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TAX ISSUES FOR AIRCRAFT OWNERS
Prepared By: J. Randolph Robida, Attorney at Law
J. Randolph Robida all rights reserved.
Please Note: These materials should not be used as a substitute for professional advice where questions of interpretation should be addressed by a professional advisor. Please read the DISCLAIMER before continuing on this page.
TABLE OF CONTENTS
B. Program Summary
II. TAX ISSUES ASSOCIATED WITH THE PURCHASE OF AN AIRCRAFT
A. Tax Basis
B. Tax Basis on the Purchase of an Aircraft
C. Effect of Financing
D. Other Expenses Included in Tax Basis
III. BASIC RULES REGARDING DEDUCTION OF AIRCRAFT EXPENSES
B. Requirements for Deductions as a Trade or Business Expense
1. Definition of Trade or Business.
2. Reasonable and Necessary Requirement.
C. Requirements for Investment Expense Deduction
1. Similarity to Section 162.
D. IRS Focus on Ordinary and Necessary Requirement Under Both Section 162 and Section 212
B. Depreciation of Aircraft
C. Depreciation System
D. Listed Property Rules
E. Depreciation of Airplanes Used for Investment Activities
V. DEDUCTION OF FLIGHT TRAINING EXPENSES
A. Flight Training Deduction
B. When are Flight Training Costs Deductible
VI. COST OF ATTENDING CONVENTIONS (FOR EXAMPLE THE AOPA EXPO)
A. General Rule
B. Expenses of Attending an Investment Related Convention
C. Factors to be Considered
VII.TAX ISSUES WHEN YOU LEASE YOUR AIRPLANE
B. Leasing Activities Resulting in Net Income
C. Tax Issues where Leasing Results in a Net Loss
D. Hobby Loss Rules
E. Effect of the Hobby Loss Rules
F. IRS guidelines
G. Passive Activity Loss Rules
H. In connection with the leasing of an aircraft, the first question is whether that activity constitutes a rental activity subject to the passive activity loss rule
I. Material Participation Requirement
J. At Risk Rules
A. Introduction This program is design to introduce aircraft owners (or renters) to many of the basic tax issues associated with the ownership and operation of aircraft. The goal of the presentation is to provide the aircraft owner or operator with the basic knowledge required to know when a tax issue arises and with materials which can be used to help resolve some of the tax questions that come up in connection with the ownership and operation of aircraft.
B. Program Summary. This seminar will cover a number of the more common tax issues facing aircraft owners and operators. It is designed to flow in chronological order from the purchase of an aircraft through its ownership and operation and finally its sale. Among other things the program will discuss tax issues associated with the purchase of an aircraft, the deduction of aircraft operating expenses, tax issues associated with leasing of an aircraft, the deduction for depreciation, deduction for the cost of obtaining an instrument rating and tax issues associated with the sale of an aircraft.
II. TAX ISSUES ASSOCIATED WITH THE PURCHASE OF AN AIRCRAFT
A. Tax Basis. For tax purposes every item of property you own has what is known as a tax basis. In essence, the tax basis is the cost of that item. This is important for tax purposes because it is the figure which can be used in the calculation of depreciation expense and which will be treated as a return of capital on the sale of the item.
B. Tax Basis on the Purchase of an Aircraft. In general terms, when you purchase an airplane, your tax basis in that airplane is equal to your cost.
Example: If you happen to see a nice little Cessna that you like at your local airport and you reach into your pocket and pull out $50,000 cash to purchase the Cessna, your cost basis and your tax basis is $50,000.
C. Effect of Financing. If you borrow money to finance the purchase of your aircraft, its tax basis is still its total cost even though you will not actually pay the full amount for a number of years.
Example: Chuck buys an aircraft with a purchase price of $100,000. Chuck finances the purchase by paying $30,000 in cash and obtaining a loan from an aircraft financing company in the amount of $70,000. On the date of purchase Chuck's tax basis in the aircraft is $100,000 even though he will not repay the $70,000 loan for a number of years.
