Before feeling sorry for fractional owners, those who own whole aircraft shou

Watch out for excise tax audits

Nobody likes a tax audit. Even Internal Revenue Service agents would probably rather go fishing.

While no audit is fun, a transportation excise tax audit can be particularly unpleasant. For proof, just read the hefty 100-page document that the IRS put out on the subject last year. (You can find it at Search for "Air Transportation Excise Tax-Audit Technique Guide.") The Audit Guide provides insight into what revenue agents are supposed to be looking for in transportation excise tax audits.

Before we discuss that, let's talk about the tax itself. The transportation excise tax is imposed on the "amount paid" by one person for air transportation provided by another person. The provider of the transportation has what the IRS calls "possession, command and control" of the aircraft and is responsible for collecting the tax, though the passenger is not thereby relieved of responsibility for payment. Airlines state the tax separately on your ticket (which is why it's often called the "ticket tax"), and charter companies tack it onto your charter bill.

The rate of tax has remained constant for years at 7.5 percent of the amount paid (though it has been as high as 10 percent). So if your charter bill is $50,000, the excise tax comes to $3,750. That won't break the bank, but it's not chickenfeed, either.

Figuring out the "amount paid" in the case of airline tickets and charter invoices is fairly straightforward. But fractional programs present a special challenge. The programs were originally intended as a form of noncommercial aviation under the rules and exemptions for "large aircraft" in Federal Aviation Regulations Part 91.501. But the IRS took the position (as it did for other FAA "large aircraft" scenarios) that the fractional program had possession, command and control of the aircraft and was providing a transportation service to the share owners. It follows that transportation tax is due.

But then what is the "amount paid" that the tax is due on? Apart from miscellaneous charges like catering, the owner of a fractional share basically has three costs to deal with: the purchase price of the fractional interest; a monthly management fee to the program manager to hangar, insure, crew and maintain the aircraft; and an hourly charge for flights (supplemented by a fuel surcharge that has blossomed into a major expense in recent years). Most fractional programs assess the 7.5-percent transportation excise tax on the hourly rate, with or without including the fuel surcharge as part of the "amount paid."

Imposing the tax on hourly expenditures certainly makes sense and is consistent with a 1997 court decision involving the NetJets fractional program, which upheld a tax on that company's occupied hourly fee on the theory that the program provides a taxable transportation service to the owners. But the court case didn't deal with whether the IRS could charge the tax on other program payments as well, and there have been rumblings from the IRS ever since that the management fee should also be subject to the tax.

However, in the Audit Guide, the IRS has pushed this issue beyond any reasonable limit. According to the Guide, "all amounts paid for taxable transportation to the Program Manager, by the fractional aircraft owners, must be included in the tax base...The amounts paid include the share acquisition cost, monthly aircraft management fee, the occupied hourly rate, and other miscellaneous charges" (my emphasis).

To see what will happen if the IRS starts taxing the share purchase price, suppose you pay $2.4 million to purchase a one-eighth share of a NetJets Hawker 4000. The IRS Audit Guide says the transportation excise tax is due on that purchase. That's a $187,500 tax bill. (Note that the transportation tax apparently would be due even though there has been no transportation, a problem that also arises when taxing the management fee.) When you sell the share back to NetJets five years later at, say, $1.8 million, don't count on the IRS refunding any of the tax. 

But the parade of horrors is not over. As noted earlier, fractional programs don't collect transportation tax on the share acquisition cost. Nor, as a rule, do they collect it on the management fee or on many miscellaneous expenses. So what will happen when a revenue agent knocks on your door armed with a copy of the Audit Guide? In addition to the excise tax itself, there are stiff IRS penalties for failure to file excise tax returns; to collect the tax; and to pay the tax, plus interest the IRS can levy on unpaid amounts. To give you an idea of how bad it can be, in the case of a willful failure to collect the tax, the penalty is 100 percent of the tax due, and that's in addition to interest and any other applicable penalties, such as those imposed for failure to file returns.

Before feeling sorry for fractional owners, however, owners of whole aircraft should look at what the Audit Guide has in store for them. Citing new IRS regulations effective in January 2008, the Audit Guide advises that the payments by the sole member of an LLC that is a disregarded entity for tax purposes may nevertheless be subject to the transportation excise tax. In other words, if my wholly owned LLC owns and operates an aircraft, any payments I make to the LLC for air transportation are subject to the 7.5-percent transportation excise tax even though the LLC is treated as a disregarded entity for almost all federal tax purposes. But what's the difference between that structure and one in which a wholly owned subsidiary corporation provides transportation to its parent corporation-where no excise tax is due by virtue of the IRS' affiliated group exemption? And why should the excise tax be treated differently from the income tax in these situations?

The IRS position is illogical. Basically, I should not have to pay tax, in effect, to fly myself around in what is, for practical purposes, my own airplane. You might try explaining that to the revenue agent who audits your return.

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