The following is a list of some of the aviation related TAX topics and advice Nick has given his clients. Scroll down to topic for a brief discussion.
-Federal and State Income Taxation
-Tax Deductible Use of Aircraft
-Bonus Depreciation and Section 179
-Charitable Use of Aircraft
-Acquisition Sales and Use Tax
-Aircraft Lease Sales Tax
-Death and Inheritance Tax
-Tax-Free Exchanges (IRC Sec. 1031)
-501(c)(3) Tax Exempt Organizations
-IRS Hobby Loss Rules
-Passive Activity Loss Limitations
-Standard Industry Fare Level (SIFL) Deductions
-Taxation of Resident Aliens
-Foreign Earned Income Exclusion
-Income-Tax-Free State Residence
-Residence in an Income Tax Free State
-Real Estate Professional
–Federal and State Income Taxation: Income tax laws generally apply to aircraft in the same way they apply to other assets with tax treatment depending upon the nature of the asset use. The costs of owning and operating aircraft are deductible against the income they earn or contribute toward earning. Aircraft do receive some special attention because they may be considered “listed property.” On occasion aircraft receive special benefits like bonus depreciation, but typically these special benefits are granted for a limited period. Many of the topics of this section relate to income tax.
-Audit Defense: Aircraft seem to be a magnet for tax audits, whether income tax, excise tax, or sales tax. Regarding income tax audits, if aircraft are used for business purposes, especially in instances where the aircraft use is not involved in the principal business activity, as they are in the case of air taxi or an FBO, documenting the business purpose underlying the aircraft use is critical. I remind my clients that a good audit is one in which the paper does the talking. That is, the tax auditor demands support for the client’s tax return and the audit consists of placing documents under the nose of the auditor with a minimum of explanation and personal contact with the auditor.
Taxpayers have extensive appeal rights if they are not satisfied with the auditor’s findings. In federal tax matters, taxpayers can ask for a conference with the agent’s manager, and if not satisfied have their case referred to the IRS Appeals Office, usually just a couple of floors up from the auditor’s cubicle. If the taxpayer is still not satisfied, a petition and $60.00 fee can be filed with the U.S. Tax Court, after which the case is normally referred back to the same appeals officer to settle the case. If no settlement is reached, the case is transferred to the local IRS District Counsel’s Office where an IRS attorney will likely try again to settle the matter. Only after this lengthy process, and only if settlement is not reached, will the case actually to to court. Alternatively, if a taxpayer is willing to pay the tax alleged to be due, or perhaps only part of it, the taxpayer can sue in U.S. District Court. State tax appeal rights and procedures typically mirror the federal process.
–Audit Avoidance: Taxpayers often hear about “red flags” that automatically bring on a tax audit. No one knows exactly what will prompt an audit. The parameters of the IRS’ DIF (differential function) tax return scoring process are closely guarded, and tax return examination “flags” are regionally sensitive. However, a generally know tax return characteristic that may prompt an audit is a self-employment loss when the taxpayer has other significant income. This is particularly true in instances where the activity could be challenged by the IRS to be a mere hobby. See the IRS Hobby Loss Rules topic. Some tax practitioners recommend their clients form “S” corporations to hide those loss activities in a corporation, which may or may not help avoid a tax return examination. Taxpayers considering this option need to weigh the benefit of trying to hide from the IRS against the cost, complication, and potential tax saving limitations associated with operating as a corporation.
–Multi-State Taxation: A common misunderstanding about multi-state activities is that if a person resides, or a business is formed, in a particular state, they do not have to concern themselves about taxation in any other state. In reality if a person or business is earning income that is sourced in a state in which there is taxation, that income is subject to the tax laws of that state irrespective of where the person lives or the business is registered. For example, an Alabama resident individual doing business in Kentucky is subject to taxation by the Kentucky Revenue Cabinet. Similarly, a corporation that is registered and based in Delaware but doing business in Iowa is subject to Iowa taxation. See the Franchise Tax topic, and also the Residence in an Income-Tax-Free State topic.
–Tax Deductible Use of Aircraft: For fixed base operations and air charter, aircraft use is obviously business related. For all other persons and businesses, to be able to deduct aircraft use, the first requirement is that the taxpayer verify the ordinary, necessary, and reasonable aspects of the aircraft use. These three elements pertain to whether in the taxpayer’s circumstances there is a genuine need for the aircraft; and whether there are other less expensive ways to satisfy that need. If these tests are not met, the entire cost of operating and owning the aircraft may be challenged.
Once the ordinary-necessary-reasonable tests are met, the taxpayer’s next burden is proving the primary business purpose of each flight. If the flight involved entertainment, additional documentation requirements must be met to verify the connection between the entertainment and its business purpose.
