Turn bizjet passive losses into tax-time wins
Business jets are expensive to own and operate, so their use has the potential to generate significant tax deductions. Unfortunately, those deductions sometimes turn into passive losses, especially for jet owners who rely on chartering their aircraft as a business activity.
On the face of it, you might think it preferable to have “passive” rather than “active” losses, but the opposite is true. Expenses are supposed to be tax deductible when you incur them in the course of generating income. If you’re not actively involved in generating that income, however, the Internal Revenue Service generally deems the activity “passive” (something of a contradiction in terms) and designates the associated expenses as “passive losses.”
You can use passive losses only to offset passive income. That means you can’t reduce taxable income from an “active” trade or business or from interest and dividends by deducting passive losses. That’s fine if you have gobs of passive income, but otherwise you may be forfeiting substantial tax deductions. The forfeited “losses” include not only the fixed and variable costs of operating the aircraft, but tax depreciation as well. The good news—sort of—is that to the extent you have insufficient passive income, passive losses aren’t actually lost; they’re merely suspended just in case you have sufficient passive income in the future to use them. If you’re carrying passive losses from an activity forward this year, though, there’s a good chance you’ll be doing the same thing next year.
How passive is passive? The IRS defines a “passive activity” as a trade or business in which you don’t “materially participate” or a rental activity. Here’s the problem for jet owners: unless you have your own charter certificate, to charter your aircraft you must in effect lease (rent) it to a charter certificate holder who in turn charters it to its customers, paying you the lion’s share of the revenue. Putting a business jet out for charter, in other words, is almost inevitably a rental activity.
Rental activities are often called “per se passive,” but six exceptions apply to the rental classification, including relatively short average rental periods and the provision of “extraordinary” personal services in the rental business, a key factor in an IRS Revenue Ruling that characterized the lease of a business jet to an affiliated company as “not a rental activity.” The most difficult exception to apply to business jets is holding the aircraft as an investment that you anticipate will appreciate. The IRS might accept that for a B17 Flying Fortress, but not for your G550.
Even if you qualify for an exception from the rental classification, you must still demonstrate that the activity isn’t passive. To do that, you have to show you “materially participate” in the trade or business. According to the tax code, this means you have to be involved in the activity on a regular, continuous, and substantial basis. The IRS has identified several ways to do this, such as spending more than 500 hours in the business annually, or more than 100 hours each year and more than anyone else. These tests won’t help you, though, if the business is a rental activity like charter; the tax code says that your participation in a rental activity can be as material as you want, but it doesn’t change the character of the activity. For a jet charter business, you still have to find an exception that applies to rentals.
There is another option, though, called “grouping.” This works for taxpayers who do materially participate in a business, just not sufficiently in the one that owns the jet: the two businesses can be “grouped” together as what the IRS calls “an appropriate economic unit” for measuring gain or loss under the passive-activity rules. If you can show that you materially participate in the unit as a whole, the losses of the unit are treated as “active.”
Whether two or more activities constitute an appropriate economic unit depends on what the IRS calls a “facts and circumstances” test, which is the agency’s way of saying it considers the matter too complicated to promulgate a hard-and-fast rule. Nevertheless, the IRS has identified several factors that have the “greatest weight” in evaluating whether activities represent an appropriate economic unit. These factors include the similarities and differences of the activities (don’t try grouping your aircraft charter business with a nail salon on Main Street), the extent of common ownership and control, and geographical location. Another factor is interdependence: the activities will be more likely to look as if they belong together for tax purposes if they share employees or customers, use a single set of books, buy or sell goods together, and the like.
It’s easier to say what doesn’t qualify as an appropriate economic unit than what does. The tax code requires that you group activities, not entities, and each activity grouped must be a trade or business or a rental activity. In Williams v. Commissioner, for example, the Tax Court wasn’t persuaded that any similarity existed between “the business of renting an airplane and that of telephone sales training” and declined to find an appropriate economic unit.
Even if the activities are “similar,” nexus between them is still important, and the more the better. Thus, to provide an example of a grouping that works, the IRS said that a partner in ABC and DEF can group ABC’s activity of selling nonfood items to grocery stores with DEF’s trucking activity where the main part of DEF’s business is transporting goods for ABC.
The grouping rules have many hidden traps, so don’t try grouping in the dark; study the rules carefully. For example, not all business activities can be grouped, and special rules apply for grouping rental and non-rental activities. Further, in 2010 the IRS changed the reporting rules for grouping activities. Under the revised regulations, you must report a new grouping in your tax return for the first year in which two or more activities are grouped or in which you add an activity to an existing group or regroup activities. According to the IRS, failure to file the reports when required will result in each activity being treated separately for tax purposes, though it’s still possible in many cases to file a retroactive grouping election on a return for a subsequent year.