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© McGrath North Mullin & Kratz, PC LLO 2009 Business and Tax Planning for Aircraft Owners and Operators McGrath North Mullin & Kratz, PC LLO First National Tower, Suite 3700 1601 Dodge Street Omaha, Nebraska 68102 www.mcgrathnorth.com

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© McGrath North Mullin & Kratz, PC LLO 2009

Business and Tax Planning for Aircraft Owners and Operators

McGrath North Mullin & Kratz, PC LLOFirst National Tower, Suite 3700

1601 Dodge StreetOmaha, Nebraska 68102www.mcgrathnorth.com

Goals of Today’s Discussion• Overview of typical Aircraft Operating

Structures

• Highlight Key FAA and Tax Issues to Consider in Aircraft Acquisitions, Ownership and Operations

Introductory• Why do people buy airplanes?

– Expensive (Black holes for $$)– Subject to limitations of weather– High probability of IRS audit

• Productivity multiplier– Limited work hours in a day– Face to face meetings are more effective– Non-hub to non-hub airline trip may take all day

• How can you help your company?– Adopt a structure that minimizes taxes– Be aware of special rules– Be careful of Bad Press– Keep good records

Terminology• FAR = Federal Aviation Regulations• Wet Lease vs. Dry Lease (FAA definition)

– “Wet Lease” is lease of aircraft with pilot• Includes charter operations

– “Dry Lease” is lease of aircraft without pilot• Can include fuel, insurance, hangar, etc.• Common assumption = without fuel

• FBO is “Fixed Base Operator”– Rents aircraft to pilots– May fuel, maintain and hangar aircraft

• Charter Company (Air Taxi)– Provides “on demand” air transportation

General FAA Rules• FAA rules govern US aircraft operations

– Primary source of guidance is the FARs• Primary objective is “safety of flight”• Aircraft operations classified by FAR Part

– Part 91 – private operations– Part 135 – charter operations– Part 121 – airline operations

• Most owners use Part 91– More liberal rules– But responsible for “Operational Control”

• i.e. for maintaining and operating aircraft– Rationale? Will operate more safely if at risk

FAA Limitations and Options • Sole Purpose Corporation

– If plane and pilots in separate corporation– Solely provides transportation to others– This is a charter operation

• Even if transport only related companies– Using SMLCC does not help

• To FAA, SMLLC is a separate corporation• Can put plane in leasing company

– Does not protect user from liability– User must lease aircraft from company– User responsible for operational control– “Truth in Leasing” rules must apply

• If Large Civil Aircraft (over 12,500 lbs MGTOW)– Also be careful of the “Same Source” Rule

Also Allowed Under Part 91• Can hire “Management Company”

– Manages aircraft maintenance.– Provides pilots to operate aircraft.– Operational Control is retained by the owner.

• Can lease aircraft to Charter Company– Puts Aircraft on Operating Certificate.– Must maintain aircraft to Part 135 standards.– Crew must meet Part 135 standards.

Also Allowed Under Part 91 (Cont.)

• Other arrangements and operations

– Intercompany flights– Co-Ownership and Joint Ownership– Timeshare – allows limited compensation– Interchange – hour for hour exchange

Other Arrangements and OperationsIntercompany Flights

FAR 91.501(b)(5)(b) Operations that may be conducted under the rules in this subpart instead of those in parts 121, 129, 135, and 137 of this chapter when common carriage is not involved, include-

(5) Carriage of officials, employees, guests, and property of a company on an airplane operated by that company, or the parent or a subsidiary of the company or a subsidiary of the parent, when the carriage is within the scope of, and incidental to, the business of the company (other than transportation by air) and no charge, assessment or fee is made for the carriage in excess of the cost of owning, operating, and maintaining the airplane, except that no charge of any kind my be made for the carriage of a guest of a company, when the carriage is not within the scope of, and incidental to, the business of the company;

Other Arrangements and OperationsCo-Ownership and Joint Ownership

Joint OwnerJoint Owner Joint OwnerJoint Owner

FAR 91.501 (b)(6) and (c)(3)(c)(3) A joint ownership agreement means an arrangement whereby one of the registered joint

owners of an airplane employs and furnishes the flight crew for that airplane and each of the registered joint owners pays a share of the charge specified in the agreement.

Timeshare AgreementAircraft User

FAR 91.501(b)(6), (c)(1) and (d)(c)(1) A time sharing agreement means an arrangement whereby a person leases his airplane with flight crew to

another person, and no charge is made for the flights conducted under that arrangement other than those specified in paragraph (d) of this section.

