January 14, 2019
Deducting the price tag of a private aircraft under the new 100 percent bonus depreciation rules is an intriguing idea, but it takes some effort. Planned correctly, a prospective aircraft owner can pocket a meaningful amount of cash related to purchasing almost any size and model of aircraft, whether new or pre-owned, including a fractional share of an aircraft.
Knowing About the Source of the Depreciation Benefit
The 100 percent bonus depreciation benefit arises under the Tax Cuts and Jobs Act of 2017, H.R. 1, enacted on Dec. 22, 2017, (the Act), and is now integrated into the Internal Revenue Code (IRC). The Act temporarily allows 100 percent bonus depreciation starting Sept. 27, 2017, and ending Dec. 31, 2022. Bonus depreciation will then phase down 20 percent per year for five years to a zero bonus. The IRS issued proposed regulations for 100 percent bonus depreciation on Aug. 8, 2018. When final, the regulations should help provide some clarity around certain ambiguous provisions in the Act.
Understanding Depreciation for Business Aircraft
Depreciation is an allowance Congress enacted to encourage businesses to purchase ngible personal property, including private aircraft. Depreciation allowances provide that business taxpayers may claim an annual tax deduction to recover the cost or other tax “basis” (adjusted cost) of the property for its wear and tear, deterioration or obsolescence.
Aircraft owners can depreciate an aircraft’s cost or other basis by using the straight-line depreciation method under the Alternative Depreciation System (ADS) or by using the Modified Accelerated Cost Recovery System (MACRS). MACRS is used to recover the cost or other basis of most business and investment property and recovers the cost of eligible property faster than under the straight-line method.
Straight-line depreciation divides up the aircraft cost or other basis in equal parts each year during the prescribed write-off period (called the “recovery period”) of the aircraft until the aircraft has been fully depreciated. The primary use of the aircraft determines the applicable recovery period.
For an aircraft used only by the owner privately, the recovery period is six years under the ADS compared to five years for aircraft and certain helicopters under MACRS. For commercial use aircraft, including aircraft used to fly charters, the recovery period is 12 years under the ADS compared to seven years under MACRS.
An aircraft that qualifies for MACRS should be eligible for 100 percent bonus depreciation in the year in which the taxpayer places the aircraft in service. Even if the aircraft is eligible for 100 percent bonus depreciation, the aircraft owner can still elect straight-line depreciation under the ADS, regular accelerated MACRS according to a schedule prescribed by the IRC (excluding the “bonus”), and 50 percent bonus depreciation – but only for aircraft acquired before Sept. 28, 2017, and placed in service before Jan. 1, 2018. The increase to 100 percent bonus depreciation applies to property placed in service after Sept. 27, 2017.
Qualifying for Bonus Depreciation
The IRC imposes certain requirements on private aircraft use to qualify for MACRS and, by extension, 100 percent bonus depreciation. The IRC includes private aircraft in a special category called “listed property” along with certain other property, like vehicles and computers, that an owner can use personally and for business. To qualify for 100 percent bonus depreciation, the owner must “predominantly” operate the aircraft in “qualified business use.”
Predominant use is a critical element that refers to using the aircraft 50 percent or more of flight time. Qualified business use, in general, refers to the aircraft owner (an entity or individual) flying its aircraft in a “trade or business.” Also a critical aspect of tax planning, “trade or business” generally refers to a business enterprise conducted regularly and continuously for income or profit – such as operating a manufacturing plant. The IRC establishes a complicated calculation to achieve the status of qualified business use, which merits careful analysis.
Among other requirements, the aircraft owner must not use the aircraft predominately outside the U.S. – an important restriction for large cabin aircraft that travel globally. Also, the owner must not have used the aircraft before acquiring it or acquire the aircraft from a related party, such as a family member.