If aircraft are used only partially for business purposes, a taxpayer will typically determine a business-use-percentage based on business vs. non-business hourly use, and then multiply that percentage times each aviation related expense to determine the deductible business portion of all related costs. A Hobbs meter or tachometer can be used to determine the business versus non-business hours for the business-use-percentage. To preserve deductions for business use of an aircraft it is paramount that contemporaneous records be maintained to document the business purpose of a flight.
–Bonus Depreciation and Section 179: The tax laws respecting aircraft depreciation change periodically. For 2008, and in some instances 2009, up to 50% of the purchase price of new, noncommercial aircraft used more than 50% for business purposes may be deducted in the year placed in service. Section 179 of the Internal Revenue Code allows up to $250,000 first-year depreciation for newly-acquired aircraft used in business. Normal depreciation is allowed in addition to the bonus and Section 179 depreciation.
Not all states follow the federal rules for depreciation.
–Charitable Deductions: Aircraft donated to charity will need to be appraised to determine the amount of the deduction. Aircraft parts may also need to be appraised.
The nature of the charity to which the aircraft is donated will limit of the amount of the deduction. Donations to churches, educational organizations, etc. can reduce by 50% a taxpayer’s adjusted gross income, while gifts to lesser charities allow only a 30% deduction. Charitable deductions do not implicate the alternative minimum tax so a taxpayer should receive full benefit from a charitable deduction. Some states don’t allow a tax deduction for contributions made to charities outside their state.
–Charitable Use of Aircraft: The use of an aircraft can create a charitable tax deduction but the deductible contribution is limited to the direct costs of a flight. The aircraft owner or operator cannot deduct percentages of indirect costs like insurance, hangar, maintenance, etc. in the way a business deduction is allowed. Direct expenses include not only fuel and oil, but also landing fees, charts purchased for the flight, crew expenses, transient hangar or tie down, etc. Other non-aviation expenses like the cost of a motel or of traveling to and from the airport are also deductible. For example, if the individual volunteers as a warbird crewmember for a charitable organization, the books, magazines, aviation seminars, etc. that enhance the crewmembers skills or increases the knowledge of history, those expenses are deductible. Make sure to obtain a receipt or acknowledgment for the contribution, or keep a log of charitable driving and travel costs. Finally, if doing charitable flying, one should be sure to meet commercial certificate requirements and 100-hour aircraft inspections, if applicable.
-Acquisition Sales and Use Tax: State sales tax accrues when an aircraft is purchased in a state having sales tax. Use tax accrues when a newly-acquired aircraft first enters a state that has sales tax and the first beneficial use of the aircraft occurs in that state. Typically states will have civil, and in some cases criminal, sanctions for continued use of their airspace without paying the tax. Often the penalties arise from failing to register the aircraft. In Minnesota it is a felony to base an aircraft in Minnesota without registering the aircraft with the Minnesota Department of Aeronautics, and the aircraft can’t be registered until the Minnesota Department of Revenue verifies that the tax has been paid–or that no tax is due. If an aircraft owner can verify to the state in which the aircraft is based that tax was paid to another state, typically the tax already paid to another state will generate a credit against the tax owed.
Where an aircraft is based typically determines where the sales or use tax is due. However, some states, like Virginia, consider an aircraft to be based in Virginia if it has spent more than 60 overnights in Virginia during a year, and thus is subject to Virginia sales or use tax. This is true even if the aircraft is legally based elsewhere.
Many states exempt all aircraft from sales/use tax, or have only very minimal sales/use tax. Other states exempt the casual sale of aircraft—given specific requirements.
Forming a corporation or LLC in a sales-tax-free state to own an aircraft that will be based in a state having sales tax can sometimes escape taxation, as long as the aircraft is not discovered by the tax-state officials. Some states, like California, order airport tower operators and airport managers to provide tail numbers to county and state tax officials for tax collection. Other states will periodically send employees to airports to record tail numbers to see if the aircraft have paid sales or use tax. See the Property Tax topic.
Rather than hiding aircraft, there are often legitimate ways to avoid or mitigate aircraft acquisition sales and use tax, including subjecting an aircraft to lease, or commercial air carrier status, etc. Persons using the lease option need to be wary of a lease that can be construed to be a purchase document in disguise. Some states will treat a lease that extends for more than three years to be a purchase document and will sales tax the aircraft based on the market value of the aircraft on the date the lease was executed.
Aircraft buyers intending to legally avoid acquisition sales tax by leasing the aircraft to others should be certain to obtain a sales tax number from the state in which the aircraft is to be operated. Michigan will not let an aircraft buyer intending to lease the aircraft to others avoid acquisition sales tax unless the buyer had a sales tax number well before the aircraft was acquired. See the Aircraft Purchases and Sales topic.
If by whatever means an aircraft buyer legitimately and successfully avoids acquisition sales/use tax, many states, like California, will audit the aircraft buyer’s financial and flight records to determine if the sales tax exemption was bona fide.