(d) Reimbursable Expenses(1) Fuel, oil, lubricants, and other additives.(2) Travel expenses of the crew, including food, lodging, and ground transportation.(3) Hangar and tie-down costs away from the aircraft's base of operation.(4) Insurance obtained for the specific flight.(5) Landing fees, airport taxes, and similar assessments.(6) Customs, foreign permit, and similar fees directly related to the flight.(7) In flight food and beverages.(8) Passenger ground transportation.(9) Flight planning and weather contract services.(10) An additional charge equal to 100% of the expenses listed in paragraph (d)(1).

Owner/Operator

Other Arrangements and OperationsTimeshare

Other Arrangements and OperationsInterchange

Owner/Operator B

FAR 91.501(b)(6) and (c)(2)(c)(2) An interchange agreement means an arrangement whereby a person leases his airplane to

another person in exchange for equal time, when needed, on the other person's airplane, and no charge, assessment, or fee is made, except that a charge may be made not to exceed the difference between the cost of owning, operating, and maintaining the two airplanes.

• Hour for Hour Exchange• Charge may be made for differences in owning, operating and maintaining the two airplanes.

Owner/Operator ALease

Interchange Agreement

Lease

Aircraft Taxes• Types of Taxes:

– Federal Transportation Tax (FET)– Federal and State Fuel Taxes– State Sales and Use Taxes– Federal and State Income Taxes– State Property and Registration Taxes

• May Apply to:– Purchase or sale of aircraft– Use and operation of aircraft

Federal Transportation Tax• Applies to “Commercial Transportation”

– Charter; Interco flights; Timeshare; Interchange.– Rate is 7.5% of “Amount Paid”– Add $3.70 “Segment Fee”– In Lieu of Federal Fuel Tax

• Fuel Tax paid is refundable• Fuel Tax is generally 1/3 of Transportation Tax

• Exemptions – FET does not apply to:– Dry Leases

• Not a transportation service– Small Aircraft Not on Established Lines

• 6,000 lbs MGTOW– Certain Related Company Flights

• Generally same as Income Tax “Affiliated Group”– 80% ownership by Common Parent

Federal Transportation Tax• Problem Areas• Audit Tax Guide & Management Company

– Suggests that tax applies to owner flights• If dry lease to Management Company and/or• If Management Company employs pilots• Both are contrary to 50 years of precedent

• Amendment to definition of SMLCC / QSSS– Not ignored for transportation tax purposes– May affect captive Charter Company

Federal and State Fuel Tax• Federal Fuel Tax

– Applies to Noncommerical” transportation– Generally included in price of fuel– Refundable if transportation tax applies

• State Fuel Tax– May be part of sales tax or separate tax– Generally included in price of fuel– May be refundable under special rules

State Sales and Use Tax• Applies to sale or use of property in State

– % of sales price or purchase price • Sales Tax on aircraft usually easily avoided

– Take delivery of aircraft in friendly State• e.g. Aircraft Exemption or Flyaway Exemption

• Avoiding Use Tax is more difficult– Applies if “Substantial Nexus” in State

• If Aircraft “Based” in State• Otherwise, more than 30-60 days in State

– e.g. Irwin Industrial Tool case

– Can apply in more than one State• Generally State will tax entire aircraft

– Must allow Credit for Taxes Paid to Other State

Sales and Use Tax Exemptions• Sales Tax Exemptions

– Flyaway Exemption– Occasional Sale Exemption

• Sales and Use Tax Exemptions– Resale Exemption Exclusion– Occasional Sale Exemption– Aircraft Exemption– Common Carrier Exemption

• But Federal Transportation Tax may cost more– Trade-in Exemption

• Leasing Company– Purchase exempt / lease payments taxed

Sales Tax – Leasing Company• Advantages of Aircraft Leasing Company

– Avoids “Up Front” Tax• Lessor claims Resale Exemption• Lessor charges tax on lease payments

– Greatest flexibility• Can lease aircraft to other users

– Lease not subject to Transportation Tax– Only taxed on own use– Provides protection from other State Use Tax

• Limitations– Generally, lessor must use only for lease

• Cannot use aircraft in lessor business• Some States allow “divergent use”

Sales Tax – Leasing Company (Cont.)• Minimize the lease payment

– If possible, lessee should pay all costs• Fuel, hangar, insurance, repair and maintenance

