Taxes–when, where, how and why they must be paid–and how to avoid them captured a major share of attention among the users and providers of business aircraft transportation attending the fifth annual Conklin & de Decker aircraft acquisition planning seminar in Scottsdale, Ariz., this fall. Legislation passed in late 2004 that addresses personal non-business use of corporate aircraft has made the taxpaying process even more complicated and costly.
The complex process of selecting a business aircraft is further complicated by myriad tax considerations, Nel Sanders-Stubbs and Keith Swirsky advised the gathering. Much of it involves determining where and how to acquire the aircraft, whether by purchase (solely or jointly), lease or some other arrangement. That decision in turn is, or should be, influenced by the tax liabilities it creates, noted Sanders-Stubbs, part owner of Conklin & de Decker.
Further complicating the issue is a section of the 2004 American Jobs Creation Act (AJCA) that affects the definition, calculation and taxation of personal travel on corporate aircraft and threatens to make flying on business aircraft more expensive– and in some cases unprofitable–by limiting deductions for aircraft expenses. That was the message delivered by Swirsky, of the Washington, D.C., aviation law firm Galland, Kharasch, Greenberg, Fellman and Swirsky.
A rider inserted into the AJCA by Sen. Kay Bailey Hutchison (R-Texas), he pointed out, had the effect of overturning the 8th Federal District Court of Appeals decision in Sutherland Lumber vs. IRS upholding the taxpayer’s right to deduct all expenses connected with providing personal, non-business flights to shareholders and employees as long as fringe benefit income for the value of the flights is imputed (charged) to the passengers.
The value of the transportation imputed to the passenger(s) was not required to equal the sum of all direct and indirect costs associated with operating the aircraft, all of which the operator could claim as a tax deduction, until the passage of the AJCA. The imputed cost of air transportation was–and still is–computed under an IRS formula called standard industry fare level (SIFL) under most circumstances.
A Back-door Tax Hike
AJCA, which took effect on Oct. 22, 2004, made a company’s cost of flying for the “recreation, entertainment and amusement” of “specified individuals” (an owner of at least 10 percent of the company or any officer or director) deductible only up to the amount of fringe benefit income imputed to or reimbursed by those people. Swirsky said the AJCA provision on personal flights “is intended to produce additional revenue and is, in effect, a back-door tax increase on companies that operate business aircraft.”
Moreover, he added that the act created a great deal of confusion in the business aviation community because, while it clearly limits the deduction taxpayers may take for expenses associated with personal flights for specified individuals, it provides neither a method to calculate the limitation nor any guidance on how to allocate costs for flights in many situations.
To address these and other questions, the IRS published Notice 2005-45, which modifies the general rule that taxpayers can deduct all ordinary, necessary and reasonable expenses incurred in carrying on a trade or business. By limiting deductions for expenses of providing flights for employee or company officer “recreation” the act and Notice 2005-45 have created significant new record-keeping requirements under which the taxpayer must document the activity of each named passenger for each leg of each flight.
If confidentiality prevents naming an individual, the company cannot deduct the expenses for that person’s business-related flight. Operators must record either the total passenger hours or passenger miles flown for business and for “entertainment” purposes by each passenger on each flight and the yearly totals of business and entertainment hours flown on company aircraft.
Since he can deduct only the SIFL value of a flight imputed as a fringe benefit to a passenger, which is invariably less than the full cost per hour or per mile of providing it, the operator loses the tax advantage he enjoyed as a result of the Sutherland Lumber decision.
Notice 2005-45 requires the operator to break out the percentage of direct and indirect costs of owning, flying and maintaining the aircraft attributed to business and non-business carriage of passengers and allows deduction only of the business percentage of total annual costs plus the total SIFL value of recreational flights imputed to or reimbursed by the passenger.
Computing the SIFL value of a given flight is itself an involved exercise. It often varies even among individuals on the same flight, because it is based on passenger status, aircraft weight, trip length and the purpose of the flight. Passengers fall into either a “control” or “non-control” category according to level of responsibility and annual compensation. The SIFL value assigned to a control employee (roughly analogous to a “specified individual”)–that is, a top executive–is often many times that of the non-control employee in the next seat.
