A new IRS chief counsel memo says that an aircraft leasing partnership that trades in an aircraft that is leased to a related entity is eligible for §1031 tax-free exchange treatment, even though the related-entity lease rate was so low that it produced tax losses during the term of the lease. This is good news for a combined state sales tax planning structure frequently used for aircraft acquisitions, to be followed by a trade-in of the aircraft when a new plane is desired.
Under this sales tax planning transaction, a company wanting to acquire an aircraft sets up a separate entity to purchase the aircraft (aircraft leasing company or ALC). The aircraft is solely used by the ALC for purposes of leasing the same to its parent company or other related entities on a “dry lease” basis — which is a lease of the aircraft only, without a pilot or crew. Most states (with some exceptions) allow the ALC to purchase the aircraft exempt from sales tax, as a sale for resale, because the aircraft is being purchased for the purpose of leasing it — analogous to a rental car company, which does not pay sales tax when it purchases automobiles to lease to its customers. Instead of paying sales tax on the purchase of the aircraft, the ALC charges sales tax on the lease payments paid by its lessee. Then, when the company wants a new aircraft, it can trade in the leased aircraft under Section 1031 and avoid recognizing recapture gain (and if the new aircraft is leased under a dry lease to a related party, there is no sales tax on the new purchase).
The upfront sales tax savings in such a structure are significant, at the cost of paying relatively small amounts of sales tax on the lease payments over the course of the ownership of the aircraft. For example, assume an aircraft purchase price of $10 million, and a sales tax rate of 6 percent. The upfront sales tax savings on the purchase of the aircraft by the ALC would be $600,000. Now, assume an hourly lease rate of $2,000 per hour (not including fuel, maintenance or pilot) for 500 flight hours a year. The sales tax on the $1 million in lease payments per year would be $60,000 — a major savings compared with the one-time $600,000 upfront sales tax that would have been paid if the ALC structure is not utilized.
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