Some states, like Washington, will consider the contribution of an aircraft owned by an individual to an LLC or corporation also owned by the same individual to be a sales taxable transaction. Most states will not consider this a taxable transaction as long as the person owning and contributing the aircraft to the LLC or corporation if the person owns at least 80% of the entity receiving the aircraft. However, some states, like Minnesota, will consider it a sales taxable event if the transaction goes the other way. That is, when the aircraft is transferred from the business to the individual.
Most states will consider transfers of an aircraft between a revocable trust and the trust grantor to not be a sales taxable event since a revocable trust in most cases is not considered a separate for legal and tax purposes.
–Aircraft Lease Sales Tax: As with aircraft acquisition sales/use tax, there is a great disparity in the way the several states tax aircraft leases. Typically, if a pilot is provided with the aircraft, no sales tax accrues on the aircraft lease. In some states, like South Dakota, sales tax is imposed on an aircraft lease even if the aircraft is used for charter.
–Property Tax: Many states that don’t have sales/use tax on aircraft will impose an annual county property tax that eventually will exceed the sales tax imposed by a sales-tax state. Those states often have mechanisms to find and tax aircraft, as explained in the Acquisition Sales and Use Tax topic.
-Excise Tax: Federal excise tax is imposed on chartering aircraft as a percent of charter revenue plus a flat charge per flight leg to a rural community; or on a cents-per-gallon basis for commercial and non-commercial use of aviation fuels and gasoline. Aircraft owners that make their aircraft available to charter operators need to be certain to maintain control over the aircraft lest the IRS tries to impose excise tax on all of the aircraft’ flights, including those where the aircraft owner is a passenger. Lately the IRS has tried to excise tax interchange agreements between companies that share the use of each other’s aircraft.
–Franchise Tax: State franchise tax is typically another way of describing a state’s corporate or business income tax. The tax is often computed as a combination of percentages that may be applied to gross revenues, wages, and net income of a business.
The franchise tax is a good example of where a Nevada corporation, for example, doing business in Tennessee will be subject to Tennessee tax, even though the corporation is formed and is based in Nevada. See the Multi-State Taxation topic.
–Gift Tax: Gift tax is generally misunderstood by the public. It is a federal tax that is imposed on gifting to non-charitable recipients when the gifts aggregate during one’s lifetime to over $1 million. Most people believe they can gift up to $12,000 per year to a person but don’t understand what happens if they exceed that amount. In reality, according to laws expiring in 2010, gifts over $12,000 annually to any one recipient only require filing a gift tax return, and no tax is due unless one’s lifetime gifting of over $12,000 per recipient exceeds $1 million. There is no limit to the number of gifts under $12,000 that can be made to different recipients. The $12,000 amount increases to $24,000 for married couples that file gift tax returns.
–Death and Inheritance Tax: Death tax is imposed on the estate of a decedent; inheritance tax is imposed on the beneficiary of a decedent’s estate. Current federal death tax law is in effect until 2010, and a person can die in 2008 with a taxable estate of $2 million and owe no death tax. The amount increases to $3.5 million in 2009.
–Tax-Free Exchanges (IRC Sec. 1031): Aircraft that are held for investment purposes and have appreciated in value can be traded for other business/investment aircraft without creating a taxable event. Similarly, aircraft that have been used in business can be traded for other business/investment aircraft without creating a taxable event resulting in depreciation recapture. These exchanges are also called “like-kind exchanges.” A tax-free exchange occurs when the aircraft are traded. If funds are exchanged, the seller typically must use a qualified intermediary to receive the funds to not create a taxable event. Normally the replacement property needs to be identified within 45 days, and received within 180 days, of the date the property given up is surrendered.
–501(c)(3) Tax Exempt Organizations: Persons and businesses can fairly easily form federal tax exempt organizations, but before doing so they should determine whether there are better ways to accomplish their goals. Not all tax exempt organizations are charities to which contributions are tax deductible. Also, tax exempt organizations have tax return filing requirements, called information returns, for which penalties for failing to timely file the returns can exceed those of a for-profit corporation. Finally, there are other entities, like corporations electing “S” treatment, that can effectively avoid income tax and may be preferable to a 501(c)(3) organization.
–IRS Hobby Loss Rules: The IRS’s hobby loss rules, or Internal Revenue Code Section 183 rules, prevent a person from deducting a loss from an activity that is not engaged in for profit. The IRS targets activities involving what might be considered hobbies, like those involving horses, cattle, the arts, and of course airplanes. To determine whether an activity is a for-profit business, the IRS looks to Treasury Regulation Section 1.183-2(b), which identifies nine points of profit motive analysis.