Tax Hint. If Chuck's airplane will be used in a trade or business or for the production of income, he will be able to take depreciation based on the full $100,000 tax basis even though he will only be "out of pocket" $30,000 at the beginning of the transaction. In short, Chuck may be able to a depreciation expense on his tax return for funds which he has not yet expended. Of course, by the end of the transaction, his cash "out of pocket" will more than make up for any depreciation deduction he has been able to take.
D. Other Expenses Included in Tax Basis. Other cost incurred in the acquisition of an aircraft may be included in its tax basis. For example, the cost of traveling to see the aircraft and the cost of an inspection of an aircraft, as well as the costs of financing maybe added to the basic contract cost in calculating tax basis.
Example: Dr. Spock is looking for a nice airplane to use in flying to patients and hospitals in his rural Montana practice. He hears of a suitable airplane in Denver, Colorado. The price of the airplane is $150,000. Dr. Spock spends $500.00 traveling to see the airplane, another $700.00 for a thorough inspection, and another $500.00 for a title search and other financing arrangements. The costs of the travel, the financing arrangements and the inspection can be added to the basic purchase price of the aircraft in determining Dr. Spock's tax basis.
III. BASIC RULES REGARDING DEDUCTION OF AIRCRAFT EXPENSES
A. Introduction. Strangely enough the Internal Revenue Code is set up so that essentially any item of income is includable for purposes of calculating income tax while only specific expenses are allowed as deductions. It is a basic rule of tax law that deductions are available only by the grace of Congress. This means that an expense or cost is not deductible unless there is a specific provision in the Internal Revenue Code allowing a deduction for that expense or cost. With respect to the ownership and operation of an aircraft, there are only two code sections which provide for deduction. The first is section 162 which allows for the deduction of ordinary and necessary expenses incurred in carrying on a trade or business. The second is section 212 which allows for deduction of ordinary and necessary expenses paid or incurred for the production or collection of income, for the management, conservation and maintenance of property held for the production of income, or in connection with the determination, collection and refund of any tax.
It is extremely helpful to understand that unless an expense meets the requirements of one of these two sections, it will not be deductible for tax purposes.
B. Requirements for Deductions as a Trade or Business Expense
1. Definition of Trade or Business. In order to be allowed deductions for trade or business expenses, the taxpayer must be engaged in a bona fide trade or business. The code never specifically defines the term "trade or business". However, there has been substantial litigation regarding this issue over the years.
Generally, in order to qualify as a trade or business, an activity must be entered into with the expectation of a profit, there must be some regularity and continuity in the operation of the activity and the taxpayer must be actively engaged in pursuing the activity, either himself or through agents.
Example: John owns an airplane and decides to make the costs of ownership deductible by engaging in a trade or business. John decides to go into business selling Broncos football jerseys and spends $500.00 buying some jerseys which he puts in his garage and occasionally offers for sale to people he meets on the street or at the airport. Whenever John goes on a trip he takes along a few jerseys and tries to sell them to whomever he happens to see. He doesn't have much success and after the Broncos get whipped in the Superbowl again, he has no success at all. John will not be treated as engaging in the trade or business of selling Broncos' jerseys and any deductions he attempts to take will be disallowed by the IRS. He will probably be liable for the negligence penalty and if he meets a grumpy examiner, may be subjected to the fraud penalty. These facts indicate that John has not entered into the activity with the expectation of making a profit and that he is not regularly and continuously involved in the operation of the activity.
2. Reasonable and Necessary Requirement. In addition to being associated with a bona fide trade or business, in order to be deductible an expense must be "ordinary and necessary". As usual the term "ordinary and necessary" is not well defined by the Internal Revenue Code. Generally, an expense is treated as ordinary if other businesses confronted with similar situations would incur the same kind of expense. Necessary has generally been defined to mean that an expense is appropriate or helpful to the business. Inherent in the phrase "ordinary and necessary" is also the requirement that an expense be "reasonable".