– May not be practical if multiple lessees• Computing the lease payment

– Essentially includes only “Cost of Capital”– Elements:

• Interest• Obsolescence• Tax Benefits

• Trade-In Exemption– May be able to use in conjunction with lease

• If lessee trades old aircraft to lessor

Sales Tax – Leasing Company Trap• Simplest structure:

– User creates SMLLC– User leases aircraft from SMLLC

• Benefits:– SMLLC ignored for income tax– SMLLC respected for sales tax

• Problem:– Some States ignore SMLLC for sales tax

• AL; MO; SC; TN; WI; Others?– Causes leasing company to disappear

• Possible Solutions:– User should not own SMLLC– Don’t use SMLLC

Sales Tax – Lease Co Trap (Cont.)• Charter company allowed to use aircraft• Typical Arrangement

– Owners pays all aircraft costs, including pilots– Charter Company employs pilots– Parties share gross charter revenues

• e.g. 15% to charter company / 85% to owner• This may be a joint venture and not a lease

– Would not qualify for Resale Exclusion• Lessor using aircraft in charter business

– Owner may have to pay tax on entire aircraft• Even where used for charter

• Solution: Lease to Charter Company

Federal and State Income Tax• Aircraft business costs are deductible

– Costs must be “Ordinary and Necessary”– Aircraft are “Listed Property”

• Greater documentation requirements• Subject to reduction of depreciation deduction

– Subject to “Entertainment Facility” rules• Change effective October 22, 2004.

• Depreciation deduction is “huge”– In 2009, “Bonus Depreciation” rules applied

• Allowed deduction of up to 60% of cost of new aircraft in 1st year– 2010: Can still deduct entire cost over 6 years– Aircraft tend to retain value

• Standard depreciation is around 2.5% per year

Income Tax – Depreciation Items• Depreciation deduction varies

– 5 Year Class – Non-transport aircraft– 7 Year Class – Transport Aircraft

• Listed Property Rules apply to aircraft– Record-keeping requirements– ADS applies if business use is 50% or less

• 25% or less if corporation• ADS might not apply to aircraft leasing company

• Limitations on first year depreciation– Short year (can use SMLLC to avoid)– Acquisition in last 3 months

• Like-Kind Exchanges especially helpful

Like Kind Exchanges• Income Tax

– Use Like Kind Exchange to Defer Gain– Types:

• Simultaneous exchange• Deferred exchange (old aircraft first)• Reverse deferred exchange

– Intermediaries• “Qualified intermediary”• “Exchange Accommodation Titleholder”

• Sales and Use Tax– Generally only simultaneous exchange works

Income Tax – Business Use• IRS tends to question aircraft deductions

– Generate “unreasonably” large deductions– More expensive than airline

• Responses:– Exclude depreciation deduction

• Not a true measure of cost• Enacted by Congress to encourage purchase

– Private aircraft saves time• Time has value

• Helpful case:Stanley M. Kurzet, 222 F.3d 830 (CA10, 2000)

Income Tax – Personal Use• If Sole Proprietorship (including SMLLC)

– Personal use is nondeductible– Can deduct only business use– Deduction includes:

• Direct costs• Allocable percentage of indirect costs

– -Percentages = Business Hours / Total Hours

• If Corporation / Partnership (including LLC)– Employee / Partner taxed on imputed value of use

• Partner reports income as guaranteed payment• Employee reports on employee’s W-2 at end of year• Can use charter value or SIFL method to compute value

– Corporation / Partnership may lose deductions• If “Entertainment Use” by “Specified Individual”• Complicated rules for computing disallowance

Income Tax – Personal Use (Cont.)• SIFL = special aircraft valuation rule

– Treasury Department calculates the equivalent of first class airfare cost per mile semiannually.

– Company calculates SIFL valuation charged to employee based on:• Size of the aircraft (Multipliers for size of aircraft and classification of employee –

larger multiplier for “Control Employee”)• Number of passengers on board• Length of the flight

– Traditional Benefits:• Employee includes SIFL value imputed costs on employee’s personal tax return. SIFL

value generally is a fraction of the actual cost of the flight.• Company may deduct 100% of the aircraft costs. (In Many Cases)

• American Jobs Creation Act of 2004: Disallowance of “Excess Deductions”– Limits the company’s deduction of aircraft costs for “Entertainment Use” flights to the

amount imputed to “Specified Individuals”.• “Specified Individuals” are officers, directors and owners of 10% of any class of equity

security.– The Act does not limit deductions for use by “Non-Specified Individuals”.

