The Role of CDEs Awarded to New Markets Tax Credits

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HOST: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters.

HOST: Welcome to this edition of the Cherry Bekaert Tax Beat podcast. Today we are talking about the tax rules for companies that own private aircraft. In February the IRS announced a program to start auditing personal use of company-owned aircraft, targeting company owners and key executives. This continues IRS recent actions to step up examinations on high-net-worth individuals.

HOST: Joining in today's conversation is Mike Grim. Mike is director with our state and local tax team, specializes in resolving controversy issues between taxpayers and tax authorities, and also has extensive experience working with company-owned aircraft.

MIKE GRIM: I'm sitting here in the Louisville, Kentucky office of Cherry Bekaert and looking forward to today's topic. I think you mentioned earlier there might be a horse race nearby in the next day or two.

HOST: There's a certain two-and-a-half minutes that is getting a lot of worldwide attention for the next couple weeks, or at least the rest of this week. It's a lively time to be in Louisville.

HOST: And as always my partner in crime joining me today is Sarah McGregor from Greenville.

SARAH MCGREGOR: Life is great. Glad it's May and we're onto summer topics. I was just thinking about all the private planes probably flying into Louisville for that race and that it's a perfect time to talk about how the costs of all those planes might be handled. I'm sure all are being strictly reported in accordance with IRS regulations.

HOST: The IRS has announced a pilot program — no pun intended — to examine tax returns associated with up to 48 corporate-owned jets. Results of these initial examinations will determine how the IRS may focus further examinations.

HOST: Before we talk about these tax issues, let's start with some background: the big picture of owning and operating a private aircraft. Mike, how would you describe the overall scene for federal regulation and oversight of private aircraft?

MIKE GRIM: Whenever clients come to talk to us, their first question relates to tax. I usually tell people I'm an aviation attorney at cocktail parties because if I say "tax" they'll snooze. They love talking about their planes.

MIKE GRIM: Normally clients come to us, especially if they are not experienced in owning and operating an airplane, and they've heard their buddies say "big depreciation, big tax write-offs" or "I have a big gain I need to address so I need to go buy an airplane."

MIKE GRIM: One of the first things we talk about before we get into the tax issues, especially federal tax issues, is the interplay of the Federal Aviation Administration and their regulations. That is vitally important because how you operate an airplane and how you structure operations can have a tremendous impact not just on the federal tax benefits you're seeking to obtain but also on whether you're legally operating the airplane in accordance with applicable law.

MIKE GRIM: I would love to tell you the FAA and the IRS have similar guidance on what is and is not non-commercial versus commercial operations, but at times they differ. The FAA looks at operational control; the FAA is about flight safety and is trying to figure out who legally has operational control of the airplane. The IRS looks more at possession, command, and control, and there are differences.

MIKE GRIM: For example, the FAA treats an interchange agreement — an agreement between two owners to swap use of airplanes — as non-commercial, but the IRS may treat that as commercial and subject to federal excess tax. That is just one example.

MIKE GRIM: When we're talking to clients about airplanes, I always want to know how they are going to be operating and using the airplane. Are they going to own it in their primary business? That has certain benefits and disadvantages. Are they going to create a special-purpose entity? A lot of clients hear from their lawyers "let's isolate this asset," but how you then manage and most importantly compensate or reimburse that airplane entity is vitally important from an FAA standpoint.

MIKE GRIM: We want to maximize our clients' tax benefits but keep them in compliance with Federal Aviation regulations. An example I give is like a carnival whack-a-mole game: you don't want to solve one problem and create FAA issues that could get the client into serious trouble.

MIKE GRIM: You'll hear references to Part 91 or Part 135; those are references to certain federal aviation regulations that determine what you can and can't do under either non-commercial or commercial operations. Those are important because the IRS uses that nomenclature as well when discussing aircraft ownership and tax issues.

