If you plan to purchase a private aircraft in the U.S. this year, developing and executing an appropriate tax strategy before you enter into a letter of intent or contract to purchase the aircraft enhances the likelihood that you will be able to take 100 percent depreciation (bonus depreciation). This strategy should incorporate your projected business revenues, intended aircraft use, and unique attributes as a business taxpayer relative to taking depreciation deductions.
Depreciation is an allowance Congress enacted to encourage businesses to purchase capital equipment and other tangible personal property such as private aircraft. Depreciation allows business taxpayers to claim an annual tax deduction to recover the aircraft cost or other basis (adjusted cost) of the property for its wear and tear, deterioration, or obsolescence. A taxpayer usually deducts depreciation over a certain number of years called the “recovery period.”
Straight-Line, MACRS, and Bonus Depreciation
Perhaps the best-known depreciation method is straight-line under the Alternative Depreciation System (ADS). This method allows the taxpayer to deduct roughly equal parts of the aircraft cost or other basis over the applicable recovery period. The recovery period depends on the predominant use of the aircraft. As a rule of thumb, the recovery period is six years for FAR Part 91 aircraft (private use) and 12 years for FAR Part 135 aircraft (commercial use such as chartering or carrying freight).
The Modified Accelerated Cost Recovery System (MACRS) is another way to depreciate aircraft. The Internal Revenue Code (IRC) sets forth specific requirements that a taxpayer must meet to qualify to use this accelerated depreciation method. MACRS allows a taxpayer to write-off its aircraft in five years for FAR Part 91 (private use) aircraft and seven years for FAR Part 135 aircraft (commercial use). A taxpayer takes depreciation in the early years of the recovery period relative to approximately equal parts under the straight-line method.
Although the total depreciation taken under the straight-line and MACRS depreciation methods is the same, acceleration of depreciation under MACRS increases the time value of the tax benefits of MACRS compared to the slower straight-line method. Consequently, a tax advisor can help evaluate system and method that maximizes depreciation arising out of a taxpayer’s unique circumstances.
Taxpayers must comply with the MACRS requirements for an aircraft to be eligible for bonus depreciation. Under the Tax Cuts and Jobs Act of 2017, bonus depreciation applies to new and, for the first time, preowned aircraft acquired and placed into service after Sept. 27, 2017, and before Jan. 1, 2023, with a phasedown of 100 percent depreciation starting in 2027. Importantly, to depreciate a preowned aircraft, the taxpayer must not have used the aircraft before purchasing it.
Qualified Business Use
The IRC establishes qualifications for, and limitations on, deducting depreciation under MACRS and, by extension, bonus depreciation. MACRS requires that an aircraft must be used in a trade or business or for the production of income. A taxpayer must also “predominantly” operate the aircraft for “qualified business use” (QBU). In other words, QBU generally means the aircraft operates in connection with the taxpayer’s business enterprise conducted regularly and continuously for income or profit. Predominant use generally refers to 50 percent or more of total aircraft use per tax year.
In part to guard against taxpayer abuse of depreciation deductions, the IRC has placed aircraft in a special category called “listed property” under IRC Section 280F. In general, listed property that a taxpayer does not use more than 50 percent for business will not qualify for MACRS or bonus depreciation. Instead, such property must be depreciated under the slower ADS using the straight-line method. In relation to depreciation, the failure to comply with MACRS may arise out of excessive personal use under the listed property rules and MACRS requirements discussed above.
However, in certain circumstances, an aircraft may be eligible for bonus depreciation if the taxpayer can demonstrate 25 percent business use. Once the 25 percent threshold is met, this special rule in IRC section 280F allows a taxpayer to add in other activity that the rule initially excludes from the QBU test. The effect of the add back is to boost the business use above the basic 50 percent requirement. It is important to prepare contemporaneous and detailed records that support all aspects of QBU on the assumption that the IRS will ask for the records.
IRC Section 274 describes various types of personal use of aircraft. Often, personal use refers to the use of the aircraft for entertainment, amusement, or recreation such as parties, golf outings, family vacations, and sporting events. But it can also mean personal use of an aircraft for another reason: non-entertainment such as travel of an aircraft passenger for business unrelated to the business activities of the taxpaying entity that owns the aircraft.
If an aircraft is used for entertainment use, the IRC has a special provision that minimizes the impact of personal use on bonus depreciation. For purposes of depreciation, the provision allows a taxpayer to elect the straight-line calculation of the disallowed deductions attributable to entertainment use. The provision permits a taxpayer to claim bonus depreciation in the acquisition year and, concurrently, elect separately to calculate an IRC Section 274 “entertainment disallowance” using the straight-line method.
This election allows the taxpayer to deduct more depreciation in the year of acquisition than it otherwise would without the special IRC section 274 rule. This area deserves planning attention as it might, if structured correctly, provide a taxpayer with an increase in after-tax value and spur the taxpayer to establish an entertainment travel policy that applies this provision.
Compliance: Recapture Income
My clients often ask whether they can claim bonus depreciation in the acquisition year by satisfying the QBU and other MACRS eligibility requirements in that year and keep bonus depreciation if they do not satisfy the QBU and other MACRS eligibility requirements after the acquisition year. In this scenario, the answer is no. And the consequence might be very expensive for the taxpayer because the Internal Revenue Service (IRS) can use a “recapture” provision.
By doing so, the IRS causes the taxpayer to recognize income for the excess depreciation taken over the allowable straight-line method as calculated through the year of recapture. After that, the aircraft remains on straight-line and cannot return to MACRS. At a minimum, the taxpayer should track and record the QBU and other MACRS eligibility requirements throughout the ADS recovery period and, to be on the safe side, as long as the taxpayer owns the aircraft.
Once a taxpayer qualifies for MACRS and bonus depreciation, the taxpayer will still encounter such other limitations as the passive activity loss limitations, the excess business loss limitations, and the hobby-loss rules.
Prospective purchasers of aircraft seem universally interested in 100 percent bonus depreciation, but, as a taxpayer, the purchaser should not assume either that the aircraft will be eligible for bonus depreciation or that bonus depreciation will offer the optimal tax and economic solution. Still, by planning ahead of a purchase and involving specialized aircraft tax advisors, a purchaser should be able to identify the appropriate type of depreciation to maximize the reduction in its taxable income and lower its after-tax cost of capital. It certainly seems worth looking closely at bonus depreciation as it is easy to appreciate the significant value it might provide in an overall tax strategy.