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Taking Accelerated Depreciation? ’Leasing Company Trap’ Can Cause Audit Problems

April 7, 2014

For companies that fly business aircraft, an audit by the Internal Revenue Service (IRS) is not unexpected. Getting a large tax bill after an audit, however, is both unexpected and a serious financial risk – especially for operators taking accelerated or bonus depreciation.

Operators that hold their aircraft in a separate “leasing company” – one of the most common business aircraft ownership structures – could find themselves with such a tax bill because of complex limitations in Section 280F of the Internal Revenue Code that involve personal use.

“The ‘leasing company trap’ can prevent you from using accelerated depreciation or bonus depreciation and force you to use ‘alternative depreciation.’” said John Hoover, senior counsel at Cooley LLP and a member of the NBAA Tax Committee.

What’s the difference? For FAR Part 91 operators, accelerated depreciation is a five-year “double declining balance” schedule, whereas alternative depreciation is a six-year straight-line schedule. For Part 135 operators, accelerated depreciation is seven years, double declining balance, and alternative depreciation is 12 years, straight-line.

Bonus depreciation, a special provision passed by Congress as part of stimulus legislation, allows for certain aircraft purchased during the provision’s window to be depreciated at 50 or 100 percent in the first year.

“The difference between five years and six years may sound small, but it’s a big deal if you took 100 percent bonus depreciation last year and 280F knocks you out of qualifying and bumps you down to six years,” Hoover said. ”It’s a really nasty surprise.”

Personal Use Limitations

Section 280F specifies that for certain types of property (including business aircraft) to qualify for accelerated or bonus depreciation, two tests must be passed:

  1. At least 25 percent of the total use of the aircraft in a year consists of qualified business use, not flights for personal purposes.
  2. The aircraft is predominantly (more than 50 percent) employed in a qualified business use for the year. To pass this test, an owner/operator is generally allowed to count as “qualified business use” personal flights by employees provided as compensatory benefits. The IRS currently maintains, however, that the owner/operator is not allowed to include flights for entertainment use.

“Here’s where it gets complicated for aircraft leased between related companies,” said Hoover. “The IRS, in current audit practice, does not allow operators to count any flights by 5-percent owners or their relatives as ‘qualified business use’ to pass the 25-percent test.”

The IRS does this, understandably, to prevent taxpayers from writing off an aircraft flown predominantly for personal use. “What’s not understandable, is that the IRS accomplishes this by inferring that all flights by 5-percent owners on an aircraft leased to a related company are for personal use,” Hoover said.

It would be more reasonable, he said, to look through the lease structure to the character of each flight. Some flights by 5-percent owners might be for business; others might be personal.

Due to the lack of clarity in the law, many operators incorrectly assume they qualify for accelerated or bonus depreciation and are surprised with large tax assessments.

“You wouldn’t know this trap existed from a casual reading of 280F,” said Hoover. “This is a very complicated area.”

To help aviation professionals better understand the “leasing company trap,” Hoover and fellow Tax Committee member Keith Swirsky, of GKG Law, will discuss this and other audit issues at the NBAA Business Aviation Taxes Seminar on May 2 in San Francisco, CA.

To receive the early-bird rate, register for the seminar by April 10.