• Allowing the continued use of company aircraft for bonuses, awards or incentives.– Different methods to compute deductions.– Use leasing company or charter to mitigate?

Income Tax – PAL Limitations• Cannot currently deduct losses where:

– Rental Activity; or– Do not materially participate in the business

• Might apply to aircraft leasing company• Exceptions:

– Not a rental (e.g. SMLLC leases to owner)– Grouping Rules

• Allows grouping of related activities• Exception: Cannot aggregate rental activity

– Exceptions to that exception:• Identical Ownership Exemption• Rental activity insubstantial to other activity

– IRS says – cannot group with C-Corp

Property and Registration Taxes• Aircraft may be subject to annual tax:

– Property tax (NE, KS, MO, WY)– Registration tax (IA, SD)– None of the above (CO)

• Significant difference in rates– Property tax generally 1-2% of FMV– Registration tax is generally nominal (IA: $5,000 maximum

per year

• Aircraft subject to tax– Property tax – if have “situs” in State– Registration tax – if based in State 30-60 days

Property Tax – Computation• Compute value

– Might use “Blue Book” to compute FMV– Some States use table

• Compute Allocable Value– If “Domiciliary”, then 100%, except:

• Percentage attributable to out-of-state situs• Amount excluded by law

– If “Nondomiciliary”, then:• Only % attributable to in-state situs; or• If better, statutory %

Property Tax – Computation (Cont.)

• Compute “Assessed Value”– Some States use classification

• Determine tax rate– Generally varies by county– Many airports in separate tax district

Property Tax – Exemptions• Types

– 100% Exemption• Business use aircraft (KS)• Personal use aircraft (WY)

– Apportionment• Large aircraft (MO)• Business aircraft (TX)

– Economic development exemption (NE)• Claiming:

– Might claim exemption on return– Might have to file special claim

Property Tax – Aggressive StatesWhy should I care? I’m in Iowa.

• Many States look for untaxed aircraft• Some States take aggressive position

– Especially States with interstate exemption• e.g. Texas and Missouri

• Federal Constitution applies– Aircraft must have “Situs” in State

• Mere landings are not enough• Requires substantial presence (e.g.>30%)

– Determining situs• States tend to look at time on ground; not landings

Iowa Taxes: Typical OperatorAssume: Acquire Used Lear 45: 7 years old

: Purchase Price: $5 million: Leasing Company acquires and leases the Lear to its Operating parent company, which

employs the pilots and operates the plane.

Taxes: Sales/Use Tax: Resale exempt at time of registration: avoids 6% upfront tax: $300,000.Lease payments: $50,000/mo. Are subject to tax on amount paid.

Registration Fees: If based / used in IA 30 days or more: Manufacturer’s list price = $10.2 million

Years from Manufacture Date• Year 1: 1.0% $5,000 maximum• Year 2: .75% $5,000• Year 3: .50% $5,000• Year 4+: .25% $5,000 (applies to aircraft mfg. 4 or more years prior)

Property Tax: None – Registration Fee applies

First year Depreciation: 20% or $1,000,0002nd – 6th Years Depreciation: 39%;10.2%;11.52%;11.52%;5.76%

General Conclusions• If acquiring an aircraft, it is important to adopt a

structure that will minimize all taxes.• Up front tax planning can save tax dollars.

– Requires attention to FAA rules.– Have to consider all taxes.

• Periodically review aircraft operations.– Review usage for tax and FAA problems.– Confirm that company kept good records.

• Aircraft ownership is an opportunity.– For your company to increase productivity.– For you to save tax dollars for your company.

DisclaimerThis presentation should not be considered as legal, tax, business or financial advice. This presentation is designed to provide information about the subject matter covered. It is provided with the understanding that while the speaker/author is a practicing attorney, neither the speaker nor the firm has been engaged by the attendee/reader to render legal or other professional services (unless a specific engagement agreement has been executed). If legal advice or other expert assistance is required by the attendee/reader, the services of a competent professional should be sought.

Circular 230 DisclosureThe following statement is required by the U.S. Treasury Department Regulations: Any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed here.

© McGrath North Mullin & Kratz, PC LLO 2009

Thank You

McGrath North Mullin & Kratz, PC LLOFirst National Tower, Suite 3700

1601 Dodge StreetOmaha, Nebraska 68102www.mcgrathnorth.com