Illustrating the Use and Loss of Eligibility for Bonus Depreciation
To illustrate one type of situation, consider that, in 2018 “Fast Food Co.” makes $5 million of ordinary income, which is reported on Form 1120S, an S-Corporation tax return. Fast Food Co. buys a $2 million aircraft in December 2018 to travel between multiple cities. Assuming the aircraft is eligible for 100 percent bonus depreciation, Fast Food Co. issues a federal tax Form K-1 to the sole owner/stockholder, who may then deduct $2 million on his tax return in 2019 for the 2018 tax year.
At a 37 percent tax rate (the highest individual tax rate under the Act), the owner can effectively reduce such taxable income by up to $2 million to a net taxable income of $3 million (not considering other tax deductions or taxes). The tax savings is approximately $740,000 cash in the owner’s pocket, thanks to 100 percent bonus depreciation ($2 million x 37 percent tax rate).
If the aircraft loses its eligibility for MACRS depreciation anytime during the aircraft ownership period, the IRS can apply “recapture” rules to add back to owner’s ordinary income an amount equal to the “excess depreciation” over straight-line depreciation. The add-back would occur in the year in which the aircraft use fails to qualify for MACRS.
At a 37 percent tax rate, the payback to the IRS on the $2 million write-off could be significant for the owner. The tax on the excess depreciation amounts to the difference between 100 percent depreciation of the cost or other basis taken in the first year and the much smaller write-off of approximately equal amounts over the aircraft recovery period between six years for private use and 12 years for commercial use (e.g., $2 million/six years = $333,333/year instead of $2 million in year one).
Using Aircraft for Entertainment and Other Personal Use
Despite planning for qualified business use, most aircraft fly for personal use reasons (e.g., entertainment, amusement or recreation). Owners cannot take depreciation deductions for the flight hours or miles devoted to such personal use, but some depreciation write-offs should remain available if the aircraft is still used predominantly for qualified business use. Aircraft owners must calculate the percentage of personal use relative to business use by noting the names of each person on board, the reason for the travel, the hours and miles of travel and other information.
These calculations determine the entertainment “disallowance” – a part of the cost or other basis of the aircraft that the owner cannot depreciate. Importantly, aircraft owners should be aware of a special rule in the IRC that minimizes the negative effect of the entertainment disallowance for owners who claim 100 percent bonus depreciation.
Planning for Use of 100 Percent Bonus Depreciation
Because each aircraft owner is likely to have a complex tax situation, each owner should engage knowledgeable tax advisors, typically an aviation tax accountant and lawyer, to propose the optimal tax plan. The advisors should analyze such factors as the taxpayer’s organizational structures (individual, S Corp, LLC or C Corp), types of qualified business use, tax rates and any net operating losses (NOLs), timing and types of income, potential for excess business losses affecting single and married taxpayers (new under the Act) and anticipated personal use of the aircraft. Ultimately, an owner’s best path may be to bypass MACRS or 100 percent bonus depreciation if the straight-line depreciation method produces a better tax result.
Further, each aircraft owner should (1) keep detailed flight and passenger records, (2) develop flight planning that conforms to the tax strategy involving the aircraft, and (3) plan for IRS challenges to flying fewer qualified business use hours than necessary to demonstrate predominant business use.
Claiming 100 Percent Bonus Depreciation in 2018
There is still enough time in 2018 to buy and place in service an aircraft or fractional share and take advantage of the 100 percent bonus depreciation. Bonus depreciation is especially valuable toward the end of the year because it’s not long thereafter until a taxpayer can file a federal income tax return and reduce its income by an amount up to the aircraft cost or other basis. However, with 100 percent bonus depreciation available until 2023, it is strongly advisable to choose an aircraft wisely rather than rush to buy the wrong aircraft just so a taxpayer can take the tax deduction in 2018.
Bonus depreciation has generated wide interest in purchasing new or pre-owned private aircraft and fractional shares. Although these purchases take time and planning to close, prospective aircraft owners understand that there is no time like the present to help boost the economy and take flight in a fully depreciated aircraft.