The Unfriendly California Skies: Avoiding Sales/Use Tax on Aircraft Purchases

Many out-of-state buyers that purchase an aircraft from a California retailer mistakenly believe they do not have to contact the California State Board of Equalizations (BOE) because they signed an out-of-state affidavit. However, that does not exempt them from filing a tax return directly with the BOE.

Besides, the California BOE holds a very wide interpretation of what constitutes residency. The mere presence of a California bank account or driver's license, owning real property, or having anything with any connection to California has been used to establish local jurisdiction. In one case, a state of Washington-domiciled corporation purchased an aircraft. During the financing process, a document was filed with the FAA that gave the California address of the primary shareholder who guaranteed the loans. The BOE discovered the document and began to harass the shareholder as if he was the owner of the aircraft; seeking the tax from him.

To make matters worse, a new state bill (AB 694) was introduced in February of 2003 that threatens to expand the presumption that California taxes apply. If enacted, any aircraft that was subject to California's registration or property tax laws during the first 12 months of ownership, or was used or stored in the state more than half the time during the first 12 months of ownership, will be taxed.

A Problem that Will Not Go Away

The most insidious aspect of this tax is that the BOE has as much as 9 years after an aircraft purchase transaction to legally notify you that you have been assessed. Until the BOE issues a document that affirms support of your exemption, you remain liable.

Ignoring the process invites economic disaster, as the state maintains the right to assess penalties and interest, which has been known to increase the amount originally owed by 50% or more. Escape is futile, as the BOE uncovers tax dodgers by combing through property tax assessments, performing routine audits of California retailers who sell aviation fuel or do maintenance work, and through random inspections at airports where the local property tax assessors run a check on the tail number of every plane on the tarmac.

In one documented case, an original $80,000 sales tax bill incurred $8,000 in penalties and $65,000 in interest because the out-of-state owner of the aircraft ignored the notice of tax assessment for 8 years. The state finally issued a Notice of Determination – at which point, the only way a taxpayer can obtain a hearing to prove exemption is to pay the entire tax and file a claim for refund. However, the aircraft owner could not recover the documentation to support the rightful exemption and had to forfeit the entire amount.

The teeth for this ultimate enforcement stems from the BOE's ability to place a lien on the aircraft, and even on accounts held in California-chartered banks as well as national banks, thrifts, and brokerage houses operating within the state.

Measures of Relief

Any equipment purchaser must protect him or herself from such a catastrophic event by properly filing the necessary paperwork to obtain an exemption. At first glance, this seems simple enough, but in practice, ensuring that your company is completely absolved of any sales or use tax involves several complicated steps, tremendous documentation, and oftentimes, several trips to the state capital in Sacramento. One misstep can completely undermine your efforts, leaving you with a stiff tax levy.

The same methodical practices are also required when obtaining exemptions for common carrier clients who run charter operations, an especially important service since most air carrier executives and flight department managers initially rely upon the false belief that “Part 135″ will obviate the need to deal with the California BOE.

Part 135 is referenced in federal regulations, but it is not mentioned in the California code. Instead, California Regulations 6366 and 6366.1 pertain to aircraft sold or leased to common carriers. These sections do offer legal exemptions. However, the law requires the longest test period (12 months), during which time extremely detailed documentation must be maintained: logbooks, flight plans, weight and balance sheets, customer revenue billings, a complete copy of engine maintenance logs showing total hours since date of purchase, and more. Every single flight is examined, and one mistake can trigger the entire tax. It takes precise guidance from an expert to guarantee compliance.

Given the expensive consequences of failure, attorneys, CPAs, and other business professionals that advise equipment leasing companies should proceed with caution when attempting to defend aircraft purchasers against the BOE. The other solution, of course, is to seek the assistance of a specialist who focuses on defending aircraft purchasers against the BOE to ensure that a leasing company meets the exemption requirements and is legally absolved of paying sales or use tax.

