Passive Activity Loss - Hinckley Allen...Passive activity losses in excess of offset-ting passive income may not be deducted. The excess passive activity losses are instead carried

122 WORLD AIRCRAFT SALES MAGAZINE – February 2011 Aircraft Index see Page 4www.AvBuyer.com

Can you afford to overlook it? by Edward Kammerer & Katie Ahern

n challenging economic timessuch as these, aircraft ownersare constantly looking forways to make their operationsmore efficient. In order to

defray expenses and to generate income,owners may enter into leases, timesharingarrangements or charter agreements.

In certain states, utilizing a lease structurefor aircraft operations may result in sales taxsavings for the owner. However, evenamidst otherwise careful planning, one taxissue is frequently overlooked, often result-ing in a substantial and surprising tax liabili-ty – the passive activity limitation.

The passive activity limitation disallowsthe deduction of losses from passive activi-ties. Since deductions for the depreciation ofan aircraft are often a substantial contributorto an overall loss of the business, this limita-tion typically means that an aircraft owner is

not able to deduct the depreciation of theaircraft.

This limitation may affect individuals,estates, trusts, partners, LLC members, andcertain closely-held C corporations. The pas-sive activity limitation typically limits losses(1) whenever the person seeking to deduct aloss from an activity does not “materiallyparticipate” in that activity, or (2) wheneverthe activity at issue is a leasing activity.

So, for example, let’s say John Smith, areal estate developer, is the sole member ofUp, LLC. John makes $400,000 per year as adeveloper. Let’s say Up, LLC owns an air-plane, which it leases to Sky, Inc. Now let’sfurther assume Up, LLC experiences a$400,000 loss for the taxable year, due prima-rily to the large depreciation deductions forthe airplane.

John expects that the loss will flowthrough to his individual tax return, offset-

ting the $400,000 he earned as a developer.Unfortunately, John may be in for anunpleasant surprise, as passive losses maynot generally be used to offset income fromother sources.

MATERIAL PARTICIPATIONIf John does not materially participate in thebusiness of Up, LLC, his ability to deductUp’s losses are limited. In order to material-ly participate, John must be regularly, con-tinuously and substantially involved in Up’sactivities.

John may have difficulty showing that hematerially participates in Up’s activities,because he has a separate career as a devel-oper, and Up is not his principal business.Fortunately, regulations offer a series of spe-cific rules to identify what generally consti-tutes material participation. For example,John may not be subject to the passive ❯

Passive Activity Loss

PASSIVE ACTIVITY LOSS

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activity limitation in any of the followingsituations:

• John participates in Up’s activities for over 500 hours during the year.

• John is the only person who participates in Up’s activities.

• John participates for over 100 hours during the year and no one else participates more than John.

• John did materially participate in the activity for five out of the last ten years.

Additional material participation stan-dards are available under the rules. John mayneed to analyze his situation under thosestandards if he cannot meet any of the above.

Aircraft owners frequently face chal-lenges in meeting the material participationstandards for several reasons. Like John, air-craft owners often have other businesses onwhich they focus their attention. As a result,their participation in the aircraft-relatedactivity may be lower than other individu-als. Also, not all participation is consideredin the owner’s material participation total.

For example, the following efforts of anowner may not count toward materialparticipation:

• Approving proposed charter customers or trips;

• Work not customarily performed by an owner;

• Studying and reviewing financial statements or reports on operations;

• Preparing or compiling summaries or analyses of finances or operations for theowner’s own use; or

• Monitoring finances or operations in a non-managerial capacity.

Finally, an airplane may be used by some-one other than the owner, such as under acharter or timeshare arrangement. In otherwords, when an aircraft owner relinquishescontrol of the aircraft, they may also sacrificethe tax benefits of the airplane’s depreciation.

Therefore, it is important that aircraftowners understand the material participationrules, which provide predictability byenabling an owner to determine whether hisor her involvement in an activity for anupcoming year will constitute material partic-ipation. Such an understanding allows anowner to conduct his or her tax planningaccordingly and to more accurately evaluatethe bottom-line financial result of a proposeduse of the airplane.

LEASINGLeasing activity is generally treated as pas-sive activity, regardless of whether the mate-rial participation tests are met. Let’s assumeJohn participates in Up’s activities for tenhours per week, for a total of 520 hours dur-ing the year. John has participated for over500 hours during the year, and therefore, hemay meet the first material participationstandard above. However, since Up’s onlyactivity is leasing, John may still be subjectto the passive activity limitation.

Fortunately, with careful planning, air-plane owners may take advantage of excep-tions to this general leasing rule. For exam-ple, leasing exceptions may be available inthe following situations:

• Certain short-term leases;• Personal services, such as pilot services,

are provided with the airplane;• Lease of the airplane is incidental to a

non-lease activity;• The aircraft is customarily made avail-

able during defined business hours for non-exclusive use, such as a company airplane made available for personal flights when not in use by the company.

Like many of the passive activity rules,the leasing exceptions are relatively complexand their potential application must be care-fully analyzed in each situation.

