Business Tool or Airplane Hobby?

Too often, the public perception of business jets is that they are so enjoyable they should be regarded as toys. One jet broker/dealer firm took advantage of this by calling itself a “toy store.” 

The Internal Revenue Service, which has characterized business aircraft as “entertainment facilities,” often seems to share this perception. It is only too happy to find that a jet is not being used in a trade or business or to produce income so that the expenses of owning and operating it won’t be tax-deductible. 

In recent years, a popular IRS strategy has been to claim the taxpayer is using the aircraft in a hobby, not a bona fide business. What’s the difference? A business is pursued for profit, while a hobby (like a toy) is for fun. Unfortunately (or maybe fortunately), the IRS doesn’t have a “fun meter” it can hook up to taxpayers to reveal their real motives.

Taxpayers found to engage in a hobby, not a business, used to be able to deduct at least some of the associated expenses to the extent that they generated income from the activity, subject to the 2 percent floor on miscellaneous itemized deductions. But the 2017 Tax Cuts and Jobs Act eliminated that possibility, at least through 2025. If your activity is a hobby, the income is taxable.

The first step in understanding hobbies is the Tax Code. It basically provides that an activity engaged in by an individual or S corporation will be presumed to be “for profit” if its gross income exceeds its deductions in three of the last five years (including the current year). 

Presumptions Can Be Rebutted

An IRS revenue agent who finds that an activity satisfies that test may look for a smoking gun elsewhere since the burden of proof has shifted to him. But presumptions can be rebutted, and to do that, the IRS is willing to consider all relevant facts and circumstances, and to help do that, IRS regulations provide an additional nine-point test that includes factors like the taxpayer’s track record of success in other similar and dissimilar businesses and the expectation that the assets (in this case presumably the jet) will appreciate in value (good luck with that!). Just to confuse you, the IRS presents another, slightly different list in its Publication 535.

Depending on how you score on the nine-point test, you could still qualify as a trade or business if you flunk the five-year test—and if you do satisfy that test, a miserable score on the nine-point test might still serve to rebut the presumption that an activity is a business.

Profit motive was a key issue in a 2016 U.S. Tax Court business jet case. The taxpayer decided to combine his executive search business, DHR, with other service businesses in a new corporation called Enterprise Profit Solutions. The investment bankers planning to take EPS public suggested that the taxpayer acquire a corporate jet to make it easier to visit its “far-flung locations” and because of the “demands of planning and executing” the upcoming IPO. However, covenants in loan agreements prevented EPS from acquiring an aircraft, so instead, the taxpayer purchased shares in two NetJets Citation Xs through an LLC he formed called Hoffman Holdings.

The case recites the usual mistakes that plague aircraft buyers who fail to use experienced aviation counsel, something the court recognized. Hoffman Holdings was probably a flight department company [See “The Flight Department Company Trap.” —Ed.] and, even before it was formed, it purported to “lease” the aircraft to DHR, whose assets were eventually acquired by EPS (also mostly owned by the taxpayer). DHR never entered into a written lease, as required by FAA regulations, was never invoiced for its use of the aircraft, and neglected to keep good records substantiating the business use of the shares.

Our question, however, is whether the aircraft were being used in a bona fide business designed to make a profit so that aircraft expenses could be deducted for tax purposes. The facts support business use at the beginning, when there was enough cash flow to cover the NetJets costs, but in the wake of the 2001 economic malaise, the IPO was scrapped, transactions unraveled, and the taxpayer started losing money. 

After agreeing with the IRS on the results of the nine tests, the court concluded that the taxpayer’s “needs for jet travel services were insufficient to support the profitable conduct of that activity.” Of particular note is the court’s emphasis on the taxpayer’s failure to take advantage of its right to terminate the NetJets shares when the business stopped making money, which led the court to conclude that the taxpayer held onto the shares “for reasons of personal convenience,” not in furtherance of a profitable enterprise.

'Grouping' the Aircraft Activity

One way to solve a potential aircraft hobby loss problem is to “group” the aircraft activity with a business activity. [See “Turn Bizjet ‘Passive Losses’ into Tax-Time Wins,” —Ed.] In the 2011 case, Morton v. United States, for example, the court held (without even considering the nine factors referred to earlier) that the aircraft activity was part of a “unified business enterprise” involving several corporations for hobby loss purposes.

Take care when grouping activities, because just lumping unrelated ones together isn’t enough. In another Tax Court case, a physician who owned and piloted his own aircraft tried to “group” it for tax purposes with a medical practice of seven doctors to which he belonged. The taxpayer argued that he and the practice, called WUG, had “common business concerns and goals,” but the Tax Court thought otherwise. 

The court pointed out that none of the other physicians used or benefited from the aircraft or, during the time period at issue, even used any air transportation for business, and that the taxpayer paid all the aircraft expenses. By the court’s calculation, the taxpayer saved little time in using the aircraft to see patients compared with driving to them in his car and the aircraft did not serve to enhance WUG’s profits. Not surprisingly, flying the aircraft sounded to the court like something the taxpayer enjoyed…a hobby. 

 For another taxpayer, a creative IRS agent tried to use hobby loss rules to negate tax deductions for business jet expenses of a business we’ll call Company P. Company P was part of a group of jointly owned entities, including Company O, where the principal business was located. Company P leased the jet to Company O for use in this business and also to provide perks to its executives. The lease payments were designed to cover the “carrying costs” of the jet, not to make a profit. In particular, they didn’t cover the depreciation deductions that Company P took for tax purposes.

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When Company P replaced the aircraft via a like-kind exchange, which required that the exchanged jets be held for productive use in a trade or business, the IRS agent cited the hobby loss rules as a way to discredit business use. The agent argued that profit wasn’t the motivation for Company P’s jet lease, effectively rendering it a kind of a hobby. Fortunately, saner heads prevailed at the IRS Office of Chief Counsel, which in Memorandum CAA201601011 not only rejected the use of hobby loss rules for determining valid like-kind exchanges but also pointed out that the businesses of Companies O and P and other companies in the group should be viewed as a whole when determining profit motive.

Though the Memorandum basically dealt with like-kind exchanges of aircraft (now defunct), it displays the kind of thinking that can make grouping work to avoid hobby losses. It also shows that careful planning is needed if your situation suggests that your jet’s main purpose is pleasure, not business.