Another Alternative

The use of a lease back arrangement is an excellent way to mitigate the sales tax on a purchase of mobile transportation equipment (MTE) without suffering the inconvenience of actual out-of-state use or the tedious record keeping required by the attempt to support an exemption based on using an aircraft in “common carriage,” or a vessel in commercial fishing. Although the examples provided here will be from California Sales and Use Tax Laws and Regulations, the overall strategy can also apply to other states also.

If you are purchasing an aircraft, the first thing you should do is create a corporation or limited liability company whose sole purpose is to be in the business of leasing aircraft. All new owners should own their aircraft in another entity other than as an individual. The liability issue in the event of serious mishap is a valid reason for using this setup. Consider the exposure to your heirs or to your successful company in the event of a mishap that not only wipes out the aircraft and its occupants but causes significant damage to life and property on the ground. What happens if the damage exceeds the policy limits? The creation of the corporation also creates a separate entity that is necessary for there to be an arms length relationship so that a lease can take place.

Once you have established your new leasing company (XXX Leasing) and obtained the proper sales tax exemption certificate, you can purchase MTE without paying the tax. Once you have made the purchase you can enter into a lease agreement between yourself and XXX Leasing.

For example, XXX Leasing acquires MTE for a price of $500,000. The leasing company has to pay $40,000 (presuming an 8% tax rate) in sales tax at the time of the purchase, or, give a resale certificate to the seller and purchase it exempt from tax. If the leasing company purchases the aircraft without tax by providing an exemption certificate to the seller, it must make a timely election to the Board that it will remit the tax based on the fair rental value. In the absence of making the timely election, the tax is due immediately on the entire purchase price.

California Sales and Use Tax Regulation 1661 provides very precise wording that defines the steps that must be completed in order to use this method of remitting use tax to the BOE. In lay terms it gives you an option of paying the tax over the life of the asset based upon the fair rental value. You can establish fair rental value by finding out what several rental operations charge for a “dry” rental rate for a similar aircraft. At a minimum, most tax agencies will require the amount to at least cover the actual costs of the aircraft.

In the absence of timely electing the option, the tax is due on the sales price. Many taxpayers interpret the “timely election” section as describing the situation to be one where the tax on the fair rental value is not due until the leasing company begins to collect rents on the use of the aircraft. This is a common pitfall that invalidates their exemption.

In an actual case in California, a leasing corporation purchased an aircraft in June of 1990 and issued a resale certificate and signed a leasing Company Exemption Certificate that accepted delivery of the aircraft from the seller and stated that the equipment was purchased for the purpose of leasing. It immediately entered into a lease with a lessee effective June 1, 1990 and established a flat rental per month.

The leasing corporation then filed monthly sales tax returns for June and July that reported zero rental receipts. Their records show that it first posted rental receipts on August 31, 1990. The first period that rental receipts were reported to the Board was for the August 1990 monthly period.

The audit staff determined that the reporting of rental receipts on the August 1990 return was not timely and assessed tax on the purchase price of the aircraft. The Board contended that the leasing company had use and possession of the aircraft from May of 1990. Repair orders dated May, June and July of 1990 showed that the aircraft was being used in those months, even though only repairs were being made on the aircraft.

The key word that was missed by the taxpayer is in the first sentence of Regulation 1661 (b)(2). The word is “limited.” Although it is easy to bypass the word when the sentence is being read, the word “limited” impacts the meaning to the degree that it alters the understanding by the reader that causes the reader to misapply the law. The definition of “limited” that should be applied in this case is “confined or restricted within certain limits.”

When the Board reads the word “limited,” it appears that it interprets it to mean that every hour the aircraft is used, tax on the fair rental value is owed. It makes it clear that even if the lessor has a signed lease it must report and pay the tax for each hour of usage even though no receipts were generated. The rate must be at “fair rental value.”

Fair rental value means the money required by the lease, except where the Board determines the receipts are nominal. There are no regulations that require a specific kind of usage by the lessee. Therefore, the lessee's type of usage is not limited to business use. The only requirements are that all the guidelines are clearly met to the Board's satisfaction.

