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Surviving a tax audit
As a big-ticket asset promising large potential tax adjustments, a business jet easily captures the attention of IRS auditors. Given the woefully complicated tax rules applicable to these aircraft, who can blame the IRS for seeking additional revenue opportunities in the flight department?
The best way to survive an audit is never to have one. Even if you buy a fractional share or lease an aircraft–options that are arguably less likely to result in an audit than purchasing a jet outright–it’s important to be mindful of the tax traps that business airplanes often unwittingly fly into. Just reciting the names of some key danger zones can be chastening: at-risk rules, passive losses, hobby losses, entertainment disallowance–plenty of audit potential lurks in these areas. The good news is that even if you cut corners and made mistakes in tax planning when you acquired your aircraft, it may not be too late to reverse or at least minimize the damage.
Basically, there’s only one way to run into trouble with the IRS: failing to pay the taxes you owe on a timely basis. This can happen because you underpaid or ignored specific taxes, such as the transportation excise tax or a taxable fringe benefit; or because you improperly took deductions against taxable income for aircraft-related expenses.
The former frequently comes down to the facts of the case: was there taxable transportation or a taxable fringe benefit? Talking to the IRS about such issues can be frustrating since there is often a major disconnect between aviation tax professionals and the government agency about the facts regarding situations subject to tax. (Witness, for example, the notorious Air Transportation Excise Tax–Audit Technique Guide, which the IRS published in 2008.) Minimizing audit risk in this arena may simply involve doing your best to comply with the rules while pulling down the blinds and hoping for an intelligent, not overly zealous revenue agent.
The second area–improper aircraft-related taxdeductions–involves complicated law. The threshold question can be particularly problematic with regard to business aircraft: do costs related to its use represent an ordinary and necessary business expense? Business aviation CPA Jed Wolcott in Fort Lauderdale, Fla., sees increasing audit activity in this area, especially for aircraft owned by special-purpose entities or where aircraft expenses are disproportionately large by comparison with revenues and other expenses.
“The company should justify that it has legitimate business reasons for using private air transportation, such as improving the efficiency of key executives,” Wolcott said. Operating a roadside lemonade stand in Palm Springs, for example, would not reasonably require use of a Citation X to transport the owner to Chicago to stock up on lemonade mix. Ideally, Wolcott noted, the company will document in writing that it has studied the issue and reasonably concluded that private air transportation was beneficial.
Are aircraft-related tax audits increasing? Wolcott doesn’t think so, though audits in particular areas may be on the rise as the focus of the IRS changes. The availability of 100 percent bonus depreciation, for example, has certainly captured auditors’ attention–it involves a giant one-time expense and often represents the first time a company takes an aircraft depreciation deduction.
An audit begins with a field examination, after which the auditor will write up his conclusions for the taxpayer. If the taxpayer doesn’t agree, he can appeal the results, and if he loses on appeal, he can go to court. A frequent mistake, according to Wolcott, is waiting to contest issues until after the IRS auditor completes his examination. In other words, don’t just send the auditor down to see your bookkeeper as though you have nothing to hide. “The field examination is the most important step,” Wolcott said. “Anything you can talk the auditor out of is gone forever. After that, it becomes much more difficult and expensive to win the point.”
Wolcott’s motto is “paper it to death.” IRS auditors love to go through the aircraft records and talk about each flight: What was the purpose? Who was onboard? Was entertainment involved? Sometimes the auditor will make the taxpayer prove he’s entitled to a deduction on a flight-by-flight basis. The flight records should therefore contain the information required to substantiate a deductible expense (see "A Recordkeeping Checklist for Aircraft Owners" below). And don’t assume you can make up the records once you’re audited or confine the auditor to a self-serving summary prepared for his benefit. IRS regulations require that flight-related records be contemporaneous, not concocted later.
IRS audits aren’t the only source of tax troubles. Revenue-hungry states are always looking for ways to impose sales and use taxes on business jet owners. It’s crucial, therefore, that before taking delivery of an aircraft, you map out your strategy for avoiding use tax not only in the state where you’ll base the jet, but also in states that you may fly to regularly, especially if you have significant contacts with those states, such as by having a residence or business there.
But well-crafted plans to avoid or minimize state and federal aircraft-related taxes are of no benefit if you don’t follow them. Wolcott confirmed that tax professionals often help aircraft buyers to create elaborate structures to own, lease, operate and manage an aircraft only to discover later that the client hasn’t been complying with the plan.
In summary, get good tax advice when you buy an aircraft and make sure you continue to follow it. And before becoming the subject of an audit, learn what records you need to be keeping and be sure you retain them. It’s the best way to make the audit process as painless as possible.
A recordkeeping checklist for aircraft owners
Here are the records you should keep contemporaneously for each person on each flight leg:
• Date of flight
• Departure airport
• Arrival airport
• Flight hours and miles
• Passenger manifest
• Purpose of flight for each passenger