–Passive Activity Loss Limitations: If taxpayers are involved in activities which are of a passive nature, taxpayers cannot deduct losses that may arise from the activity until the activity is abandoned and the assets, if any, are disposed of. Other tests apply like requiring taxpayers to have a minimum amount of participation in the activity. By definition, rental and lease income are passive, unless certain requirements are met. When aircraft lease revenues are collected by aircraft owners, and if the activity generates a loss, the owners are not able to deduct the losses until the aircraft is sold or otherwise disposed of. One way to avoid the lease limitations is to have short-period rental of the aircraft that avoids the automatic passive activity designation. Similarly, instead of drafting a lease, taxpayers can use marketing agreements. Further, if the lease is not a financial lease, but rather has as its only purpose meeting FAR operational control requirements, taxpayers have a good argument for avoiding the passive loss limitation rules.
–Standard Industry Fare Level (SIFL) Deductions: Companies owning and using aircraft for business purposes can provide fringe benefits to employees and have the employees impute into their personal income what may be a small amount based on a cents-per-mile computation for employee use of company aircraft. The IRS periodically issues rulings to adjust the amounts to be reported by employees; Revenue Ruling 2008-48 is an example.
–International Taxation: International taxation is a very complicated area of tax law. Most countries have treaties with the U.S., the purpose of which is to avoid double taxation by the participating countries. Typically when a U.S. business operates in another country they are subject to the tax laws of that country, and the IRS will give the company a credit against U.S. tax for foreign taxes paid.
–Taxation of Resident Aliens: Foreign born persons who reside in the U.S., or who work in the U.S. for more than a period of limited duration or purpose, are subject to U.S. taxation as is any U.S. citizen. Those persons are U.S. taxable on their world-wide income irrespective of where that income is earned.
–Foreign Corporations: Foreign corporations having income that is effectively connected to a U.S. trade or business are taxed in the U.S. as a “C” corporation and file federal Form 1120F to report their income. Passive income of a foreign entity in the U.S. may be taxed at a 30% flat rate.
–Foreign Earned Income Exclusion: The foreign earned income exclusion allows U.S. individuals having a tax home in a foreign country to exclude from U.S. taxation $87,600 (2008) of income earned in a foreign country. To begin to qualify the person must either spend 330 days per year in the foreign country (or countries), or become a bona fide resident of a foreign country (or countries). To qualify for the latter test individuals must also not have an abode in the U.S. which they continue to use as their residence. Recently the IRS has been challenging the exclusion for flight time over international waters because income earned there is not earned in a foreign country.
–Bankruptcy: Bankruptcy doesn’t normally result in the discharge of a taxpayer’s income. However, there are certain circumstances in which income taxes are dischargeable, e.g. when a taxpayer files for bankruptcy more than three years after filing a timely tax return and still has tax due, or when a taxpayer files for bankruptcy more than two years after filing a late tax return and has tax due. Bankruptcy will temporarily suspend the collection of income tax, but it will not automatically discharge income tax due. Discuss with your bankruptcy attorney the possibility of filing two tax returns for the year in which you file for bankruptcy under IRC Section 1398(d). Doing so may result in your unpaid taxes being paid before other creditors are paid.
–Debt Forgiveness: If debt is forgiven, as in a foreclosure on property with the debt not being paid in full, the amount canceled or forgiven must be included in the debtors taxable income. However, if the debt is discharged in bankruptcy, or when the taxpayer is insolvent, the debt cancellation is not taxable to the debtor. Although unrelated to aviation, the Mortgage Forgiveness Debt Relief Act of 2007, which was extended through 2012, excludes from federal taxation up to $1 million per person of debt discharged on a principal residence.
–Residence in an Income-Tax-Free State: There are several states within the U.S. that have little or no individual income tax. They are, east to west, NH, FL, TN SD, TX, WY, NV, WA, and AK. Establishing or maintaining residence in those states can be accomplished with a little care and planning. The states that have income tax can obviously tax their own residents, but they can also tax nonresidents that have income earned in their states. States have the power to income tax persons who are either physical residents or domiciliary residents. Physical residents are typically those who spend more than 183 days in the state and who also have an abode in the state. Domiciliary residents are those whose hearts lie (my words) in the state. It doesn’t matter how much time a domiciliary spends in a state; if that state is truly where they wish to be, then that state can tax that person irrespective of where the person works or spends time. Some states have reciprocity, which means they will not income tax residents of each other’s states. Most states will give their residents a credit for tax the person pays to another state. See the Multi-State Taxation topic for a discussion regarding operating a businesses in more than one state.
Nick wrote a 50-page booklet on this topic that he sells.
–Real Estate Professional: Persons who consider themselves to be real estate professionals may be able to consider their hours flying their aircraft to meet the material participation hour requirements to avoid the passive loss limitation rules that would otherwise suspend the deduction of their real estate losses.