HOST: Mike, now that we've got FAA rules sorted out about how the plane is going to be owned and operated, we have to deal with the IRS issues, which can be pretty complex. Can you talk about some of the key issues the IRS looks at in its compliance reviews?

MIKE GRIM: Even before they announced the new pilot program, if you got an audit with any type of aircraft activity the biggest thing for them has always been the control employee — defined as a 5% or greater owner. They want to see that the control employee is paying income tax on their personal use. That has always been issue number one.

MIKE GRIM: Other things we're seeing more and more review on include bonus depreciation, which can include accelerated depreciation. Currently bonus depreciation is 60%, though it was 100% for several years. This can include using five-year recovery periods.

MIKE GRIM: I'm also seeing a lot of federal excise transportation tax audits. I had two clients earlier this year who received federal excise transportation tax audits. It's challenging when you're meeting with an auditor who doesn't understand Part 91 and Part 135.

MIKE GRIM: We have many new and inexperienced auditors now. I personally like that because I can teach them the right way to do it and improve our clients' audit outcomes. Another major issue is distinguishing personal use from entertainment or business use, because how you use the airplane drives how much of the tax benefits you can take.

MIKE GRIM: If you use a special-purpose entity, the FAA requires that the entity lease the airplane; a single-member LLC cannot legally operate an airplane from an FAA perspective. Setting up a leasing structure, including related-party leasing, can create passive losses, and clients often don't consider that the lease arrangement could be a passive activity.

MIKE GRIM: There are a lot of landmines to navigate to use and report the aircraft from a tax purpose. It may or may not have the benefits a company is looking for, but it does provide benefits in helping key executives manage their business and time more efficiently.

HOST: You mentioned the IRS, but those are not the only tax authorities. You work in our state and local tax team, so can you fill us in on state and local taxes that need to be considered?

MIKE GRIM: If we're brought in early enough in the deal we can try to maximize clients' exemptions or deferrals of certain key taxes, specifically sales and use taxes. Many clients focus on the purchase location of the airplane, which is good for sales tax, but they forget what exemptions or deferrals they have in the state where they're actually going to hangar the airplane. There are use tax benefits to consider.

MIKE GRIM: There are various exemptions like resale or Flyaway exemptions. Some states, like South Carolina, have caps. If brought in early enough, we can plan around some of those issues.

MIKE GRIM: Tangible personal property tax continues to be an issue in certain states. Whether you park the plane in Louisville, Kentucky, or across the river in Clark County at Clark County Airport in southern Indiana could affect property taxes by as much as $100,000 a year depending on the value of the plane. That drive over the river might be worth it to save $100,000 a year, and we can assist with that planning.

HOST: Let's go back to the income tax side. There are really two major issues the IRS focuses on: income inclusion for personal use of the aircraft and expense disallowance. Take the first one: what can you tell us about the income inclusion rules?

MIKE GRIM: Historically, pre-TCJA, the company could deduct commuting expenses even if imputed to the employee. Any personal use of a company-owned asset results in income inclusion, whether it's commuting, weekend trips, medical travel, or entertainment.

MIKE GRIM: One of the benefits is the SIFL rate — the Standard Industry Fare Level — published by the Department of Transportation. It looks at a variety of factors, including the length of the trip in nautical miles, size of the airplane, and number of passengers. It effectively calculates an imputed income amount that can be similar to the cost of a first-class air ticket.

MIKE GRIM: If you've chartered a plane recently, chartering can be $5,000 to $10,000 an hour, while the imputed income that the control employee takes into their W-2 may only be a fraction of that. The control employee does not get imputed the entire expense associated with use of that airplane.

MIKE GRIM: There are different ways to calculate personal versus business use. One method is the predominance test based on occupied seats. For example, in an eight-passenger airplane if four seats are occupied and three are for business, that is 75% business use and predominately business, and you may not have to worry about personal use. We can assist clients in determining income inclusion and commuting calculations.