Example: Dr. Smith has a rural practice in Wyoming. Many of his patients live on ranches which have small private air strips and which are separated by hundreds of miles. Dr. Smith routinely uses his Cessna 172 to fly to his patients when it is impossible or inconvenient for them to come to him. The expenses incurred by Dr. Smith in flying to see his patients probably meet the "ordinary and necessary" requirement for deduction as a business expense.
Example: Dr. Jones practices in San Jose. He uses his airplane to take other doctors and business contacts to dinner in San Diego or gambling in Las Vegas. He attempts to deduct these trips as a marketing expense. In addition, when Dr. Jones is required to attend a conference in Dallas, he flies his own airplane at a cost of $750.00 when a commercial ticket is available at a cost of $150.00. Though Dr. Jones is clearly engaged in a trade or business, these expenses probably will not qualify as ordinary or necessary and thus will not be deductible by Dr. Jones.
C. Requirements for Investment Expense Deduction. Section 212 of the Internal Revenue Code provides that the taxpayer may deduct ordinary and necessary expenses incurred for the production of income, the management of property held for the production of income, or in connection with the determination, collection or refund of any tax.
1. Similarity to Section 162. Generally, the requirements for deduction under Section 212 are very similar to the requirements for deductions under the trade or business section. That is, an expense must be incurred in connection with the production of income and the expense must be ordinary and necessary. The primary distinction is that under section 212 certain activities which do not rise to the level of a trade or business still can generate a deduction if they are bona fide investment activities.
Example: Tom is a Certified Public Accountant. In addition to his job as a CPA, Tom also owns some vacant land outside of Denver. He holds the vacant land as an investment and can document that it is held for investment as opposed to personal use. Though the ownership of the land does not constitute a trade or business it can qualify as a bona fide investment and consequently Tom can deduct expenses associated with the ownership of the land.
Example: Assume Tom's ownership of the land outside of Denver does qualify as an investment. He may be able to deduct the cost of flying his own plane to inspect the land on a periodic basis if such cost compares favorably with taking a commercial flight.
D. IRS Focus on Ordinary and Necessary Requirement Under Both Section 162 and Section 212. Anyone owning or using an aircraft and attempting to deduct the expenses of operating such aircraft should be aware that the IRS generally scrutinizes the deduction of aircraft expenses. In general terms, the first question that comes to the mind of the IRS is whether such expenses are ordinary and necessary (reasonable). The important thing to remember is that if you plan to take deduction for cost of operating an aircraft you should be prepared to show why that deduction is appropriate and reasonable under the circumstances. For example, you should be prepared to compare the cost of using the aircraft to the cost of taking commercial flights and you should be prepared to explain why the use of an aircraft is appropriate in connection with the activity.
A. Introduction. If a taxpayer is engaged in a trade or business or an investment activity as those terms are defined by the Internal Revenue Code, then the taxpayer may be able to take a depreciation deduction for assets used in the trade or business or investment activity. The basic concept behind the depreciation deduction is that certain assets used in a trade or business or for investment purposes will last for a number of years and that deduction of their cost should be spread over their useful life.
Example: Herb, an attorney opening a new office, spends $15,000 on office furniture, including desks, credenzas and book cases which are expected to last for a minimum of 5 to 10 years. Because the furniture is expected to last for a substantial period, the Internal Revenue Code provides that its cost cannot be deducted in the year it was purchased and instead provides for a depreciation deduction over the useful life of the furniture. Herb also purchases approximately $5,000 worth of office supplies (pens, pencils, paper clips, etc.) during his first year of operation. In general all of those items will be used within one year of purchase. The Internal Revenue Code allows Herb to deduct the full cost of those office supplies in the year they were acquired instead of depreciating the cost over time.
