the company, let alone what you would pay for an equivalent
Turning now to the company's tax position, the IRS and aircraft owners battled in the courts and elsewhere for years about the correct amount of expenses the company should be entitled to deduct for personal flights. Initially, the IRS lost this battle, and the agency conceded that a company was generally entitled to write off all expenses of a personal flight. But the IRS enjoyed the last laugh. In late 2004, Congress passed legislation that limited deductions for such flights in the case of certain top executives (or "specified individuals") to the amount of imputed income recognized by the executive or the amount paid by the executive for the flight.
To see why this is a drastic change, suppose a company operates an aircraft that makes 50 flights annually, 10 of which are non-business trips for top executives, and that total expenses associated with the aircraft for the year, including tax depreciation, are $5 million. Depending on how you do the calculations (and there is plenty of uncertainty about how to do them), the company could easily lose on average one fifth, or $1 million, of tax deductions to which it might have been entitled if the personal flights had instead been business-related. This $1 million deduction is not suspended, postponed or carried over-it's just lost.
In 2005, the IRS released a notice designed to provide interim guidance on how to calculate the disallowance of deductions for personal flights until regulations could be promulgated. Unfortunately, the notice exhibited little understanding of how business aviation works and occasioned almost as much controversy as the new legislation. As of this writing, the IRS regulations have still not appeared.
Understanding Excise Taxes
The basic federal taxes specifically applicable to business aviation are the excise taxes on transportation and fuel. Both of these taxes are relatively esoteric and not well understood by many tax professionals not directly involved in aviation.
The fuel excise taxes are payable by the aircraft operator when it buys jet fuel. Currently, they total approximately 22 cents per gallon, though increases are expected. (The FAA's February 2007 funding plan called for an increase of more than 300 percent.) The excise tax on transportation, on the other hand, is owed by the person paying for the transportation, and it is sometimes called the "ticket tax" because it is listed as a separate item on airline tickets.
The transportation excise tax is a tax on commercial aviation. According to the IRS, a flight is commercial, and transportation excise tax is payable, when the provider of taxable transportation is engaged for compensation for hire and has possession, command and control of the aircraft. So the tax applies to charter flights and other flights conducted under Federal Aviation Regulation (FAR) Part 135. In addition, transportation tax is payable on certain flights that the FAA treats as "noncommercial," such as a time share or demonstration flight under FAR Part 91.501. Fuel excise taxes, on the other hand, generally apply to noncommercial aviation. If a flight is commercial and subject to transportation excise tax, you are entitled to request a refund or credit for most of the fuel taxes paid for the trip.
The rate of the transportation excise tax used to vary, but it has remained the same for some years now at 7.5 percent of the "total amount paid" for "taxable transportation," plus a "segment fee" that usually adds a modest amount to the bill. The transportation excise tax has traditionally been considerably higher than the fuel tax, so most tax planners seek to avoid it.
A potential major new tax on the horizon is "user fees." The airlines have been advocating that the FAA be funded by a user fee system that would cause business aviation to bear a larger-and many industry experts believe unfair-percentage of the agency's costs. The issue will come to a head later this year when the current scheme for funding the FAA expires.
Get Professional Help
As you can see, the various taxes related to business aviation form a confusing and often frustrating web that can easily ensnare the unwitting aircraft purchaser. Solutions for one tax issue inevitably have ramifications-often disastrous ones-for other tax issues. Aircraft purchasers would be well advised to seek advice on such issues from professionals who are intimately acquainted with them.