For owners of business aircraft who find themselves flying fewer hours per year than their aircraft can reasonably support, an attractive option is often to contract with a Part 135 charter company to use the excess capacity of the aircraft to sell flights to the public.  Such an arrangement can create a valuable revenue stream from charter customers, which often serves in addition to the owner’s primary reason for the aircraft—i.e., enhancement of the owner’s business through Part 91 flights to meet with customers, solicit prospects, manage business operations, etc.

However, incorporating Part 135 use into an aircraft structure may have surprising effects on the calculation of aircraft tax depreciation.  The IRS Chief Counsel’s office on July 13, 2012, released a ruling (CCA 201228036) holding that the “primary” use of an aircraft governs it’s depreciation schedule; and if the aircraft is primarily used for charter purposes, then that necessitates following the slower depreciation method dictated for commercial air transport property, rather than the faster method allowed for non-commercial aircraft.

Commercial vs. Non-Commercial Aircraft Depreciation Schedules

The tax law establishes two different depreciation classifications for aircraft and aircraft equipment.  The first addresses “Airplanes (airframes and engines), except those used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines)”—a classification that typically applies to Part 91 aircraft; and the second addresses “assets (except helicopters) used in commercial and contract carrying of passengers and freight by air”—typically charter or airline aircraft.  (Emphasis added.)  Under most circumstances, non-commercial, US-based business aircraft can be depreciated over 5 years, while the analogous period for commercial aircraft is 7 years (noting, however, that some circumstances can extend these periods to 6 years and 12 years, respectively).

Recently, this distinction between commercial and non-commercial tax depreciation schedules has received more media attention than ever before, owing to President Obama’s much-discussed proposal to move all aircraft to the longer, commercial schedule.  The future prospects for this proposal remain uncertain, although, if it were adopted, it would render moot this Part 91/Part 135 depreciation distinction.

Aircraft owners considering partial Part 135 use, but wary of the potential adverse depreciation consequences, may find some comfort in the following analysis of the actual, economic cost of the move from 5-year to 7-year depreciation.  The below analysis assumes an income tax rate of 35%, and a time-value-of-money interest rate of 5%.  Using these assumptions, it is possible to determine the economic impact of the depreciation change as a percentage of the aircraft price by discounting future tax savings according to the assumed interest rate.  This analysis compares the maximum percentage of aircraft price that can be depreciated each year under the 5-year and 7-year schedules, uses the assumed tax rate to determine the maximum tax savings that could result from the depreciation, and then discounts to present value these future tax savings.  For simplicity, an aircraft cost of $1,000,000 is assumed, although this amount does not alter the value of the 5- vs 7-year schedules, as measured as a percentage of aircraft price.  (One potential point of confusion in the below example is that, due to an accounting convention, the depreciation deductions for property are taken over a span of tax years equal to one plus the property’s life—i.e., 6 years for a 5-year asset; 8 years for a 7-year one.)

Thus, with an actual economic effect (based on the above assumptions) of about 1.2% of the aircraft value, the difference between the 7- and 5- year schedules should not generally dictate the decision whether to place the aircraft on charter—although it will be a relevant consideration.

Primary Use Governs

In its July 2012 Chief Counsel ruling, the IRS held that the primary use of the aircraft, determined on a year-by-year basis, will govern the aircraft depreciation schedule.  Primary use is not swayed by the aircraft owner’s thought process in deciding to acquire the aircraft; rather, it simply looks to the actual flights of the plane, disregarding, in many cases, the fact that the owner’s motivation for ownership is to use the aircraft for Part 91 flights in furtherance of his or her business, with the Part 135 flights being an incidental way of profiting from the aircraft’s excess capacity.  No allocation of the aircraft cost is made between Part 91 and Part 135 use; the primary use governs entirely; an aircraft used 51% for Part 135 is subject to the same depreciation schedule as one used 100%.

The determination of primary use can be made in “any reasonable manner,” although the only methods the IRS Chief Counsel appears willing to consider are flight miles or flight hours during the year—two calculation methods that will almost invariably arrive at the same result.

Year-To-Year Variation

With depreciation schedule governed by primary use, it is possible for a single aircraft to alternate between schedules, year-after-year, as its usage profile fluctuates around the 51%-charter cut-off.  The tax rules for such fluctuations create an insidious trap that, without proper handling, could significantly extend the depreciable lives of changing-use aircraft.

When property undergoes a change in use, resulting in a shift from a shorter depreciation schedule to a longer one, the depreciation starting in the year of the change is determined as though the property had been subject to the longer depreciation schedule ever since the taxpayer first placed it in business service.  Simply stated, if a 5-year, Part 91 aircraft is converted to 7-year, Part 135 use, the effect of that change will be that any remaining future depreciation will be recalculated and stretched out over an additional 2 years.

However, when property changes from a longer schedule (such as 7-year) to a shorter one (such as 5), the default rule is to evaluate the un-depreciated basis of the property in the year of the change, and then depreciate this remaining basis from that point forward as if it was initially placed in service in the change year, under the new schedule.  This, in effect, takes the remaining basis of the aircraft and “starts over” the depreciation on the shorter schedule.  The following examples illustrate this trap:

Example 1: An aircraft is purchased and placed in service in Year 1, and is depreciated under the 5-year, Part 91 schedule up until Year 4, at which time it is transferred to the 7-year, Part 135 schedule.  This results in a recalculation of depreciation, and the remainder of the aircraft cost is depreciated according to the extended schedule, such that it becomes fully depreciated in Year 8 (exactly when it would have become fully depreciated if it had initially been placed in service primarily under Part 135).

Example 2: For Years 1 through 5, the aircraft is depreciated under the 7-year, Part 135 schedule.  In Year 6, it is transferred to the 5-year, Part 91 schedule.  The default rule would treated this as if the aircraft were placed in service anew, under the 5-year schedule.  As a result, the depreciation would occur over a total 10-year period: the 4 Part 135 years, plus the depreciation life of the new 5-year asset.

Fortunately, the tax law provides an election to escape the time-extending feature of conversions of property from longer to short depreciation schedules.  This election has the taxpayer ignore the change in use and continue to depreciate the property under the longer schedule, meaning that the taxpayer neither reaps a benefit from the conversion in use, nor is punished through a longer recovery period.

Conclusion

The disparate rules governing depreciation of commercial versus non-commercial aircraft should be a consideration weighed in any decision to place your aircraft in charter use.  The primary use in each year will govern the depreciation schedule, with no allocation made for a secondary type of use.  Although commercial aircraft are depreciated more slowly, the true economic effect of the difference will often not be so large as to change the commercial decision for the aircraft owner.  This article is not intended as a comprehensive treatment of its subject matter, and there may be important other considerations that have not been raised.  Always seek out a qualified adviser.

July 13, 2012

Jonathan Levy, Esq.

Legal Director

Advocate Consulting Legal Group, PLLC

Advocate Consulting Legal Group, PLLC is a law firm whose practice is limited to serving the needs of aircraft owners and operators relating to issues of income tax, sales tax, federal aviation regulations, and other related organizational and operational issues.

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