B. Depreciation of Aircraft. Since aircraft are generally expected to last more than one year, the cost of acquiring an aircraft is not deductible as an expense, but must be depreciated over the useful life of the aircraft. Of course, this depreciation deduction is available only if the aircraft is used in connection with a bona fide trade or business or a bona fide investment activity. The IRS has developed detailed and specific rules for deduction of depreciation. The Internal Revenue Code assigns a useful life and a depreciation method for almost all assets. In the case of airplanes, the Internal Revenue Service has assigned a useful life of five years for basic depreciation purposes. In the case of airplanes used in air transport operations, the basic useful life is seven years.
C. Depreciation System. In addition to assigning a useful life the IRS has also developed tables for calculating the amount of depreciation to take in any year based on the tax basis of the aircraft. Consequently, if you own an aircraft used in a trade or business or in connection with investment activities, the depreciation tables created by the IRS will tell you exactly you can deduct by way of depreciation in any year.
D. Listed Property Rules. The tax laws impose certain restrictions on the deduction of depreciation for certain types of property which have been deemed particularly susceptible to abuse. Airplanes are included among these assets.
In order to receive the standard depreciation deduction, aircraft must be used predominantly in a "qualified business use during the taxable year." If the aircraft is not used predominantly for a qualified business use, it must be depreciated using a more restrictive depreciation method. In addition, if the airplane is used predominantly in a qualified business use in one year and later ceases to be so used, a portion of the depreciation previously taken may be subject to recapture.
E. Depreciation of Airplanes Used for Investment Activities. The use of listed property for investment or income producing purposes is not treated as a qualified business use. Consequently, depreciation for aircraft used for investment purposes will be restricted to the "alternative depreciation system" which has longer useful lives and thus, lower depreciation deductions. The mechanics of the depreciation deduction can become extremely complex and are beyond the scope of these materials. It is extremely important that you consult your tax advisor in connection with calculation of the depreciation deduction for any aircraft used in a trade or business or investment activity.
V. DEDUCTION OF FLIGHT TRAINING EXPENSES
A. One expense we would all like to be able to deduct is the cost of our flight training. This issue has come up in a number of tax cases and revenue rulings. Flight training is generally treated as an educational expense. Educational costs are deductible if they are for education that maintains or improves skills required by the individual in his or her job, or trade or business, or if the education meets the express requirements of the individual's employer or the requirements of law as a condition to retention of a job. However, educational costs are never deductible if they qualify the taxpayer for a new trade or business or constitute the minimum educational requirements for qualification in his or her job.
B. When are Flight Training Costs Deductible. Based on the rules discussed above, flight training costs have been held to be deductible where the use of the airplane has been shown to be deductible as a trade or business or investment expense and where the training has not led to a certification which qualified the taxpayer for a new job.
Example: Gus, a salesman owns an airplane which he uses to visit customers in his widespread sales territory. Gus is able to show that the expenses incurred in the use of this airplane are ordinary and necessary and are deductible as a business expense. In order to allow him to use his airplane more often and more efficiently, Gus takes flight training in order to receive his instrument rating. If Gus can show that the instrument rating will be beneficial and appropriate to his use of the airplane in his trade or business he will be able to deduct the cost of this instrument training.
Example: Sally works as an air traffic controller in the tower of Centennial Airport in Denver, Colorado. Sally has a private pilot's license and maintains her proficiency in order to improve her skills as an air traffic controller. Sally enters into a program to receive her commercial license and attempts to deduct the cost of the commercial training on her tax return. Sally will not be able to take the deduction because obtaining her commercial license qualifies her for a new job, i.e., as a commercial pilot.
