MESSAGE BOARD

ONE TAXPAYER VS. THE IRS

By Glenn G. Kautt

Do you want thrills, excitement, and negative interaction with a powerful government agency as part of your flying? No, I wasn’t talking about interacting with DHS, FAA, or even an Apache gunship. I was talking about flying your Twin Commander for business without managing your tax situation. Here’s my personal story about just such a situation. Try not to make this story yours!

Here’s some background:

In October 2003 I decided my business could support a serious business aircraft, so I formed an S corporation, Aviation Associates, Inc. (AAI), for the express purpose of owning and operating a twin Cessna as part of my business operations. In 2006 I traded up to a bigger Cessna, which I sold in 2009 due to the global financial crisis. Because our business came roaring back in 2010, I bought a nice 690B Twin Commander. The fact that it is a Twin Commander is irrelevant to the tax issue.

The Audit

In early 2010 the IRS notified me that AAI was being audited for tax years 2006-2008. We kept immaculate records, filed returns, and had a copy of every document as part of our business dealings. Providing the IRS with all substantiation for expenses, income, travel records, etc. was easy. However, after examining my aviation and corporate records, the auditor presented her findings—and a bill for about $250,000. Here was her analysis:

• My company, in existence for more than 25 years with multimillion-dollar gross revenues, was not a legitimate business. Thus, my entire business was not entitled to ordinary tax treatment reserved for a business. What?!
• Contrary to every piece of legitimate evidence, the aircraft were not being used for business. Thus, all ordinary business expenses pertaining to the aircraft operation were not deductible. Huh?!
• Even though AAI owned both aircraft, made a hefty down payment, and took loans for the balance, there was no basis (equity in the equipment). Without basis you can’t depreciate something, so all depreciation was disallowed. Say again?!

Preparing for Battle

Even though the auditor’s conclusions were seriously flawed, I was troubled by her initial report. I realized I was dealing with someone who would need educating on tax issues. I also suspected I didn’t get everything right on my side. With those thoughts in mind, I: A) Hired a very competent, experienced aviation CPA to do battle with the auditors; and B) Immediately reconfigured my corporations prior to the purchase of my Twin Commander.

Before you start laughing about the poor fool who took tax and financial matters into his own hands, you have to know something else. I’m an Enrolled Agent, federally licensed to represent taxpayers before the IRS. I’m not a tax amateur, which makes my story even more interesting.

The Fight

The CPA realized we were dealing with someone just beginning her IRS career. She didn’t understand basic financial records and was clueless about aviation tax issues, so proving the firm was an actual business was easy.

In one sense, it was laughable because it was blatantly obvious I was running a legitimate enterprise. In another sense, it was expensive to deal with, and an ominous warning about the IRS’s willingness to put nonsense in an official government document.

Because we had contemporaneous records for every flight, including corporate logs, business logs, and reams of evidence of client and business meetings, the non-business use allegation went away. So far, so good.

The depreciation matter was a problem, however. By the time of the audit, I had sold the second Cessna and recaptured the depreciation on my 2009 tax return. In other words, I took depreciation deductions on my 2006, 2007, and 2008 returns, and because I sold the depreciated aircraft for more than I paid for it, tax law required that I recapture all the breaks I got the prior three years. This amounted to about $95,000 of tax.

The CPA calculated my basis in both aircraft and determined that, due to the form of the corporate entity I chose when I started, the auditor was correct. The tax law would not allow me to take the deduction. The bad news was I had to pay the tax for years 2006, 2007, and 2008. The good news was I had already paid it back to Uncle Sam in 2009. Technically, I had to file returns for those three years, and pay the tax plus interest, then file a refund for the extra tax paid in 2009. The result? $10,000 in interest and a hefty accounting bill.

The Bottom Line

There’s another chapter to this story, about the Twin Commander owned by my very profitable corporation rather than a stand-alone aviation company. Maybe I’ll get a chance to tell you how that’s going in another edition of Flight Levels!

Glenn Kautt is president of the Monitor Group, Inc., a wealth management firm with offices in McLean, Virginia, and North Palm Beach, Florida. He received his MBA from Harvard Business School and is a President's Distinguished Scholar graduate of Purdue University. Named repeatedly as one of the nation's top investment advisors by Barron's, Worth, Mutual Funds, Washingtonian, and Medical Economics magazines, Kautt is a regular columnist for Financial Planning magazine and has written and spoken professionally on business and advanced financial planning topics for nearly 30 years. He went on his first instructional flight in 1964, and currently has a Commercial certificate with a seaplane rating. He considers his Twin Commander to be a fantastic business tool.

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