Additionally, there are no exclusions for any usage that must be paid for, including out-of-state usage. It isn't like a sales tax transaction where the tax is not due because the sale occurred out of state. The lessor is the consumer of the aircraft by definition. The tax is on the lessor for all usage. The application of tax to sales and leases of aircraft is never a “sale” or “purchase.” (Rev. & Tax. Code 6006(g) (4) and 6010 (e) (4).) Thus, a sale of aircraft that the purchaser subsequently leases is not a sale for resale; which means the purchasers, owners and users of the aircraft, are liable for the use tax. The lessee has no California sales or use tax liability as a result of any lease from the lessor or use of the aircraft pursuant to any such lease. It is irrelevant even if the lease is signed in or out of state.

Another area of the regulation that is easily misunderstood is: once the lessor has made his timely election to pay the tax based on fair rental value, the tax must be paid on the rental as long as the lessor owns the aircraft. This is a situation where the amount of time that a lessor intends to own the equipment can dramatically affect whether using the exemption granted under regulation 1661 is cost effective. An accurate analysis of the expected hours of usage over the life of the ownership can create a situation where significantly more tax is paid measured by fair rental value than if it had been paid on cost at the time of the purchase.

For example, if MTE was purchased for $500,000 and the option was exercised to pay on the fair rental value, the purchaser must have a good understanding of the expected usage and the ownership life of the aircraft otherwise the taxpayer may wind up paying a lot more tax than would have been originally due. Using a “dry” fair rental value of $500 per hour, the example table below illustrates when the fair rental method becomes more expensive than remitting the tax at the time of the transaction.

Regulation 1661 sets out the guideline for paying the tax based on fair rental value, which if the aircraft is going to be owned for a period of time that results in a usage rate that is calculated to create less tax than the original purchase price, it clearly is a legal, viable option for mitigating sales tax.

Most of the failed attempts at using a lease back arrangement are because the taxpayer didn't understand the nuances of how the tax agency interprets the law. Although some agencies publish regulations that are their interpretations of the law, it is nearly impossible for a novice to steer his own ship through the maze of sales tax laws and regulations without years of research into the underlying documents of each case. The information that is buried in the annotations, case histories, and internal memos can take years to read through and understand. It takes a clear understanding of these documents in order to be certain of using any exemption strategy.

Basically the issue of leasing aircraft that may be used inside California has many pitfalls. The primary danger is that leases of tangible personal property in California are regulated very similarly to the leasing rules in most other states. A sales tax is due on the monthly payment amount. This type of lease is covered in Regulation 1660. However, in California, aircraft and certain types of vessels and vehicles are not classified as tangible personal property. Under Regulation 1661 they are classified as MTE. Leases of MTE are not considered a continuing sale and the tax is a use tax on the lessor, not a sales tax. In simple terms, you must throw most of what you know about sales and use tax on leases out the window. The ground rules pertaining to the language on the invoices and the defaults are reversed if a proper election is not made.

However, there is a great deal of good news hidden in all these methods of avoiding or mitigating the use tax on an aircraft. By using proper planning, a lessor can exempt an aircraft by using one of the many exemption strategies and no tax is ever owed on the fair rental value payments. The same cannot be accomplished with a lease of tangible personal property. In fact, if a lessor is not sure if his aircraft will qualify for an exemption, he can start the lease by properly reporting and paying tax based on fair rental value while he is leasing the aircraft in its first several months of ownership. Once it is determined that the aircraft has supported a claim for an exemption and no tax is due on the purchase cost, the lessor may file a claim for refund and get all the previously paid tax on fair rental value refunded.

Imagine getting slapped with a $100,000 past-due tax bill from the state of California several years after you purchased an aircraft, and you don't even live in that state. Think it can't happen? Better think again, as this type of scenario plays out with increasing frequency as California grapples with perennial budget shortages.