VI. COST OF ATTENDING CONVENTIONS (FOR EXAMPLE THE AOPA EXPO)
A. General Rule. Generally, the cost of attending a business convention is deductible as an ordinary and necessary business expense where attendance is beneficial to the taxpayer's trade or business. Any expenses incurred which are primarily personal in nature are not deductible. The IRS has said that expenses of attending a convention or meeting are deductible where the agenda of the convention or meeting is so related to the taxpayer's business or position as to show that the taxpayer's attendance was for business purposes.
B. Expenses of Attending an Investment Related Convention. Under Internal Revenue Code Section 274(h)(7), the cost of attending a seminar or convention related to a taxpayer's investment activities is not deductible.
C. Factors to be Considered. The courts have said that in determining whether attendance at a convention was for business or pleasure they would look to, among other things:
1. The amount of time devoted to business versus the time devoted to recreational or social activities;
2. Whether the convention was held at a resort;
3. The primary purpose of the convention; and
4. Whether or not the taxpayer was compelled to attend the convention by his or her employer.
D. Summary. The business related costs of attending a convention are deductible if the taxpayer can show that attendance at the convention was directly related to the taxpayer's trade or business (not an investment activity).
Example: In connection with this convention, if you are engaged in a trade or business involving the buying, selling, renting, building, maintaining, etc. of airplanes, you have a good chance of being able to deduct the costs of attending this expo. However, if you are a doctor, lawyer, salesman or other business-man who uses an airplane in connection with your business, it may be difficult to show that attendance at this convention is directly related to the operation of your business.
VII. TAX ISSUES WHEN YOU LEASE YOUR AIRPLANE
A. Introduction. Many aircraft owners lease their aircraft to help offset the cost of ownership. The basic idea is that when you are not flying your airplane you lease it to others and use the income to defray your costs. There are two basic tax issues that arise as a result of such a transaction. First, is how the owner reports the income from the leasing operation and second, is how any expenses associated with the leasing operation and the ownership of the aircraft may be deducted. The answers to these questions depend in large part on whether the leasing activity results in income or a loss.
B. Leasing Activities Resulting in Net Income. If the income from leasing the aircraft exceeds the expenses of owning the aircraft, there will be few tax problems. The income will be taxable and the expenses will be deductible if they meet the requirements previously discussed in this presentation.
C. Tax Issues where Leasing Results in a Net Loss. When an aircraft owner attempts to take a tax deduction for a loss generated by leasing of his or her aircraft there are a number of complex tax issues to be addressed. Generally, the IRS frowns on the deduction of losses in such situations. There are three specific rules designed in part to prevent the deduction of such losses. They are the Hobby Loss Rules under Code Section 183, the Passive Activity Loss Rules under Code Section 469 and the At Risk Rules under Code Section 465.
D. Hobby Loss Rules. Over the years many taxpayers have attempted to convert hobbies such as raising horses, fly fishing, flying, etc. into businesses in order to take deductions for the cost of engaging in such activities.
Example: Allen has loved horses all of his life. He has had a number of horses on his ranch outside of Boulder for five years and recently it occurred to him that if his activities associated with raising horses were treated as a business, he could deduct the cost of his barn, his groomers, etc. With this in mind, Allen purchases an advertisement in the local paper a few times a year and offers to buy, sell or trade horses. However, he does not devote a substantial amount of time to these activities and does not really intend to make a profit doing it. Allen's activities in this area will be subject to the hobby loss rules and at best, he will be allowed to deduct his expenses up to the amount of income earned but will not be allowed to use excess expenses to offset income earned in his regular occupation.
E. Effect of the Hobby Loss Rules. If an activity is found to be a hobby as opposed to a bona fide business operation, the taxpayer will be allowed to deduct expenses which are deductible regardless of profit motive, such as home mortgage interest and will also be allowed to deduct other expenses which are attributable to the activity but not in excess of the income earned by that activity. The bottom line is that expenses incurred in connection with the hobby activity will not be available to offset income earned from other activities.
