Depreciation of Corporate Aircraft
By : Fern O'brien, Partner, Faegre & Benson LLP

Depreciation of corporate aircraft can provide significant tax benefits to the corporate aircraft owner. Many corporate aircraft are depreciable under the Modified Accelerated Cost Recovery System ("MACRS"). The MACRS statute permits the acceleration of depreciation of certain assets by claiming a greater percentage of the depreciation deductions during the first few years of the applicable recovery period than would result using a straight-line depreciation method.

In some cases aircraft do not qualify for accelerated depreciation under the MACRS system. In such cases, the aircraft, must be depreciated under the generally less favorable Alternative Depreciation System ("ADS"). Depreciation under ADS is based on a straight-line method which results in equal depreciation deductions each year during the applicable recovery period. Recovery periods under ADS are usually longer than recovery periods under MACRS.

The availability and extent of the depreciation for a particular owner depends primarily upon (i) the asset class of the aircraft as established in the Internal Revenue Code and (ii) the use of the aircraft - whether the aircraft is operated under FAA Part 135 or Part 91. Part 135 aircraft which are commercial aircraft and charters (other than helicopters) are considered to be in the asset class 45.00 and may be depreciable under MACRS over a recovery period of seven years or under ADS over a recovery period of twelve years. Part 91 aircraft which are used for qualified business purposes (and helicopters used in commercial and contract carrying of passengers and freight) are determined to be part of asset class 00.21 and have a cost recovery period of five years under MACRS or six years under ADS.

Qualified Business Use

A qualified business use is generally defined as any use in a trade or business for which a deduction would be allowed under IRC § 162. The qualified business use must be greater than 50% of the total use in a given year or the MACRS schedules cannot be used and the aircraft will be depreciated under ADS. In the event the qualified business use is greater than 50% one year and less than 50% the next year, there will be recapture to the extent of the excess deductions claimed under MACRS and thereafter the aircraft will only be eligible for depreciation under ADS.

Certain uses that may seem to be qualified business uses are subject to special rules - if the aircraft (1) is leased to a person (or someone related to such person) who owns 5% or more of the company that owns the aircraft; (2) is used as compensation to such 5% owner or related person; or (3) is used as compensation for any other person unless an amount is included in the gross income of such person and there was withholding if required. These uses will not be treated as qualified business uses for depreciation purposes unless at least 25% of the total use of the aircraft otherwise qualifies as business use.

A Combination of Part 91 and Part 135 Use

Often it is unclear what asset class the aircraft is in because it may be used for business purposes (Part 91) part of the time and available for charter (Part 135) when the corporate owner is not using it. It, therefore, can be difficult to determine the appropriate MACRS recovery period. Treasury regulations specify that when property is used for different purposes at various times in such a manner that the property could potentially be classified into more than one asset class, the property shall be included in the asset class in which the property is primarily used. In the case of an aircraft that is subject to a lease, the asset class is determined based upon the use of the lessee. The regulations do not provide any guidance with respect to a method for determining "Primary Use" but any reasonable method such as total flights, total flight hours or total days of use should be sufficient. Primary use only needs to be determined for the first taxable year during which the aircraft is in service. A subsequent change in the use of the aircraft will not effect the length of the depreciation recovery period.

Personal Use of Aircraft

If an aircraft is used part of the time for qualified business uses and part of the time for personal, non-business use, the depreciation deduction allowable for the taxable year will be the fraction of the otherwise allowable deduction that bears the same ratio as the qualified business use during the taxable year does to all uses of the aircraft during that taxable year. In other words, if the total allowable depreciation deduction for the taxable year (assuming 100% qualified business use of the aircraft), was $1,000,000, but in reality only 75% of the total use was qualified business use, then only $750,000 could be deducted that year. But the depreciable basis of the aircraft would be reduced by the whole amount of $1,000,000 so that $250,000 of depreciation would be lost forever.

The Predominant Business Use Test

Whether an aircraft is depreciated under MACRS or ADS will depend on whether the Depreciable Use or Personal Use predominates. If an aircraft fails the Predominant Business Use Test and is used less than half the time for qualified business use in any given taxable year, the consequences are draconian. First, the aircraft must be depreciated under the ADS system during such taxable year AND all subsequent taxable years. Second, if the aircraft has been depreciated under the MACRS system in prior taxable years, all prior depreciation must be recaptured to the extent that it exceeds the depreciation that would have been taken under the ADS system for all prior taxable years. Finally, any excess depreciation from all prior years that is recaptured will be taken as income in the first taxable year in which the Predominant Business Use Test failed.

Bonus Depreciation Benefits

As a result of the Job Creation and Worker Assistance Act of 2002, the rate of depreciation of new business aircraft was significantly accelerated. Aircraft owners have the option of taking 30% of the depreciable basis in the first year and the remaining 70% of the depreciable basis may be depreciated over the tax life of the aircraft. The Tax Act of 2003 extended the eligibility date for this 30% bonus depreciation so that it now extends to aircraft placed in service before January 1, 2005.

In addition, If your company acquired or will acquire new aircraft after May 5, 2003 and before January 1, 2005, you may qualify for bonus depreciation in the first year of 50% thanks to the 2003 Tax Act. This bonus depreciation also applies to new engines and other capital upgrades.

It is possible for a qualified aircraft to qualify for either the 30% or 50% bonus. An aircraft owner can choose either or may not want to claim either. It is important to note that any acceleration of depreciation benefits the first year necessarily results in decreased depreciation deductions in subsequent years. Tax planning is a crucial component in making this determination. If a taxpayer owns more than one aircraft, the election with respect to bonus depreciation must be followed with all other aircraft in the same asset class.

Depreciation for Fractional Owners

The first owner of a fractional interest in a new aircraft is considered the "original user" of its interest in the aircraft. the fractional owner, therefore, is eligible to depreciate its interest in any of the above ways, including the 30% or 50% bonus depreciation, subject to the same rules and tests as the owner of a whole aircraft.

Depreciation of Engine & Airframe Maintenance

The general rule for the tax treatment of maintenance and incidental repair costs of engines of corporate aircraft is that they may deducted as business expenses in the year in which such cost was incurred. This rule does not apply, however, if the expenses for maintenance and repairs materially add to the value of the aircraft or arrests deterioration and appreciably prolongs the life of the aircraft. These type of expenses must be capitalized and depreciated. It is necessary, therefore, to analyze the effect of the specific repair and/or maintenance on the aircraft to determine the appropriate tax treatment for the cost incurred.

The rule of thumb with respect to engine heavy maintenance has generally been to capitalize the cost based on the position of the IRS that such expenditures increased the value and life of the engine. However, an IRS ruling in 2001 allowed the repair and maintenance of an aircraft airframe as part of a engine heavy maintenance to be deductible as ordinary business expense. The business aviation industry is hopeful that this may signal a trend toward deducting such expenses that will result in deducting engine heavy maintenance costs as well. The conservative course at this time, however, is to capitalize such expenses.

Contact:
Fern O'Brien
Faegre & Benson LLP
(303) 447-7773
fobrien@faegre.com
www.faegre.com