Jan. 6, 2016

The IRS recently released a memorandum (CCA 2016-01-011 (Dec. 31, 2015)) that provides information to business aircraft owners considering like-kind exchanges or using special purpose entities to own and lease aircraft.

Generally, gains from sales, exchanges or other dispositions of property (including aircraft) are taxable, however Section 1031 of the tax code allows these gains to be deferred if like-kind property is acquired. These transactions, known as like-kind exchanges (or 1031 exchanges), are a commonly used tax planning tool for business aircraft owners, as long as the aircraft being exchanged are held for productive use in a trade or business.

According to the memorandum, although the special purpose entity leasing the aircraft may not have had a profit motive in leasing the aircraft at a below market rental rate to a related lessee, the lessee of the aircraft used the aircraft in its operating business which was conducted to make a profit. The auditor attempted to use the hobby loss standards to argue that the aircraft did not qualify as property used in a trade or business for purpose of qualifying for like-kind exchange treatment. However, the memorandum explains that the statute and regulations applicable under the hobby loss rules do not apply to the determination of whether an asset is held for business or investment purposes for 1031 exchanges.

“To qualify for a like-kind exchange, the property must be used in a trade or business or for investment, but the hobby loss rules under section 183 should not be used to make this determination,” said John Hoover, a special counsel with law firm Cooley LLP and member of NBAA’s Tax Committee. “This memorandum is significant in illustrating that you look at the primary purpose for which the aircraft is held, taking into account its use by the related lessee, to determine whether it qualifies as business or investment property for purposes of a like-kind exchange.”

The aircraft leasing structure described in the IRS memo is common, as it allows the aircraft to be operated by one business entity while it is owned by a separate lessor entity. The memo acknowledges that the leasing structure was established for business and legal reasons, and the IRS determined that the entity structure should not be used as grounds to determine that the aircraft was not held for business or investment purposes.

Beyond its impact on like-kind exchanges, the memo may provide insight into how IRS views related party leasing arrangements under the hobby loss rules in section 183. “The memo is instructive as it shows the IRS looked at the entire lessor/lessee ownership structure when determining that the aircraft was used in a trade or business with the intent to make money,” said Hoover.

“NBAA welcomes this memorandum as it provides insights into how the IRS views the trade or business test for purposes of like-kind exchanges and will be of additional value for federal tax planning,” said Scott O’Brien, NBAA’s senior manager of finance and tax policy. “We plan to discuss this ruling in more detail at NBAA’s May 6 Business Aviation Taxes Seminar in Washington, DC,” said O’Brien.

Review the IRS Memorandum (PDF)