AJCA and Notice 2005-45 have a particular effect on recent purchasers of business aircraft who have heretofore benefited from the accelerated depreciation of capital assets permitted by the tax code, because now they can take only a portion of that depreciation if the aircraft is flown for both business and personal use.
Moreover, the operator loses a percentage of all fixed, variable, direct and incidental operating expenses such as fuel, landing fees, overnight hangar or tiedown fees, catering, flight crew meals and lodging, management fees, hangar rent, salaries of pilots and maintenance personnel and others assigned to the aircraft, maintenance costs and insurance premiums.
Calculating Benefit Losses
While limiting the amount of “recreational and personal” flight on company aircraft will minimize the loss of tax deductions, many firms have a policy that, for security reasons, top executives must travel by air only on aircraft owned or provided by the company.
Swirsky suggested that companies include a policy provision limiting personal non-business flying on company-owned aircraft to a fixed number of hours. Any hours over that limit would be provided on charter flights. This, of course, limits the utility of a business aircraft for which the company bought it in the first place while increasing the fixed costs per flight hour. Company bean counters would then have the task of finding the point where the line representing lost tax deductions crosses the line representing the cost of chartering as well as the increased cost per flight hour due to flying less.
Swirsky then discussed the tricky matter of determining whether a trip to a particular destination should be treated as business or recreational when a specified individual engages in both at the same destination. Both the act and the IRS notice are unclear on this point, he noted, adding that “in the absence of guidance in the act or notice, it should be reasonable to assume” that U.S. Treasury regulations governing imputation of fringe benefits for personal air travel would apply. These state that in such cases a fringe benefit need be imputed only when the primary purpose of the flight is personal and business activity is incidental.
He offered a hypothetical example of how, under the AJCA and implementing IRS notice, personal use of a business aircraft could cost an operator nearly 73 percent of his operating-cost deductions. This comes about because the computation is based on passenger hours or miles, not aircraft flight hours or miles.
In Swirsky’s example, an aircraft is flown for 15 hours in one year. Potential aircraft expense and depreciation (if used only for business) totals $86,000. One passenger flies alone on business for five hours, and for four hours accompanied by a specified individual on board for entertainment purposes.
A specified individual and four family members take a three-hour flight for entertainment, and a three-hour deadhead flight returns the aircraft to its base. Because it was returning from an entertainment flight carrying five people, the deadhead leg is also charged with 15 entertainment passenger hours.
After credit for imputed income and reimbursement from the family entertainment flight, the operator loses $62,300 of his $86,000 in potential deductions and depreciation even though the aircraft was actually flown on business for nine of the 15 total hours.
If there is a silver lining within this dark cloud it is an IRS transitional rule covering the period between Oct. 22, 2004, when AJCA became effective, and July 27 of this year that allows taxpayers to carry over disallowed expenses from tax years ending between those dates to the first taxable year ending after July 27. Swirsky also made the encouraging comment that, “Presumably, Sutherland Lumber still applies for personal flights of employees who are not ‘specified individuals.’”
He went on to discuss planning to maximize federal tax benefits. This includes identifying and weighing the factors surrounding aircraft operating expense and depreciation deductions, including the types of depreciation recovery periods.
Again, recent changes could cost operators tax-deduction dollars. One example is a new rule regulating the conditions under which aircraft depreciation is claimed. Under the previous rule, when the operator chose a depreciation schedule in the first year of use, that formula applied throughout the period regardless of changes in the primary use of the aircraft.
This is significant because for non-commercial use (Internal Revenue Code Asset Class 00.21) a five-year accelerated cost recovery period is allowed; the accelerated cost recovery period for aircraft used in commercial air transport (Asset Class 45.0) is seven years. The straight-line recovery period for Asset Class 00.21 is six years, and 12 years for Class 45.0.
Under the new rule, a change in the primary use of the aircraft after the year in which it was put into service, such as placing it under a Part 135 certificate and offering it for charter, can result in a change in the depreciation method, recovery period or both.
