Tax Depreciation of General Aviation Aircraft

Businesses throughout the country routinely make use of general aviation aircraft to provide travel and communication efficiencies that provide them with an important competitive advantage.  As part of a general Congressional approach to encourage business investments, the Tax Code allows a rapid depreciation schedule for aircraft that allows owners to fully write-off purchase/acquisition costs over a period of time (usually five year) that is far less than the economic life of an aircraft.

The depreciation period is governed by the Tax Code’s “modified accelerated cost-recovery system” (known as “MACRS”), which allows deduction of a percentage of the purchase cost in each year, starting when the aircraft is placed into business service.  The deduction schedule is typically, as follows:

This schedule generally applies to aircraft that are predominately based in the United States, used more than 50% for qualified business use, and not used primarily in the commercial carriage of passengers (i.e., typically, airlines or Part 135 charter).  Business aircraft that do not meet these criteria are generally also eligible for depreciation deductions, although they will be calculated under a different yearly schedule.  Also, taxpayers who, in the year the plane is placed in service, make more than 40% of their total capital investments in the last quarter may need to apply a slightly different schedule.

Although these depreciation deductions provide a great benefit to those who are diligent in preparing their taxes, they also present a potential trap for the unwary.  A general tax rule is that, if a person purchases property for $X, and then sells it for a greater amount, $X + $Y, that person will owe taxes due to the boon received in the sale—taxes on the $Y of gain.  When property that is eligible for depreciation deductions, those potential deductions are treated as reducing the purchase price $X for later gain-at-sale calculations.  Note that the prior sentence looked to whether the property is eligible for depreciation, not whether depreciation was actually claimed on a tax return.  As the IRS recently put it, “even if no depreciation deduction was taken, the net profit or loss on the disposition of the property must be computed as if depreciation was actually taken.”  FS-2006-27 (reaffirmed 8/14/2012).

If properly accounted for, the accelerated nature of tax depreciation represents a great incentive to use general aviation aircraft in business.  However, if excluded from a tax return, it stands as a potential tax trap for the unwary.

Expensing of Improvements

In 2014, an expensing election under Tax Code section 179 can be useful to deduct up to $25,000 of improvements to business equipment, including aircraft, for taxpayers whose total annual investment in such equipment does not exceed $200,000.  For taxpayers with investment over this limit, the $25,000 is reduced dollar-for-dollar to the extent that equipment investment surpasses the $200,000 ceiling.  Improvements only qualify for this expensing election if the aircraft in question meets a set of requirements similar to those needed to utilize the MACRS depreciation method, discussed above.

Proper Business Use and Substantiation is Key

Although Congress and the President are encouraging taxpayers to invest in new property purchases under these incentive provisions, taxpayers must exercise extreme care to sustain the deductions under IRS scrutiny.  The IRS has a number of tools at its disposal to claw back tax savings so graciously provided by the legal tax incentives.  Some of the more common attacks include the following:

1. The aircraft is a hobby, not a business at all – the substantial tax savings available under these incentive provisions can actually provide fodder to the arsenal of the Service in asserting the transaction was tax motivated rather than business driven.
2. It’s a passive activity and therefore deductions are limited to this undertaking – common industry practice is to hold an aircraft in a special purpose entity for business and liability reasons.  Income tax laws provide for grouping elections that must be meticulously complied with to avoid having the airplane activity be treated on a stand-alone basis.
3. Personal entertainment use of the aircraft by owners may reduce allowable depreciation – in 2004 Congress passed legislation limiting deductions of aircraft used for personal entertainment of owners and key employees.  Great care must be exercised in both the use of the aircraft and its documentation to guard against loss of depreciation deductions due to these limitations.  Proposed regulations also provide for a special depreciation election deduction solely for purposes of computing this limitation.
4. Basis and at-risk limitations – aircraft are often purchased through borrowed funds the debt repayment of which is amortized over many years.  Although funds may be borrowed and repaid in future years without impacting deductibility, limitations exist related to both entity basis and “at-risk” requirements.
5. Other MACRS limitations – there are also restrictions for qualified property impacting related party leasing, business use by shareholders, and domestic use requirements.

As is apparent from the issues outlined above, the assurance of bonus depreciation and enhanced expensing deduction analysis cannot end at the time of acquisition.  Although the acquisition of a new aircraft may be an effective business tool, the tax benefits must be carefully planned, documented, and defended.  Federal Aviation Regulations also impact issues relating to ownership, registration, operation, and compensation.  These regulations must be integrated into aircraft tax and liability issues.

This information is general in nature and purchasers are encouraged to seek experienced legal counsel in aircraft acquisition planning and implementation.

January 20, 2014

Jonathan Levy, Esq.

Legal Advisor

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.

IRS Circular 230 Disclosure.  New IRS rules impose requirements concerning any written federal tax advice from attorneys.  To ensure compliance with those rules, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under federal tax laws, specifically including the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.