An Issue of National Importance

Of the 360,000 general aviation aircraft currently registered in the United States, 11% are based in California. Additionally, approximately 10% (250 to 400) of all new and used aircraft sales occur in California each month. These numbers alone justify further understanding of California's tax laws. Additionally, California regulations dictate that aircraft purchased out of state, but brought into California within 90 days, will be presumed to have been purchased for use in the state. In other words, a “use” tax could be levied on anyone, in any state, if they land in California. The use tax is set at the same rate as the sales tax – as much as 8.5%.

Many out-of-state buyers that purchase an aircraft from a California retailer mistakenly believe they do not have to contact the California State Board of Equalizations (BOE) because they signed an out-of-state affidavit. However, that does not exempt them from filing a tax return directly with the BOE.

Besides, the California BOE holds a very wide interpretation of what constitutes residency. The mere presence of a California bank account or driver's license, owning real property, or having anything with any connection to California has been used to establish local jurisdiction. In one case, a state of Washington-domiciled corporation purchased an aircraft. During the financing process, a document was filed with the FAA that gave the California address of the primary shareholder who guaranteed the loans. The BOE discovered the document and began to harass the shareholder as if he was the owner of the aircraft; seeking the tax from him.

To make matters worse, a new state bill (AB 694) was introduced in February of 2003 that threatens to expand the presumption that California taxes apply. If enacted, any aircraft that was subject to California's registration or property tax laws during the first 12 months of ownership, or was used or stored in the state more than half the time during the first 12 months of ownership, will be taxed.

A Problem that Will Not Go Away

The most insidious aspect of this tax is that the BOE has as much as 9 years after an aircraft purchase transaction to legally notify you that you have been assessed. Until the BOE issues a document that affirms support of your exemption, you remain liable.

Ignoring the process invites economic disaster, as the state maintains the right to assess penalties and interest, which has been known to increase the amount originally owed by 50% or more. Escape is futile, as the BOE uncovers tax dodgers by combing through property tax assessments, performing routine audits of California retailers who sell aviation fuel or do maintenance work, and through random inspections at airports where the local property tax assessors run a check on the tail number of every plane on the tarmac.

In one documented case, an original $80,000 sales tax bill incurred $8,000 in penalties and $65,000 in interest because the out-of-state owner of the aircraft ignored the notice of tax assessment for 8 years. The state finally issued a Notice of Determination – at which point, the only way a taxpayer can obtain a hearing to prove exemption is to pay the entire tax and file a claim for refund. However, the aircraft owner could not recover the documentation to support the rightful exemption and had to forfeit the entire amount.

The teeth for this ultimate enforcement stems from the BOE's ability to place a lien on the aircraft, and even on accounts held in California-chartered banks as well as national banks, thrifts, and brokerage houses operating within the state.

Measures of Relief

Any equipment purchaser must protect him or herself from such a catastrophic event by properly filing the necessary paperwork to obtain an exemption. At first glance, this seems simple enough, but in practice, ensuring that your company is completely absolved of any sales or use tax involves several complicated steps, tremendous documentation, and oftentimes, several trips to the state capital in Sacramento. One misstep can completely undermine your efforts, leaving you with a stiff tax levy.

The same methodical practices are also required when obtaining exemptions for common carrier clients who run charter operations, an especially important service since most air carrier executives and flight department managers initially rely upon the false belief that “Part 135″ will obviate the need to deal with the California BOE.

Part 135 is referenced in federal regulations, but it is not mentioned in the California code. Instead, California Regulations 6366 and 6366.1 pertain to aircraft sold or leased to common carriers. These sections do offer legal exemptions. However, the law requires the longest test period (12 months), during which time extremely detailed documentation must be maintained: logbooks, flight plans, weight and balance sheets, customer revenue billings, a complete copy of engine maintenance logs showing total hours since date of purchase, and more. Every single flight is examined, and one mistake can trigger the entire tax. It takes precise guidance from an expert to guarantee compliance.