MIKE GRIM: In our work-from-anywhere world, if a business owner lives in Colorado and commutes to the New York office once a month, that commuting to that work location will count as personal use of the aircraft. The bigger issue is the company historically could deduct the expenses, but with personal use imputed as income the company can lose the corresponding deduction.

MIKE GRIM: At year-end the company looks at all direct operating costs and indirect operating costs like hangar, insurance, maintenance programs, and depreciation, then takes a haircut for personal commuting or personal entertainment. The company loses the benefit of the deduction for the personal portion, while the employee picks up imputed income on their W-2.

MIKE GRIM: For example, if the SIFL value imputed to the employee is $1,000 for a flight but the expenses were $4,000, the company effectively loses the deduction for that $4,000 while the employee reports $1,000 of imputed income.

SARAH MCGREGOR: There is a haircut on the expense side, but if it's a business flight for business purposes, then there is no income inclusion and the expenses are deductible.

HOST: It is costly to own an aircraft, but it provides benefits to key executives. Are there any exceptions?

MIKE GRIM: One minor exception I call the "Taylor Swift exception." If you're traveling on a company airplane for security reasons, the company may be able to retain the deduction. You still have imputed income, but you generally must have a security plan. High-net-worth individuals with safety concerns could qualify under that exception. It also applies to travel in and out of high-risk areas, such as unstable environments where you need to move personnel safely.

HOST: Mike, pull out your crystal ball: what is the IRS going to be doing on these pilot audits, and what should they be looking for?

MIKE GRIM: They'll be looking at flight logs. It's best practice to begin capturing contemporaneous flight logs that document the business purpose of each flight. You need to maintain flight logs from an FAA perspective anyway, but you should contemporaneously document the business purpose.

MIKE GRIM: Most clients fly between the same city pairs, especially for commutes, but if you legitimately fly to Turks and Caicos or Las Vegas for business, document it contemporaneously. Auditors will look at flight logs and ask questions about the nature of the trip, and that's why rules about how you characterize a trip on a per-seat basis or flight basis are vitally important. We should be involved from the outset on these audit issues.

HOST: It seems there is a lot of administrative effort on the front end to keep recordkeeping, accounting, and payroll straight. What questions should a business owner consider before acquiring a plane?

MIKE GRIM: Talk to a professional to fully understand the interplay between FAA guidelines, IRS tax issues, and state and local tax concerns. It truly needs to be a holistic review because how it is structured is vitally important to get all benefits and advantages possible, and there are going to be tradeoffs.

MIKE GRIM: Talk to a professional who understands the interplay between the FAA, the IRS, and state and local tax issues so they can maximize your benefits and minimize shortcomings.

HOST: Mike, any final comments?

MIKE GRIM: Even if you're a pre-existing aircraft owner and have been using airplanes for years, it's always good to have a gut check. We did that with a client earlier this week and found a couple of things they could improve to strengthen their position from an audit perspective. Even seasoned aircraft owners and operators could benefit from a review.

SARAH MCGREGOR: I agree. Owning an aircraft in a company has a lot of positives, but the company and its key executives need to walk through the guidelines and document carefully. The better the documentation and the more contemporaneously it's recorded with the flight event, the better it will be if the IRS or a state comes calling.

SARAH MCGREGOR: We've always known that if you have a company-owned airplane you will draw a question on an IRS audit; it will be at the top of the list. It's going to be even more heightened and may prompt an audit just for having the plane. It's not for the faint of heart if you're going to own it and take significant deductions.

HOST: That's a wrap on this discussion of tax reporting issues for income inclusion and expense disallowance for company-owned aircraft. A quick disclaimer: we are not providing tax advice on this podcast. Please consult with your tax advisor, hopefully at Cherry Bekaert, for your specific tax issues or to discuss information from today's podcast.

HOST: Check out the firm's website at cb.com for the latest guidance and materials on this and other tax and business topics. This concludes today's podcast. Please like, share, and subscribe.

HOST: Thank you, Mike, and thank you to our listeners for spending time with us.

MIKE GRIM: Let's call it a day.

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