May 11, 2016
To deduct aircraft expenses from taxable income, business owners must be able to show that the aircraft was used in a bona fide trade or business and not as a casual investment.
That’s a fairly basic principle, and strictly enforced under the IRS’s hobby loss rules.
A recent court case shows how one taxpayer ran afoul of the hobby loss rules, and presents a cautionary tale for all aircraft operators.
In 2016 T.C. Memo 69, filed on April 19, the U.S. Tax Court, it was found that David Hoffmann, owner of an executive search business and a related entity with fractional shares in two Cessna Citation Xs, did not operate the aircraft for profit.
In 1998, Hoffmann pursued an opportunity to combine his executive search business, DHR International, with many service businesses across the country. The resulting company, Enterprise Profit Solutions (EPS), had plans for an initial public offering (IPO). Toward that end, DHR sold its assets to EPS in 1998.
“The investment bankers for the IPO apparently encouraged Hoffmann to acquire a business aircraft to meet the travel needs of the new company,” said Phil Crowther, an attorney at Jackson & Wade and member of NBAA’s Tax Committee.
In 1999, Hoffmann, through his holding company, bought a 12.5-percent share in a Citation X from NetJets, and in 2000, a he bought a 6.25-percent share in a second Citation X. The holding company was to lease the aircraft to DHR.
“Initially, the plan worked as intended,” said Crowther. “For 1999 and 2000, the aircraft holding company received enough lease income to generate a positive cash flow. However, as with so many other businesses, things began to unravel in the economic downturn of 2001.”
A Nine-Factor Test
The IPO was cancelled and Hoffmann’s companies had consistent tax and accounting losses from 2001 through 2004. For 2003 and 2004, the IRS argued that Hoffman did not operate the aircraft for profit.
The Tax Court upheld the IRS determination, citing the nine factors listed in Section 1.183-2(b) of the income tax regulations. Review the IRS audit technique guide for details on the factors.
However, the court seemed most concerned that Hoffmann did not attempt to mitigate his losses by selling the shares back to NetJets. As the court noted, “Our concern is not why Mr. Hoffmann began his jet service activity in 1999, but why he continued it during 2003 and 2004 when it had become clear that the activity could not be conducted profitably.”
“While the Tax Court memo cannot legally be cited as precedent, I do think it is a cautionary tale,” said Crowther. “If you want to deduct your aircraft expenses, you should be prepared to show that you’re using the aircraft as part of a business.”
When aircraft usage drops due to economic conditions, “you should be prepared to show how you are attempting to mitigate losses, the same as you do for the rest of your business,” Crowther said. “If resale values have taken a nosedive, you may decide it’s best to hold onto the aircraft, hoping they improve.”
Crowther recommended preparing a contemporaneous written analysis explaining the basis for that decision.
“As always, you should keep good records, the same as you would do for any business,” he said. “Taxpayers should be prepared to address the nine factors in the tax regulations. It’s like a checklist.”
Finally, Hoffman was not only assessed the taxes due after the deductions were disallowed, he was also charged a large understatement penalty.
“If he had sought expert tax advice, he might have at least avoided the penalties,” said Crowther.