Depreciating Business Aircraft: Avoiding the Entertainment Disallowance and §280F
Business aircraft are often viewed as a luxury item rather than a productivity tool. Due to this image, the Internal Revenue Service closely scrutinizes aircraft purchases as well as their use. Despite this general perception, when used appropriately, a business aircraft can serve as a seamless extension of a business owner’s office and provide a significant market advantage for highly mobile businesses.
Aircraft have substantial operating expenses; however, the single largest fixed expense for a business aircraft is generally depreciation. Despite similarities to deducting operating expenses and maintenance, there are various provisions of the Internal Revenue Code1 that are unique to depreciation of aircraft.
Depreciation of Aircraft
Aircraft, along with other forms of tangible personal property, are depreciable under I.R.C. §§167 and 168. In order to qualify as depreciable property, an aircraft must be used in a trade or business or held for the production of income.2 Furthermore, even if an aircraft is used in a trade or business, the allowance for depreciation does not apply to any personal use.3 Therefore, if an item of tangible personal property (including an aircraft) is used partly for business purposes and partly for personal purposes, only the portion used for business purposes is depreciable.4 Importantly, personal use is determined in reference to the owner of the aircraft rather than its individual passengers.5 Therefore, if an employee uses an employer-provided aircraft for personal purposes, then the employer, as the taxpayer, is likely still utilizing the aircraft for a business purpose (provided that the value of the flight is included in the employee’s gross income as a taxable fringe benefit).6 Alternatively, if the aircraft is owned directly by the taxpayer, then any personal use of the aircraft by the owner or guest may result in a direct disallowance of deductions attributable to personal flights.
Employees often own aircraft directly and, in turn, attempt to use the aircraft in furtherance of their trade or business of being an employee. For example, in Noyce v. Commissioner, 97 TC 670 (1991), an Intel executive used his personal aircraft to travel to Intel board meetings, conventions, business meetings, and board of trustee meetings for two colleges (Intel flights).7 In addition to the Intel flights, the taxpayer used the aircraft for admittedly personal purposes and allowed a charter company to charter the aircraft when the aircraft was idle (charter flights).8 The Tax Court held that all of the Intel flights and charter flights served business purposes;9 however, the flights that were admittedly personal were not deductible. In applying this holding, the Tax Court included the Intel flights and charter flights in the numerator and all flight hours in the denominator (including various maintenance and delivery flights) in order to reach a business use percentage that was applied to all variable and fixed costs associated with use of the aircraft.10
When the taxpayer owning the aircraft is an employer rather than an employee, the courts have generally favored a position that personal flights provided to employees serve the legitimate business purpose of providing compensation to employees.11 Therefore, the Internal Revenue Service has instead focused on whether the flights are subject to the entertainment disallowance under I.R.C. §274, discussed below, or the burdensome substantiation requirements required by I.R.C. §274.
Even more discretion is granted to aircraft that are held out as charter operators. Therefore, if an aircraft is held out for rent or charter at market rates, any use attributable to these flights will generally be treated as use in a leasing trade or business. Admittedly a bad facts case, Didonato v. Commissioner, T.C. Memo 2011-13, involved a taxpayer that purchased an aircraft through a wholly owned S-corporation and exclusively provided the aircraft to his related business for chartering purposes. The taxpayer failed to adequately substantiate any flights as business flights; however, the underlying S-corporation was still entitled to a depreciation deduction for operation of the aircraft in a leasing trade or business, subject to I.R.C. §280F discussed below.12
Class Life and Depreciation Method
Aircraft that are used for noncommercial purposes have a class life of six years and are subject to a five-year recovery period under the modified accelerated cost recovery system (MACRS) of I.R.C. §168(b).13 Alternatively, aircraft that are used for commercial purposes have a class life of 12 years and are subject to a seven-year recovery period under MACRS.14 Despite these clear lines, it is common for aircraft to be held for both commercial and noncommercial purposes. For example, as in the Noyce case discussed above, business owners often register their aircraft as a noncommercial aircraft with the Federal Aviation Administration (FAA), but contract with a charter operator to place the aircraft on their commercial certificate and periodically charter the aircraft in an attempt to defray the carrying costs of the aircraft. In these mixed-use circumstances, the primary use will determine the aircraft’s useful life.15 In CCA 201228036, the taxpayer purchased an aircraft for business travel. After a period of operation, the taxpayer determined that the aircraft was less necessary and less affordable than originally contemplated, but was unable to sell the aircraft due to its depressed value.16 In order to cover the substantial maintenance expense of owning the aircraft, the taxpayer leased the aircraft to a charter operator. Chief counsel determined that the aircraft was used 83 percent for leasing activity and, thus, was commercial use property subject to a seven-year recovery period.
