Answers for Pilots: Tax Time

March 1, 2013

AOPA’s online publication, The Pilot’s Guide to Taxes, has recently been reviewed by author, pilot, attorney, and CPA, Raymond Speciale for the 2012 tax year. Two sections have some updates – on the “hobby loss rule” and on aircraft depreciation – that may be helpful to you as you work with your tax professional to prepare your IRS documents.

The hobby loss rule
The hobby loss rule applies to individuals, LLCs, and subchapter S corporations. If the IRS determines that your aviation activity is a hobby, expenses related to the activity are generally deductible – but only to the extent of the gross income from the hobby activity. Essentially, the IRS is saying that it's not going to allow a write-off of losses you've incurred while engaged in a hobby.

The challenge is often determining whether you are engaged in an activity for a profit under the IRS standards. The IRS regulations say that when making a determination as to whether an activity is engaged for a profit, it will look to all of the facts and circumstances of each case.

Some aircraft owners who use their aircraft for business purposes, place the aircraft in a separate business entity in an effort to mitigate liability exposure (this is often an ineffective strategy due to the fact that the aircraft is operating in the furtherance of an underlying business enterprise anyway) or for other business reasons. One unintended consequence of operating an aircraft out of a separate entity and leasing it to the entity that performs underlying business functions is the potential triggering of the hobby loss rule for the entity owning the aircraft. This is typically due to depreciation taken on the aircraft that causes a tax loss. These tax losses may trigger closer IRS scrutiny.

The IRS has taken the view that when it looks at profit motive, it will look to the particular entity that is generating the loss. When the IRS takes that approach, the aircraft owning entity may encounter difficulty when attempting to push back on a hobby loss challenge.

The following two cases, newly added to The Pilot’s Guide to Taxes, provide some insight into the logic behind the Tax Court rulings dealing with the question of hobby losses and separate entities housing aircraft.

Morton v. United States, 107 A.F.T.R. 2d Par. 2011-1 U.S.T.C.

Peter Morton, co-founder of the Hard Rock Café, owned and/or controlled several businesses related to the Hard Rock Café. One of these entities was a subchapter S corporation that owned and operated a Gulfstream jet. This S corporation was not profitable. However, the aircraft was used in connection with the profitable businesses of his other holdings.

The IRS took the position that the S corporation operating the Gulfstream was a “hobby” as per Sec. 183 of the Internal Revenue Code. Morton countered that he should be able to deduct all aircraft related expenses because all of his businesses were part of a “unified business enterprise” that should be looked upon as an aggregate.

The court ruled in favor of Morton on the hobby loss issue. In its ruling, the court stated that the “unified business enterprise” theory was applicable. The court further held that “[a]s long as [Morton] used [the aircraft] to further a profit motive in his overall trade or business, the deduction is allowed.”

Rabinowitz v. Commissioner, T.C. Memo 2005-188

In this case, the Tax Court wrestled with the question of whether a separate company operating an aircraft in an unprofitable charter business should be evaluated independently of its owner’s profitable clothing business when determining whether hobby loss rules apply to the air charter business. In making its determination, the Tax Court considered the following factors from Treasury Regulation Section1.183-2(b):

  1. Whether the undertakings share a close organizational and economic relationship;
  2. Whether the undertakings are conducted at the same place;
  3. Whether the undertakings were part of the taxpayer’s effort to find sources of revenue from his or her land;
  4. Whether the undertakings were formed as separate businesses;
  5. Whether one undertaking benefited from the other;
  6. Whether the taxpayer used one undertaking to advertise the other;
  7. The degree to which the undertakings shared management;
  8. The degree to which one caretaker oversaw the assets of both undertakings;
  9. Whether the taxpayer used the same accountant for the undertakings; and
  10. The degree to which the undertakings shared books and records.

In Rabinowitz, the Tax Court ruled that the clothing and aircraft charter businesses should not be treated as one activity for the purpose of applying the hobby loss rule. Nonetheless, the court did rule that the aircraft charter business was established and operated with a principal purpose and intent of generating a profit. Therefore, the hobby loss rule was not applicable.

As is usually the case, working with experienced and qualified legal and tax professionals is necessary when planning for how a business aircraft should be owned and positioned within an underlying business or multiple businesses.

Depreciation 

"The American Taxpayer Relief Act” extends 50 percent bonus depreciation through tax year 2013. In some instances it extends bonus depreciation through 2014 (for designated transportation equipment). In order for new aircraft and equipment to qualify for bonus depreciation, they must be original or first-use aircraft (or equipment), used primarily for business purposes, and must also meet existing tests necessary to qualify for accelerated depreciation under MACRS. If your aircraft is not used predominantly (50% or more) on an annual basis in your trade or business, the aircraft will be depreciable only under the straight line alternate depreciation system (ADS) method and is not eligible for bonus depreciation. 

If you purchased an aircraft (used or new) in 2012, you may qualify for a Section 179 deduction, which allows for an election to deduct or expense the cost of an aircraft. Under current law, if you purchase a new or used aircraft that is used in the active conduct of a trade or business, a special election may be made to take an immediate deduction of up to 100% of the first $500,000 of aircraft price for 2012 (and extended into 2013). This election is subject to a number of limitations, including a dollar-for-dollar reduction for an aircraft placed in service which costs in excess of $2,000,000 for 2012 (which means the maximum investment in a new or used aircraft would need to be less than $2,500,000 to be eligible for a Section 179 deduction). Importantly, the amount of any Section 179 deduction is further limited by the amount of taxable income from your aviation-related activity.

For more complete information, read The Pilot’s Guide to Taxes. While AOPA cannot and does not give personal tax advice, we can direct you to a tax professional for guidance. And, as always, if you have questions, call AOPA’s Pilot Information Center, 800-USA-AOPA (872-2672), Monday through Friday, 8:30 a.m. to 8:00 p.m.