In the past some clients have asked in a joking tone, "Can't I just write off the new jet this year and call it good?" and the answer has always been "No". Then the Tax Cuts and Jobs Act of 2017, "The Tax Bill", passed in December 2017 and the answer is now "Maybe". The Tax Bill added a provision for 100% bonus depreciation on Qualified Assets, both new and used, placed into service after September 27, 2017 and before January 1, 2023 when a phaseout begins.
Now clients are asking, "If I buy a new aircraft does it qualify for 100% bonus depreciation?" and the answer is not always black and white. I find myself asking three questions right off the bat... The first question is whether or not the airplane operations qualify to take bonus? The second question is whether or not the personal use and/or personal passengers on the flights will affect the ability to deduct 100% of that bonus depreciation, or will it be limited? The third question that I am asking is about the future operations to see if there is a strong possibility that the depreciation will be recaptured in the future due to decreased business use. There are many other follow up questions, but for the purpose of this post, let's just explore these three.
Disclaimer: This post attempts to simplify the law as much as possible, but does not cover all exceptions to the general rules. Each situation should be evaluated separately and if you have specific questions, contact your advisor.
Question #1: Is the aircraft a qualified asset for bonus depreciation?
To qualify for bonus the asset must be eligible for MACRS depreciation. One of the requirements is that the asset is not used predominately outside the United States. Therefore, additional due diligence is needed for aircraft operations with a large international component. Another requirement for Qualified Assets is the IRC 280F 50% Qualified Business Use Test. Qualified business use means any use in the taxpayer business except for the few exceptions put in IRC 280F(d)(6)(c) which includes leases or compensatory flights to a 5% owner and related parties. IRC 280F(d)(6)(c)(ii) has a special rule for aircraft that states, if at least 25% of your flight activity is for the core business operations/qualified business use then you are allowed to include compensatory flights (such as those included in the annual SIFL calculation) and other flights for leasing to a 5% owner and related parties that normally would have been excluded under IRC 280F(d)(6)(c)(i) in calculating the 50% test.
If you fail the 25% test or if you pass the 25% test but cannot meet the overall 50% test, then you do not qualify for bonus depreciation or accelerated depreciation under MACRS and you will need to use straight line depreciation over the longer Alternative Depreciation Systems (ADS) life. If you pass both tests, then you generally qualify for MACRS accelerated depreciation and can take bonus.
It is also important to note that for purchases after September 27, 2017 100% bonus depreciation is available for new and used equipment. In the past, bonus depreciation was only available for new equipment. The Tax Bill opened this up to used equipment as long as it was the first use by the taxpayer. I will be watching for guidance to clarify what the drafters meant by this language. I anticipate that regulations will be necessary to clarify situations such as prior leasing of the equipment and assets contributed into an entity that is considered a separate taxpayer under the Internal Revenue Code.
Question #2: To what extent will your personal entertainment flights and passengers affect your ability to deduct a portion of the 100% bonus depreciation? And what can we do to reduce the impact of these entertainment passengers?
In the year of acquisition is it is important to keep an eye on personal entertainment passengers, including spouses. Under IRC 274 these entertainment passengers affect the amount of deductible aircraft expenses for the business, including bonus depreciation. Luckily, the regulations for 274(e)(2) and (9) permit a taxpayer to elect to compute depreciation expenses on a straight-line basis for all of the taxpayer’s aircraft and all taxable years for purposes of calculating expenses subject to disallowance, even if the taxpayer uses another method to compute depreciation for other purposes.
If elected, you will need to use this method for all aircraft in the fleet both owned and leased. The regulations provide a transition rule for applying the straight-line election to aircraft placed in service in taxable years preceding the election, which requires the taxpayer to apply the straight-line method as if it had been applied from the year the aircraft was placed in service. The straight line election is easily made when filing your tax return, but it is important to be aware that according to Regulation 1.274-10(d)(3)(iii), "a taxpayer may revoke an election only for compelling circumstances upon consent of the Commissioner by private letter ruling."
Using straight line for the calculation will significantly reduce the amount of the 100% bonus depreciation that is disallowed as an income tax deduction under the IRC 274 calculations. It has also been clarified in Regulation 1.274-10(d)(3)(i) that in year two after the bonus depreciation has been taken, the disallowed depreciation calculated on a straight line basis cannot exceed the amount of depreciation actually taken on the return, which will be $0 if 100% bonus depreciation is taken in year 1.