F. IRS guidelines. In determining whether a particular activity is a hobby or a business, the IRS looks to all of the facts and circumstances of the particular situation. However, there are a number of factors which are consistently taken into account. They are:
1. The history of income or losses with respect to the activity;
2. The amount of occasional profits, if any, which are earned;
3. The cause of any losses;
4. The success of the taxpayer in carrying on other similar or dissimilar activities;
5. The financial status of the taxpayer;
6. The time and effort expended by the taxpayer;
7. The taxpayer's expertise or the expertise of his advisors;
8. The manner in which the activity is carried out;
9. The taxpayer's expectation of profit;
10. The expectation that assets used in the activity may appreciate in value; and
11. Any elements or personal pleasure or recreation associated with the activity.
Example: Gordon owns a health club. He has his commercial pilot license and also owns an airplane. After reading an article in an aviation magazine, Gordon decides that he can deduct all the expenses associated with owning the airplane if he uses it to take passengers on sightseeing trips. Gordon puts up one ad on the bulletin board in the health club offering to take passengers on sightseeing trips. And when anyone expresses an interest he offers to take them on such trip for a minimal fee. Gordon does not spend a lot of time in connection with his sightseeing business and undertakes no other marketing activities. Gordon's sightseeing business is probably subject to the hobby loss rules and he will be allowed to take deductions only to the extent of income earned by the sightseeing business.
G. Passive Activity Loss Rules. In an effort to prevent taxpayers from taking tax losses associated with activities in which they had little or no participation (e.g., real estate tax shelters) Congress enacted the passive activity loss rules in 1986. Generally, losses from passive activities are not available to offset non-passive income such as wages or business income. A passive activity is defined as any rental activity or any business activity in which the taxpayer does not materially participate.
H. In connection with the leasing of an aircraft, the first question is whether that activity constitutes a rental activity subject to the passive activity loss rule. Leasing an aircraft does fall under the general definition of a rental activity, however, if the average rental period is less than seven days it can avoid treatment as a rental activity under a special exception.
I. Material Participation Requirement. If aircraft leasing is excepted from treatment as a rental activity, the next question becomes whether the taxpayer materially participates in the activity. If not, then the activity will be subject to the passive loss rule.
Generally, a taxpayer is treated as materially participating in an activity if he or she is involved in the operations in a regular, continuous and substantial basis. There are specific rules for determining whether this requirement is met. The most likely rule under which an aircraft may be treated as materially participating in leasing activities is one that states that the taxpayer meets the material participation tests if he or she participates in the activity for more than 100 hours during the year and his or her participation is not less than the participation of any other person.
Example: Tony owns a Cessna 172 which he uses generally for personal purposes. However, he also leases it to other pilots through his local flying club. Tony spends approximately 150 hours per year in connection with his leasing activities reviewing the logs, doing the accounting and taking care of other administrative issues. The owner of the flying club spends approximately 90 hours per year in connection with the rental of Tony's airplane. No one else spends a substantial amount of time in connection with this activity. Consequently, Tony meets the material participation test because he spends more than 100 hours in the activity and the time he spends is not less than the time spent by any other person in connection with the activity.
Note: the IRS has taken the position that for purposes of this test all of the employees at a flying club are treated as one individual. In the above example if the total time spend by all employees of the flying club exceed 150 hours, then Tony would no longer meet this test. It is not absolutely clear that the IRS position would stand up under challenge, however better to be aware than to find yourself in tax court.
J. At Risk Rules. Under certain circumstances taxpayers are not allowed to deduct losses from an activity beyond the amount for which they are "at risk" with respect to that activity.
Example: Bill buys rental real estate for $100,000, his friend at the bank arranges the financing so that Bill puts $5,000 down and receives a $90,000 non-recourse loan (meaning that the loan is not secured by the property and that Bill is not personally liable on the loan). Bill will not be able to take deductions in excess of the $5,000 for which he is at risk in connection with this activity. As the loan is paid off and Bill becomes at risk for additional amounts, he will be able to take increasing deductions.
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