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Is your airplane a hobby?
What do a business jet and a stamp collection have in common? According to the Internal Revenue Service, both may be hobbies. If the IRS considers your aircraft a hobby, you won't be able to write off all the related expenses for tax purposes.
To the extent that you employ an aircraft in a genuine business, you can ordinarily deduct the costs of owning and operating it. In good times, these expenses will offset taxable income from the business, but in bad times, expenses (including those for the aircraft) may exceed business income. In that case, the expenses may offset taxable income from your other activities or be carried forward to offset income in future years.
The deduction of expenses of owning and operating a business jet frequently attracts IRS scrutiny because of the large sums involved. If the IRS takes a hard look at your business and decides that it's really a hobby, you won't be able to use expenses of the hobby to offset income from other activities, and you will be able to deduct expenses only up to the amount of income the hobby generates. Instead of being carried forward, losses in excess of this amount are gone forever.
How do you know whether your aircraft is involved in a hobby? According to the IRS, a business differs from a hobby because it's conducted for profit. Fortunately, you don't actually have to make a profit; the IRS acknowledges that people can make poor business decisions and that businesses often fail despite the best intentions. But the intentions have to be there; profit must be the goal.
A good candidate for an aircraft hobby masquerading as a for-profit enterprise is a charter "business." Except in unusual circumstances, putting your jet out for charter will rarely do more than help cover some of your fixed ownership expenses, such as capital cost, hangar rent and crew salaries. So if you claim you own a business jet so you can make money chartering it out when the aircraft's real purpose is personal use or enjoyment, you may have a tough time convincing the IRS that you're really engaged in a for-profit business.
Interestingly, not everyone has figured out that it's virtually impossible to make money by buying and chartering a business jet. The leading case in this area, Rabinowitz v. Commissioner (2005), is actually a victory for the taxpayer. Rabinowitz and his spouse set up a company called Beverly Hills Jet (BHJ) to own and operate a Falcon 200. BHJ chartered the aircraft to third parties, including California Fashion Industries (CFI), a company also owned by the Rabinowtizes. Not surprisingly, the
business jet charter company consistently lost money, and the IRS disallowed BHJ's substantial tax deductions on the grounds that the taxpayers did not engage in the jet charter activity for profit. Presumably, the IRS figured they enjoyed having the jet available for their own travel, including through CFI.
After refusing to consider CFI and BHJ as one enterprise, the U.S. Tax Court decided the case by considering nine nonexclusive factors drawn from IRS regulations (see box). Although some of these factors weighed against the taxpayers, the court on balance concluded that they had entered into the charter business with the aim of making money. Despite this conclusion, even the non-aviation-savvy court admitted it was uncertain the Rabinowitzes "ever would have earned a profit from the jet charter activity because of the significant fixed costs involved." Perhaps the weak-minded may have an advantage when trying to avoid a hobby-loss disallowance.
Ill-conceived charter schemes aren't the only way business jets run afoul of hobby-loss rules. Another typical scenario is the employment of the jet in service of a relatively modest business, often one that seems to be a hobby in its own right. You'll have an uphill battle trying to convince the IRS that you need a Global 5000 to visit your Burger King franchises in Palm Springs, Vail and Hilton Head. Classic hobby-loss "businesses" include treasure hunting, gentleman farming, car restorations and raising and running racehorses.
The Internal Revenue Code contains helpful provisions for those worried about hobby losses. Ordinarily, the taxpayer has the burden of proving that an activity was a bona fide business, not a hobby, but the Code says that an activity will be presumed to be for profit if the gross income for three of the last five years (two of the last seven years in the case of breeding, training, showing or racing of horses) exceeds the deductions from the activity. If you satisfy this test, you aren't home free, since the IRS can still rebut the presumption, but you're certainly on stronger ground.
To avoid the disallowance of hobby losses, make sure you conduct your activity as you would any other business. Even the simplest things, like keeping a separate bank account for the activity, can be helpful in establishing it as a business. If you use the aircraft in the service of a non-aircraft-related business, keep careful records of how the aircraft helps to further business objectives. In the Rabinowitz case, for example, the Tax Court noted with apparent approval that the taxpayer, who was in the fashion business, would bring "garments on the jet and add finishing touches" en route to marketing appearances. Careful consideration and implementation of the nine factors can go a long way toward maximizing the chance that the IRS will view your aircraft-related business as a for-profit enterprise and not a hobby.
Nine points to ponder
The IRS takes into consideration nine factors that help determine whether an activity is a business or hobby. Briefly summarized, they are:
• Whether the taxpayer carried on the activity in a businesslike manner.
• The expertise of the taxpayer and his advisors.
• Time and effort spent on the activity by the taxpayer.
• Expectation that the asset may appreciate.
• The taxpayer's success in other business activities.
• The history of income or loss with respect to the activity.
• The amount of occasional profits.
• The taxpayer's financial status.
• Whether the activity involves personal pleasure or recreation.