Given the expensive consequences of failure, attorneys, CPAs, and other business professionals that advise equipment leasing companies should proceed with caution when attempting to defend aircraft purchasers against the BOE. The other solution, of course, is to seek the assistance of a specialist who focuses on defending aircraft purchasers against the BOE to ensure that a leasing company meets the exemption requirements and is legally absolved of paying sales or use tax.

Another Alternative

The use of a lease back arrangement is an excellent way to mitigate the sales tax on a purchase of mobile transportation equipment (MTE) without suffering the inconvenience of actual out-of-state use or the tedious record keeping required by the attempt to support an exemption based on using an aircraft in “common carriage,” or a vessel in commercial fishing. Although the examples provided here will be from California Sales and Use Tax Laws and Regulations, the overall strategy can also apply to other states also.

If you are purchasing an aircraft, the first thing you should do is create a corporation or limited liability company whose sole purpose is to be in the business of leasing aircraft. All new owners should own their aircraft in another entity other than as an individual. The liability issue in the event of serious mishap is a valid reason for using this setup. Consider the exposure to your heirs or to your successful company in the event of a mishap that not only wipes out the aircraft and its occupants but causes significant damage to life and property on the ground. What happens if the damage exceeds the policy limits? The creation of the corporation also creates a separate entity that is necessary for there to be an arms length relationship so that a lease can take place.

Once you have established your new leasing company (XXX Leasing) and obtained the proper sales tax exemption certificate, you can purchase MTE without paying the tax. Once you have made the purchase you can enter into a lease agreement between yourself and XXX Leasing.

For example, XXX Leasing acquires MTE for a price of $500,000. The leasing company has to pay $40,000 (presuming an 8% tax rate) in sales tax at the time of the purchase, or, give a resale certificate to the seller and purchase it exempt from tax. If the leasing company purchases the aircraft without tax by providing an exemption certificate to the seller, it must make a timely election to the Board that it will remit the tax based on the fair rental value. In the absence of making the timely election, the tax is due immediately on the entire purchase price.

California Sales and Use Tax Regulation 1661 provides very precise wording that defines the steps that must be completed in order to use this method of remitting use tax to the BOE. In lay terms it gives you an option of paying the tax over the life of the asset based upon the fair rental value. You can establish fair rental value by finding out what several rental operations charge for a “dry” rental rate for a similar aircraft. At a minimum, most tax agencies will require the amount to at least cover the actual costs of the aircraft.

In the absence of timely electing the option, the tax is due on the sales price. Many taxpayers interpret the “timely election” section as describing the situation to be one where the tax on the fair rental value is not due until the leasing company begins to collect rents on the use of the aircraft. This is a common pitfall that invalidates their exemption.

In an actual case in California, a leasing corporation purchased an aircraft in June of 1990 and issued a resale certificate and signed a leasing Company Exemption Certificate that accepted delivery of the aircraft from the seller and stated that the equipment was purchased for the purpose of leasing. It immediately entered into a lease with a lessee effective June 1, 1990 and established a flat rental per month.

The leasing corporation then filed monthly sales tax returns for June and July that reported zero rental receipts. Their records show that it first posted rental receipts on August 31, 1990. The first period that rental receipts were reported to the Board was for the August 1990 monthly period.

The audit staff determined that the reporting of rental receipts on the August 1990 return was not timely and assessed tax on the purchase price of the aircraft. The Board contended that the leasing company had use and possession of the aircraft from May of 1990. Repair orders dated May, June and July of 1990 showed that the aircraft was being used in those months, even though only repairs were being made on the aircraft.

The key word that was missed by the taxpayer is in the first sentence of Regulation 1661 (b)(2). The word is “limited.” Although it is easy to bypass the word when the sentence is being read, the word “limited” impacts the meaning to the degree that it alters the understanding by the reader that causes the reader to misapply the law. The definition of “limited” that should be applied in this case is “confined or restricted within certain limits.”

When the Board reads the word “limited,” it appears that it interprets it to mean that every hour the aircraft is used, tax on the fair rental value is owed. It makes it clear that even if the lessor has a signed lease it must report and pay the tax for each hour of usage even though no receipts were generated. The rate must be at “fair rental value.”