Let's take a look at two different scenarios:
On September 28, 2017, in both scenarios, the taxpayer buys a jet for $20M and places it into service in 2017. The aircraft meets all the tests for a Qualified Asset and is eligible for bonus depreciation.
Scenario 1: The taxpayer has an internal aircraft use policy in their company that does not allow any personal passengers on board the aircraft. In this hypothetical example, the client sticks to this policy and at the end of the year their aircraft expenses are 100% deductible. This includes the full $20M in bonus depreciation. Basis in the asset when sold in the future will be $0.
Scenario 2: The taxpayer often travels with personal guests and his spouse on company trips. For the purpose of this comparison, the calculated percentage that is disallowed for the spouse and other personal entertainment passengers during the year is 35% and the ADS life of the asset according to IRS Revenue Procedure 87-56 Asset Class 00.21 is 6 years for a private business aircraft not used predominantly in a commercial aviation business (aircraft used predominately in commercial and contract carrying of passenger and freight have an ADS life of 12 according to Rev Proc 87-56 Asset Class 45.0). The taxpayer would not want to reduce the bonus depreciation by 35%, losing $7M in immediate tax deductions; so the taxpayer elects to calculate the disallowance using straight line. Therefore, ADS half year convention is used and $583,333 of the depreciation is disallowed. The effective rate of bonus depreciation in year 1 for this taxpayer is not 100% due to personal entertainment passengers. The taxpayer is allowed to deduct only 65% of the other aircraft expenses as well as $19,416,667 of the bonus depreciation. The $583,333 in depreciation that was disallowed will be suspended and included as basis when sold.
The difference in the simplified scenarios above attempt to demonstrate that it is important, especially in the year of acquisition, to understand the impact that your personal travel can have on bonus depreciation and your ability to deduct your aircraft costs and it is also import to know that too much personal travel and not enough core business travel can trigger depreciation recapture, which leads us to question #3...
Question #3: What is the possibility of recapture due to decreased business use in the future?
The IRS requires a taxpayer to recapture and include in income any excess depreciation taken over the ADS life using straight line depreciation in the year that the taxpayer's qualified business use is 50% or less. The taxpayer then reports the excess amount of depreciation taken as income on their tax return in the year the recapture provision is triggered. The amount recaptured increases the adjusted basis of the property by the same amount and going forward you would depreciate the aircraft using the straight line method over the remaining ADS life still taking into account any disallowance calculated under IRC 274.
If you look at the above scenarios under Question #2 let's assume that before the 6 year ADS life expired the qualified business use of the aircraft was 50% or less and/or the taxpayer could not meet the special 25% qualified business use for aircraft discussed in Question #1. This would trigger the recapture provisions and income would be recognized on their tax return that year. If this happened early in the ADS life, for example in year 2, the recapture could be well over $19 million thus reversing almost all of the tax benefit received in year 1. The tax due on the income from the recapture could be detrimental to the taxpayer's cash flow if they were unaware that they would have to recapture this amount.
The recapture is similar to what we call "phantom income." The business did not receive any cash from the sale of an aircraft and may have spent or distributed the bulk of their after tax earnings from year 1. As a result, there may or may not be enough cash in the business to pay the tax bill or make a distribution to a pass-through owner in the year the recapture provision is triggered. If there is a strong possibility that you would have to recapture the bonus depreciation taken, then you may want to discuss with your tax advisor electing to take 50% instead of 100% bonus depreciation, electing out of bonus, making the election to use straight line to depreciate your new aircraft, or simply discuss creating a deferred tax reserve so that you have the cash to pay the tax or distribute to the owners in the year the recapture is triggered.
Overall the 100% bonus depreciation in The Tax Bill will be a huge tax savings for many clients and it remains important for tax professionals to educate the aircraft owners on the impact of personal passengers. If the business is getting close to 50% qualified business use then they may need to consider limiting the amount of personal use allowable on the aircraft. This is an asset by asset test and therefore, it is possible to use outside charter and other strategies to ensure the business use does not fall below 50%. These strategies are often only effective if done proactively. So be sure to monitor the personal usage closely and frequently.
As I stated above, this post attempts to simplify the law as much as possible, but does not cover all exceptions to the general rules. Each situation should be evaluated separately and if you have specific questions, contact your advisor.