Unlock aircraft tax deductions: Overcome passive loss limits.

The tax code passive-loss rules pose a big hurdle to deducting losses from the business use of your aircraft. Despite proper planning, you may experience passive losses that you cannot use to offset income from other sources. Let’s discuss tax strategies to help you deduct your aircraft losses. Here is the latest US Supreme Court decision that could impact you and your heirs in case of your demise.

Passive Activity Limitations Explained

The passive activity loss limitation rules apply to estates, individuals, closely held C corporations, trusts, and personal service corporations. According to Internal Revenue Code Section 469, passive losses can only offset passive income, and any excess is disallowed and carried forward to future tax years.

In order to set free trapped passive losses, you need to generate passive income in subsequent tax years or dispose of the passive activity.

You have to be very careful, or else your aircraft activity may be categorized as a passive activity, and all your losses can be suspended. This is because aircraft activities generally run at a loss, and you may be stuck with passive losses until you sell the aircraft. To avoid this unfortunate situation, you should avoid two traps while structuring your aircraft operation.

Trap 1: Leasing your aircraft in a separate entity

It is a common practice to structure the business use of an aircraft through a related party lease. Normally, you own the aircraft in a separate legal entity and lease it to your related company.

For instance, you & your business partners run a large medical practice through an S corporation, and you own an aircraft through a single-member LLC. You lease the aircraft to the medical practice, which uses it to transport key personnel for business purposes. If the tax code considers this a passive activity, then the losses incurred from owning the aircraft will not offset the income from your medical practice. So, to avoid the passive activity limits with your aircraft leasing arrangement, you need to overcome two hurdles.

Overcome the first hurdle.

The tax code automatically deems rentals as passive activities. But the IRS gives you examples where an aircraft leasing arrangement is not defined as a passive activity:

Certain short-term leases
When the aircraft lease provides personal services, like full-flight crew
When the aircraft is available during defined business hours for non-exclusive use by various customers

Overcome the second hurdle.

Even if the first hurdle is cleared, the tax code can consider your leasing arrangement a passive activity. Let’s see how the material participation rules work. To deduct the losses from an aircraft leasing activity, you must establish that you materially participate in the activity. Here are three of the seven possible tests for material participation relevant to you:

You participate in the aircraft leasing activity for over 500 hours in a year
Your participation in the aircraft leasing activity during the year is substantially all the participation in the activity
You participated in the activity for more than 100 hours during the tax year, and no other individual participated more than you did.

If you clear either of these tests, you materially participate in your aircraft leasing activity for the year.

Tossing Hurdles Aside

It may not be possible to clear both hurdles, but there is a strategy you can use to avoid the passive rental rules: the grouping election. You can group your aircraft with another business activity to avoid being classified as a passive activity. You can group your aircraft with a medical practice and treat both as non-passive activities, assuming you materially participate in your medical practice.

Also, remember that you cannot group a business or trade activity with a rental activity unless the group constitutes an appropriate economic unit. You can sidestep the passive loss rules on rentals and claim your aircraft losses if you demonstrate some of the factors above:

Similarities and differences between the businesses
The extent of common control
The extent of common ownership
Geographic location, and
Interdependencies between the businesses

Trap 2: Leasing to third-party charters

The most common trap is leasing your aircraft to a third-party charter like NetJets. To bear the expenses of the high cost of aircraft ownership, you may choose to lease your aircraft to a third-party charter for some passive income. Though this appears as an option for quick cash, it could put the deductibility of your tax losses into jeopardy.

This is because a ‘dry lease’ of your aircraft to a third party could create separate rental activity within your business. Your aircraft ceases to be your company’s business asset and becomes a rental asset subject to passive rental rules.

The lesson to take is do not use the third party lease, like leasing arrangement with NetJets if you want to prevent passive loss rules.

Takeaways

Be careful when structuring an aircraft lease, especially through a related party. By meeting specific criteria, like providing personal services with the lease or making the aircraft available for short-term use, you can ensure your leasing activity is not automatically classified as passive.

Additionally, you must demonstrate material participation in the leasing activity to claim losses.

Consider grouping elections if the passive classification hurdle cannot be cleared. Grouping the aircraft leasing activity with other active businesses like medical practice and showing that these two form an appropriate economic unit, you can prevent passive loss limitations and deduct aircraft-related losses.

Remember, tax code does not allow grouping for closely held C corporations.