Fair rental value means the money required by the lease, except where the Board determines the receipts are nominal. There are no regulations that require a specific kind of usage by the lessee. Therefore, the lessee's type of usage is not limited to business use. The only requirements are that all the guidelines are clearly met to the Board's satisfaction.

Additionally, there are no exclusions for any usage that must be paid for, including out-of-state usage. It isn't like a sales tax transaction where the tax is not due because the sale occurred out of state. The lessor is the consumer of the aircraft by definition. The tax is on the lessor for all usage. The application of tax to sales and leases of aircraft is never a “sale” or “purchase.” (Rev. & Tax. Code 6006(g) (4) and 6010 (e) (4).) Thus, a sale of aircraft that the purchaser subsequently leases is not a sale for resale; which means the purchasers, owners and users of the aircraft, are liable for the use tax. The lessee has no California sales or use tax liability as a result of any lease from the lessor or use of the aircraft pursuant to any such lease. It is irrelevant even if the lease is signed in or out of state.

Another area of the regulation that is easily misunderstood is: once the lessor has made his timely election to pay the tax based on fair rental value, the tax must be paid on the rental as long as the lessor owns the aircraft. This is a situation where the amount of time that a lessor intends to own the equipment can dramatically affect whether using the exemption granted under regulation 1661 is cost effective. An accurate analysis of the expected hours of usage over the life of the ownership can create a situation where significantly more tax is paid measured by fair rental value than if it had been paid on cost at the time of the purchase.

For example, if MTE was purchased for $500,000 and the option was exercised to pay on the fair rental value, the purchaser must have a good understanding of the expected usage and the ownership life of the aircraft otherwise the taxpayer may wind up paying a lot more tax than would have been originally due. Using a “dry” fair rental value of $500 per hour, the example table below illustrates when the fair rental method becomes more expensive than remitting the tax at the time of the transaction.

Regulation 1661 sets out the guideline for paying the tax based on fair rental value, which if the aircraft is going to be owned for a period of time that results in a usage rate that is calculated to create less tax than the original purchase price, it clearly is a legal, viable option for mitigating sales tax.

Most of the failed attempts at using a lease back arrangement are because the taxpayer didn't understand the nuances of how the tax agency interprets the law. Although some agencies publish regulations that are their interpretations of the law, it is nearly impossible for a novice to steer his own ship through the maze of sales tax laws and regulations without years of research into the underlying documents of each case. The information that is buried in the annotations, case histories, and internal memos can take years to read through and understand. It takes a clear understanding of these documents in order to be certain of using any exemption strategy.

Basically the issue of leasing aircraft that may be used inside California has many pitfalls. The primary danger is that leases of tangible personal property in California are regulated very similarly to the leasing rules in most other states. A sales tax is due on the monthly payment amount. This type of lease is covered in Regulation 1660. However, in California, aircraft and certain types of vessels and vehicles are not classified as tangible personal property. Under Regulation 1661 they are classified as MTE. Leases of MTE are not considered a continuing sale and the tax is a use tax on the lessor, not a sales tax. In simple terms, you must throw most of what you know about sales and use tax on leases out the window. The ground rules pertaining to the language on the invoices and the defaults are reversed if a proper election is not made.

However, there is a great deal of good news hidden in all these methods of avoiding or mitigating the use tax on an aircraft. By using proper planning, a lessor can exempt an aircraft by using one of the many exemption strategies and no tax is ever owed on the fair rental value payments. The same cannot be accomplished with a lease of tangible personal property. In fact, if a lessor is not sure if his aircraft will qualify for an exemption, he can start the lease by properly reporting and paying tax based on fair rental value while he is leasing the aircraft in its first several months of ownership. Once it is determined that the aircraft has supported a claim for an exemption and no tax is due on the purchase cost, the lessor may file a claim for refund and get all the previously paid tax on fair rental value refunded.