Charter Yacht Taxes: Interview with Mike Kimball, Yacht Tax Expert

The prospect of using a charter yacht as a tax shelter has been debated since the industry was founded in the 1960s. Conflicting information has been circulated by different sources. Yacht brokers may have unintentionally misinformed their customers because practical, authoritative information was difficult to find. In recent years the hype and misinformation has somewhat lessened but there continue to be different opinions expressed by well-regarded sources.
For practical advice about what the law does and does not allow Sailonline met with Mike Kimball, CPA author of the Tax Guide for Business Yachtsmen, recently at the Miami Boat Show. Kimball’s accounting/tax consulting firm is based in Tyler, Texas.

Kimball:

Let me qualify my answer by saying that most of my clients are involved in charter management programs. I’ve done consulting work for a few startup charter “businesses” but most of my clients are involved in “rental” charter activities. Different rules apply with respect to personal use issues, depreciation, passive losses, tax return disclosures, etc.
Regarding agency-managed yacht rentals, buyers usually have one of two objectives. Some believe that buying a charter boat is a license to be extremely aggressive and expect that they can deduct large operating losses each year and save tens of thousands of tax dollars. Working for people in this group is a challenge. It’s not because I want to prevent them from reducing their taxes but as their professional advisor I am responsible for advising them correctly. These are high-income folks and fairly likely audit candidates even before you consider the yacht charter issues. It’s an obvious IRS audit flag if they take the 50% bonus first-year depreciation deduction that causes a large operating loss and then claim they are “active” with respect to their charter activity when they are employed full-time in an unrelated profession and live a thousand miles away. After their second or third year owning a charter boat is no fun because their loss deductions are disallowed and all the tax savings plus punitive penalties and interest come due at once.

The guys in the second group are not buying a boat with the objective of using it as a tax shelter. They just want to enjoy sailboat vacations in paradise and take advantage of whatever tax saving opportunities are available under the circumstances. I enjoy working for them because this is where strategic planning does the most good. I’ve developed some strategies that produce about the same end result over a period of five years that the overly aggressive yacht owners seek to accomplish except that there are no obvious audit flags and, in case of an IRS audit, I am confident that their returns can be defended successfully. (An IRS audit is no problem when you are prepared and its fun when you win.)

Sailonline:
Please go on. We’re especially interested in your no audit flags strategies.

Kimball:

First I’ll tell you what I think are the audit flags. There are four tax code sections that target yacht chartering and similar activities—like hobby farming for example.
The Form 1040 Schedules have questions on them that are designed to alert IRS reviewers when certain circumstances exist. Like on Schedule E where it asks whether a rental property was used more than 14 days (or 10% of charter days if greater) during the year for personal use. (By the way I advise my clients not to report their rental income and deductions on Schedule E but it is not because I am trying to conceal or misrepresent personal use. In most cases it is actually more advantageous for them to exceed the 14-day/10% vacation home threshold)
Another audit flag has to do with the question on Schedule C where it asks whether you “materially participated” in your business. In order to take an operating loss deduction you must enter income and deductions on Schedule C and, unless you have a net passive income from rental real estate or other passive investments, you must answer “yes” to the material participation question. Again, I advise my clients not to report rental income and deductions on Schedule C but it is not because I am trying to avoid answering the active participation question. The reason has to do with the charter “business” v. “rental” issue. If an owner uses his boat for more than the 14 days each year this question is irrelevant.
The third flag is on Form 4562 where it asks you to enter the method used to calculate depreciation and the percentage of the time a yacht is used for business/rental use. In my opinion, owners whose boats are engaged in “rental” charter activities must use the alternative (straight line) depreciation method over 18 years rather than the accelerated 10-year declining-balance method. This opinion was confirmed a few months ago when a charter boat owner from Arizona contacted me for help with an IRS audit.
Finally, the fourth obvious flag has to do with continued operating losses. If a person starts a business with the intention of earning profits and it produces operating losses he does one of two things right away. Either he changes his operating methods or he closes the business.

