Tax research memo:
One of our clients, Williams Aero Flight Services, is seeking advices regarding several tax issues they are currently facing. This research memo addresses these issues and helps management find a solution based on current regulations.
Williams Aero Flight Services is a charter carrier operating out of Manassas, Virginia, that flies both passengers and cargo. Their primary customer for both the cargo and passenger divisions is the U.S. Military in support of the war on terrorism. Prior to 2001, their primary business was the transport of corporate executives. This business now represents 10% of their total revenue.
The company’s fleet consists entirely of jets. A properly maintained jet aircraft has a useful economic life of thirty years. Frequent and necessary maintenance must be performed on the engine and airframe in order for the jet to last all thirty years. There is necessary maintenance that must be performed on the engine and airframe to enable the planes to last this long. The aircraft engines and auxiliary power units must be serviced every 24 to 60 months, based on usage. In order to service an engine and power unit, the engine must be removed from the aircraft and sent to a third party specialized maintenance company that maintains and repairs the engines and power units. The annual cost of these repairs, resulting from the age of the fleet and the annual usage, is $2,000,000. Annual revenue is approximately $40,000,000.
The company is losing contracts supporting the wars in Iraq and Afghanistan. With the level of violence subsiding, the government is not renewing existing contracts, which has significantly reduced revenue. The latest estimates are a 40% reduction in billings to the government.
During the past six months, Williams Aero Flight Services has incurred significant costs relating to transition planning, planning to obtain more commercial work to replace the dwindling government work. In order to improve the efficiency of the business, a team of executives and staff have been gathering information regarding processes and operations. Every department participated in meetings to assess ways to improve efficiency and venture into the commercial passenger and freight markets. There may be layoffs for those individuals who cannot be re-assigned to the commercial market.
Currently, Williams Aero Flight Services got into a dispute with IRS regarding repairs versus capitalization. The IRS is preparing to audit the past three years of income tax returns filed by Williams Aero Flight Services.
Williams Aero Flight Services is facing three tax issues presented below. We will discuss the issue, discuss relevant tax law and recommend a solution for each issue.
Issue number one: The Ccompany treats both the engine and the aircraft as one unit of property for depreciation purpose. They depreciate this property over its 30-year useful economic life. The IRS contends that the jet engines and power units are separate units of property from the airframe of the aircraft, each with separate economic useful lives, for depreciation purposes.
Tax research: Depreciation for any business asset depends on the cost of the asset and the useful life classification for that asset. Section 167(a) provides that there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion and wear and tear of property used in a trade or business or held for the production of income. Tangible fixed asset depreciation or wear and tear is calculated over the expected useful life of the asset. Its depreciation is determined by the estimated steady decrease in value while the asset is in use by the corporate entity.
Aircraft depreciation is special because each component of an aircraft has a different depreciation rate. Aircraft depreciation is dissected by the longevity of each of its parts rather than by the total value of the