EFFECT OF PASSIVE ACTIVITY LIMITATIONAgain, the passive activity limitation disal-lows the deduction of losses from passiveactivities. Instead, any loss resulting from apassive activity may only be used to offsetincome from other passive activities.

Such offsetting passive income mayinclude certain rental income, or incomefrom other activities where material partici-pation is lacking. The disallowed passivelosses may not be used to offset income fromsources such as interest, dividends, annuitiesand certain royalties. The practical result isoften an airplane owner who is unable tomake use of depreciation deductions for theaircraft.

Passive activity losses in excess of offset-ting passive income may not be deducted.The excess passive activity losses are insteadcarried forward to the next taxable year. Inother words, if there is no passive activityincome to offset the passive activity loss inone year, the loss is carried forward untilthere is passive income in another year oruntil the entire interest in the activity is sold.

When an individual disposes of his or herentire interest in the activity and recognizesa corresponding gain or loss, any previouslydisallowed losses that are carried over from


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previous years are generally allowable atthat time. So, for example, if John is unableto deduct his share of the losses, he mayneed to wait until he sells his membershipinterest in Up, LLC to deduct those losses.

GROUPING ACTIVITIESAt this point, John is presumably ratherunhappy but need not give up hope just yet.John may yet be saved by the so-calledgrouping rules.

Let’s assume John does materially partici-pate in Development, Inc., his real estatedevelopment practice. John participates inreal estate projects worldwide. Assume fur-ther that the airplane is used solely to trans-port John to his various project sites. In thisscenario, we can put aside John’s leasingproblems for now and assume that John’spassive activity problem results solely fromhis lack of material participation in Up, LLC.

John may assert that, because the air-plane supports the activities ofDevelopment, his real estate developmentbusiness and the ownership and operationof the airplane are really all one activity.

More importantly, that one activity is anactivity in which John materially partici-pates, and therefore, he should be allowed todeduct any losses of Up, LLC. In some cases,leasing activities may also be grouped withother activities.

To determine whether the groupingapproach is appropriate, the airplane ownershould consider the following factors:

• How are the applicable businesses similar?

• How are they different?• Are they under common control?• Are they under common ownership?• Are they located in the same place?• Does the activity of one business depend

on the activity of the other(s)?• Do they buy and sell goods among

themselves?• Do they have the same customers?• Do they involve services that are

normally provided together?• Do they have the same employees?• Do they share books and records?

Airplane owners should also be aware ofnew reporting obligations that apply to thegrouping rules. The Internal RevenueService now requires that taxpayers reportcertain groupings of activities, regroupingsof activities, and the addition or dispositionof activities within existing groups. Therequired written statements must generallyaccompany the taxpayer’s original incometax return for the year in which activities aregrouped, added, regrouped, etc.

Special rules apply for groupings by part-

nerships and S corporations. If the groupedactivities are not properly and timely report-ed, the activities will typically be treated asseparate activities. In other words, if thereporting rules are not followed, the taxpay-er may lose the opportunity to deduct losses.

A WORD OF CAUTION…It should be noted that this article is limitedto a description of certain general rulesregarding the passive activity loss limitation.However the rules surrounding these issuesare fairly complex and each situation mustbe carefully analyzed in order to plan aneffective solution. Additionally, a host ofother tax and regulatory rules apply to theownership and operation of aircraft.

Aircraft owners should take cautionbecause an effective planning solution withregard to one issue, such as the passiveincome limitation, may trigger other tax orregulatory issues. For example, an aircraftplaced in a special purpose entity may be aneffective solution to certain tax and businesschallenges, however, this structure may cre-ate a risk of violating myriad FAA rules.

Similarly, providing pilot services alongwith an airplane may remove an activityfrom the definition of leasing, and therefore,from the passive activity limitation.However, that arrangement may triggerother federal taxes and FAA rules.

Such intersections of government regula-tions, federal tax rules, state tax rules, andbusiness concerns highlight the importanceof building a team of advisors that are

educated in the unique issues implicated byaircraft ownership and operation.

This article is not intended to be legaladvice, but is intended only to inform thereader of recent developments in the law.The enclosed materials are provided for edu-cational and informational purposes only,for the use of clients and others who areinterested in the subject matter. If legaladvice is required concerning a particularmatter, your attorney should be consulted.To comply with IRS regulations, we adviseyou that any discussion of Federal tax issuesin this document was not intended or writ-ten to be used, and cannot be used by you,(i) to avoid any penalties imposed under theInternal Revenue Code or (ii) to promote,market or recommend to another party anytransaction or matter addressed herein.❯ Edward Kammerer is a Partner, and Katie Ahern anAssociate at Hinckley, Allen & Snyder LLP. Edwardcan be contacted via telephone: +1 401 274 2000;or email: [email protected]. Alternatively,email Katie at [email protected]. More information from www.haslaw.com


Airplane owners should also be aware of new reporting obligations that

apply to the grouping rules.

ED KAMMERER KATIE AHERN


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Passive Activity Loss - Hinckley Allen...Passive activity losses in excess of offset-ting passive income may not be deducted. The excess passive activity losses are instead carried