If this causes the aircraft to fall into the less favorable Asset Class 45.0, it not only reduces the yearly depreciation deduction but could also make the taxpayer liable for recapture of depreciation taken under the previous method. Thus it behooves an operator to consider carefully the tax implications before making his aircraft available for charter use.
Another potential tax pitfall for the unwary operator is that of passive activity expenses and losses. Passive activity is defined as “business activities in which the taxpayer does not materially participate.” Swirsky listed five categories that can fall under that heading: individuals, partnerships and LLCs, S corporations, closely held C corporations and personal service corporations.
Swirsky warned that under IRS Section 469, operating expenses and depreciation attributable to generating passive income, including those for owning and operating aircraft, might have little or no tax benefit. Another tax disadvantage of passive activity income is that expenses incidental to it cannot be used to offset income from other, non-passive sources.
One passive activity that can lead the IRS to disallow deductions for aircraft expenses involves rental income. Swirsky described exceptions and various means to avoid the disadvantages of income being characterized as “rental,” including ways to make rent income “incidental to a trade, business or investment activity.” He explained methods–such as single-member LLCs and use of dry leasing of aircraft between companies owned by the same person or group–to avoid rental characterization.
Choosing the Right Aircraft
Before tax issues grabbed the seminar spotlight, Massachusetts-based Conklin & de Decker part owner Dave Wyndham reviewed factors for “making the right aircraft decision.” To those running corporate flight departments or operating their own aircraft, he advised, “It’s a good idea to do a periodic review of your current situation. Track changes in utilization, spot trends. Do they warrant changes in your fleet composition?”
He recommended making three- to five-year projections of transportation needs, requirements, costs and aircraft residual values. But most of all, Wyndham emphasized the importance of defining the company’s key mission, “the flight department’s reason for existence.”
To “newbies” looking at entering corporate aviation for the first time, he advised, “You need to quantify mission requirements, then find the aircraft to match. Look at aircraft-related performance parameters such as payload, range, the number of passengers you expect to carry, the anticipated weight of baggage and equipment.”
As an example, Wyndham explained that planning for long, inter- continental flights should prompt an evaluation of the need for nonstop capability versus an aircraft that will require an en route fuel stop. “There will always be tradeoffs in terms of fuel, range and number of seats, runway length and expected density altitudes. You must also consider the availability of product support. That will, or should, affect your choice of destination airport, along with factors like noise constraints and curfews.”
The nonstop option will require a bigger aircraft that will be more expensive to acquire and operate, he noted. Wyndham said the most important evaluation parameters of all would be “required” versus “desired.” The “required” column includes everything that is a “must” to carry out the flight department’s mission, which should be defined precisely and understood by all concerned. “Above all,” he emphasized, “quantify, quantify and quantify!” And, he added, consult directly with the people who will be flying in the aircraft, which will almost always include the top executives of the company.
While seminar attendees expressed wide interest in tax issues, a number of other topics drew them to the event. Brian Adams, representing VLJ start up Eclipse Aviation in Albuquerque, N.M., said, “I’m here to learn about financing and insurance,” two subjects that will be high on the list of Eclipse 500 very light jet purchasers when they begin taking delivery of production aircraft next year.
Bill Baptista of Cessna Finance came to Arizona “to get customer perspectives” as well as to hear the takes on current conditions of experts in the insurance, financing, asset management and cost-analysis realms. The Conklin & de Decker aircraft acquisition planning seminar is part of the NBAA professional development program series.
Bill de Decker, co-founder of the firm, advised during his presentation on asset management that “The pen is sometimes more powerful than the screwdriver. Good maintenance and bad records equals one thing: Bad!”
He emphasized that complete documentation affects aircraft value at least as much as or even more than appearance, upgrades such as TAWS, RVSM, and 406 MHz ELTs and the quality of maintenance. “Most aircraft are good in those areas, but without complete records it’s a different story. Incomplete documentation is the source of a lot of heartbreak. It can and does determine the airworthiness and saleability of the airplane.” De Decker added that “excellent” maintenance logbooks can have a value of between $50,000 and $250,000.