© 1998 By Michael P. Fleming

State Sales and Use Taxes. Most states impose a sales tax on the purchase and delivery of an aircraft within the state, and nearly all have a similar tax on use of the aircraft within the state. Many operators take delivery in a tax-beneficial state and wrongly assume that they have avoided state taxation. The state where the aircraft is based usually has sufficient nexus to assert taxation, as well as any state where the aircraft is used to a significant degree. Some states also include leasing activities within the use tax, creating implications for any structure that amounts to a lease of the aircraft. Many states provide exemptions for commercial operators (especially those states where airlines have headquarters or large hub operations), creating a tax benefit for "commercial" operations fitting within the state’s definition. Any sharing (or for that matter any operation) should involve careful state sales and use tax planning, considering all states that could assert a claim.

Federal Tax Issues. Federal tax matters often create the most significant financial structuring concerns. This section briefly addresses some of the more common issues.

Depreciation. Aircraft that are used in a trade or business or for the production of income, primarily operated domestically, and not used in common or contract carriage may be depreciated over a five-year MACRS (Modified Accelerated Cost Recovery System) schedule. Aircraft used in common or contract (such as Part 135) carriage are depreciable under seven-year MACRS. Using a charter arrangement can therefore substantially impact the depreciation allowance.

When property is used partially in a manner that would qualify it for depreciation and partially in a manner that would preclude the ability of the owner to take depreciation, the IRS generally allows depreciation to the extent used in the qualifying manner. For example, if an aircraft is used half of the time for personal use and half in a trade or business of the taxpayer, and the other requirements for depreciation are met, then the taxpayer should be allowed to depreciate 50% of the aircraft. Consider this when involved intensively in Personal Use.

To be eligible for deductions associated with an asset?s use, such as the depreciation deduction, the property in question must be subject to wear, tear, exhaustion or obsolescence. Accordingly, the IRS does not allow depreciation for property (including aircraft) that it considers inventory or stock in trade, determined under a ?principal purpose" test. If the buyer’s principal purpose of purchasing the aircraft is to use it in its trade or business or for the production of income, then the plane is not inventory and the associated expenses and depreciation are currently taken into account. Conversely, aircraft principally held for sale to others, and not for ?use? by the taxpayer in its trade or business or for the production of income, are considered non-depreciable inventory. This issue is particularly relevant in fractional programs and programs using brokers or sales entities.

Passive Loss Limitations. Even if depreciation otherwise is allowed to be taken, the current ability to recognize losses generated from certain activities might be restricted if the activity is deemed to be "passive." For entities that are "flow-throughs" for federal tax purposes, passive loss limitations are imposed at the level of the individual owners. Therefore, if using flow-throughs, review the following sections carefully.

Passive losses can be taken in a tax year only to the extent that they can be used to offset passive gains from other activities. These often do no exist. The tax benefits of these losses are likely to be lost, or at best deferred. Owners of flow-through entities engaged in significant sharing should determine whether they meet the passive loss tests. The issue often arises when the aircraft is placed in a separate leasing company in order to achieve regulatory or liability objectives.

Grouping of Activities. The easiest way to dispose of passive loss problems is to group activities, where allowed, so as to avoid having any passive losses altogether. The IRS gives taxpayers a good deal of discretion in determining which sets of income and deductions to group together as one activity.

The regulations allow for any groupings that constitute ?appropriate economic units for the measurement of gain or loss? in light of all the relevant facts and circumstances. But if the taxpayer’s groupings are determined to be unreasonable or abusive, the IRS may regroup them. Additionally, grouping must be consistent from year to year. Finally, rental and non-rental functions usually must be considered separate activities.

Rental Activities - the Per se Rule. If passive loss concerns cannot be avoided entirely by grouping to prevent losses, determine whether the group of unprofitable activities will be treated as ?passive." Rental activities are especially problematic because the IRS treats them as per se passive. There are six regulatory exceptions to this per se treatment, but they are often difficult to meet. Even if the taxpayer can apply an exception, the inquiry is not over. The individual owner of a flow-through entity must also pass the "material participation" test.

Material Participation. Whether non-rental activities will be considered passive or active depends upon whether the individual owner meets one of the seven ?material participation? tests, applied on an activity-by-activity basis. If the taxpayer materially participates, he or she may treat the non-rental activity as active. The same is true for rental activities, provided that the per se test is passed. In short, if using flow-throughs, especially for leasing, consider passive loss issues carefully.

Capital Gains Treatment. In 1997 Congress passed the Taxpayer Relief Act, lowering the maximum rate of tax levied on long-term capital gains of individuals to 20-28%. The IRS continues to tax ordinary income at rates as high as 39.6%. The character of items of income and loss as either capital or ordinary in the hands of a flow-through entity generally passes through to the individual owners. Operators generally prefer to obtain long-term capital treatment upon the sale of their aircraft.

Gain from the sale of inventory, stock-in-trade or property held primarily for sale to customers is considered to be ordinary income and not capital gain. Conversely, an aircraft owner may obtain capital gain treatment on the sale of non-inventory aircraft. The IRS generally takes the position that where a taxpayer is engaged in both leasing and selling a certain type of property, gain recognized upon the disposition of all such property is ordinary in nature, including property that was previously leased for some period of time. If the sale is considered to be within the normal course of business of the taxpayer, then capital gain treatment will not be allowed.

Similar to the depreciation issue addressed above, the matter arises if a company in the business of buying and selling aircraft holds the plane for sharing purposes. Any company intending to share use should consider its impact on capital gains treatment, along with the other significant federal tax issues discussed above.

Income Tax Treatment. Personal Use of the company aircraft can give rise to income tax liability. See the discussion below.

Liability and Insurance Issues. Aircraft sharers should consider carefully the liability aspects of any arrangement, and ensure that insurance policies allow the activity in question. Similarly, the policy should cover all users (usually the owner is named insured and the others additional insureds). Parties using an aircraft owned by another entity should ensure that they are covered, given notice of termination of the policy, and that the policy contains appropriate clauses protecting their interests. If any complex sharing is planned, contact an expert in aviation insurance in the sharing context. Because many structures created to attempt to minimize liability run afoul of the FAA’s charging limitations (see the discussion below on "flight department companies"), companies generally should approach liability as an insurance, rather than structuring, matter. The greater the degree of sharing, the greater the liability coverage should be, and very extensive sharing might require the purchase of a policy designed, from a liability perspective, to cover charter companies, even though operating under Part 91.

Public Company Disclosure Requirements. Finally, public companies must consider S.E.C. disclosure requirements. For example, individual executives that use the corporate aircraft for personal transportation might have to disclose the arrangement (analogous to a constructive dividend for tax purposes) if they are paying less than fair market value (FMV). This will be discussed further in the section on Personal Use.