If an owner buys a charter boat and represents that: 1) it is a for-profit business; 2) that personal use does not exceed 14 days per year; and 3) he materially participates in day-to-day operations, and then reports uninterrupted operating losses for 5 years, I think it is more likely than not that IRS will challenge his deductions. At this point he’s got to prove his for-profit objective, which is a difficult and time-consuming task. He’s got to produce credible tangible records regarding charter usage and personal usage, and he’s got to produce a detailed record to prove that he spent at least 500 hours each year attending to on-site business duties. That’s a lot of facts to prove and unless he can prove all of them he loses the deductions.

Sailonline:
You’ve mentioned two forms that you advise clients not to use in their tax returns. What forms do you advise them to include?

Kimball:

Before I can advise a buyer about taxes I have to get a pretty good idea of what to expect over the term of their charter activity. This means making cash flow projections—usually for five years. I don’t think I have ever worked for anyone who was investigating a yacht purchase that had not made a cash flow estimate before contacting me but, for purposes of making the rent v. buy decision and then estimating the tax results, the expenses have to be arranged in categories according to the Tax Code provisions.
Another thing I strongly advise is to consider how many days they will use their boats because this directly affects their cost per day. Finally, to estimate the cumulative capital contributions and overall gain or loss, an owner must estimate what the boat will be worth at the end of the charter term. I’ve heard my business friends refer to this kind of analysis as “due diligence” and I believe that if someone is about to spend a half-million dollars, more or less, its worth taking the time to make a fairly thorough analysis of the financial consequences just like any other business deal.
Now, keeping in mind that we are talking about agency-managed rental charter activities, in most cases the personal use will exceed 14 days per year. If it doesn’t its unlikely that after making the cash projections and figuring the cost per day for renting v. owning, they will choose to go forward on the purchase.
When personal use exceeds the 14-day/10% limit the yacht charter income and deductions are “definitively” governed by the vacation home rules. This sounds like bad news but in my opinion it is an extremely useful planning tool (safe harbor) because it overrides all the other Code Sections having to do with hobby losses, passive investments, etc.
Another feature I like about the vacation home strategy is the treatment of interest deductions. Regardless of whether the 14-day/10% limit is exceeded part of interest and other fixed expenses (insurance, dockage, maintenance) must be allocated to personal use and part to business use. Only when the 14-day/10% limit is exceeded can the interest allocated to personal use be deducted on Schedule A. There are two methods authorized for making the personal/business allocation and the method that usually produces the more favorable result is only available when the vacation home rule applies.
The vacation home strategy works best for most owners but there are other strategies to deal with special circumstances. For example, if a person has unapplied passive losses from other investments and there is either no mortgage or a small mortgage on his boat, it is advisable to avoid the vacation home treatment. Its possible to accomplish this and still use the boat for about four owner weeks a year by choosing a guaranteed income management plan.

As far as actually preparing clients’ tax returns I take a proactive approach. The Form 1040 instructions say to include income and deductions from the rental of personal property on Lines 21 and 35 and to enter the abbreviation “PPR” beside the amounts. Yachts are personal property and that is basically how I represent charter income except that I include a Disclosure Statement in my clients returns that cites the applicable Code Sections, the number of fair rental days and days of owner use, and the calculation of the limit on the depreciation deduction if any. By including this information in their tax return a person is demonstrating to IRS that they are aware of the applicable Code Section laws and are voluntarily disclosing the relevant circumstances. It is a sort of negative audit flag. An example of this Statement is included in the Tax Guide for Business Yachtsmen.

Disclaimer
The foregoing information is of a general nature and is not intended to address the circumstances of any particular individual or business entity. Neither Mr. Kimball nor Sailonline.com are herein engaged in rendering any legal or income tax advisory services whatsoever. Mr. Kimball & Sailonline.com expressly disclaim liability resulting from any actions taken in reliance on this information. Readers with specific tax questions are urged to seek the advice of an experienced income tax professional.

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