Given the primary use test, monitoring charter use of the aircraft is important in order to avoid unintended tax consequences. Charter agreements are often of an “on-demand” nature. Therefore, if the aircraft is available, then the charter operator will use the aircraft as much as the market (and the charter agreement) will allow.
When a change in the use of a depreciable asset results in a longer recovery period or a slower depreciation method, the asset will be depreciated as if it had been originally placed in service by the taxpayer with the longer recovery period or slower depreciation method.17 Alternatively, if a change in use results in a shorter recovery period or a more accelerated depreciation method, the depreciation allowances are determined as though the asset is placed in service by the taxpayer in the year of change.18 Therefore, if the primary purchase of an aircraft changes from noncommercial use to commercial use for any one year, the recovery period for the asset will be permanently extended, even if it is primarily used for noncommercial purposes in the following taxable year.19
Aircraft are considered listed property pursuant to I.R.C. §280F(d)(4)(A)(ii). Therefore, aircraft are subject to the various depreciation limitations of §280F. Most notably, §280F(b)(1) provides that depreciation of any listed property not predominately used for a qualified business use for any taxable year will be limited to the alternative depreciation system (ADS) for the current taxable year and all future taxable years.20 Under ADS, noncommercial aircraft have a six-year recovery period and are depreciated based on the straight-line method while commercial aircraft have a 12-year recovery period and are also depreciated on the straight-line method. In addition to the extended useful lives and applying a slower depreciation method, §280F also disallows bonus depreciation under §168(k) and expensing pursuant to §179.21
Section 280F presents a two-part test in calculating qualified business use of an aircraft. The first test requires that 25 percent or more of the aircraft’s occupied seat hours or miles qualify as business use excluding 1) leasing the aircraft to any 5 percent owner or related person; 2) the use of the aircraft as compensation for services by a 5 percent owner or related person; or 3) the use of the aircraft as compensation for services by any person other than a 5 percent owner or a related person unless the provider of the aircraft includes the value of the compensation in the recipient’s gross income, the employer and recipient properly report the income and, when necessary, both parties treat the compensation as wages subject to withholding (25 percent test).22 If the 25 percent test is met, then categories one, two, and three above are added back to the definition of qualified business use, and this total must exceed 50 percent of the aircraft’s flight hours or flight miles during the taxable year (50 percent test).23
Generally, business aircraft are able to comfortably meet the 50 percent test when considering flights provided for compensation and leases to related parties; however, the 25 percent test often presents a greater challenge. The primary barrier to meeting the 25 percent test is often the aircraft’s ownership structure and nontax considerations.
It is often difficult for a single business venture to support the expenses associated with owning an aircraft. Therefore, it is common for multiple businesses under common ownership to share the use of an aircraft. In order to comply with FAA regulations and to avoid classification of the aircraft as a commercial carrier (subject to additional inspection and flight documentation requirements), dry leases are put in place to transfer operational control among the various businesses. Despite the leased aircraft being used directly in furtherance of a related business, the Internal Revenue Service has arguably taken the position that these leased flights will not qualify for the 25 percent test.24 Based on informal conversations with associate chief counsel’s office, this issue is currently under review and, thus, guidance is forthcoming. However, in the interim, the use of an aircraft must be closely monitored to ensure that excessive leasing activity does not impact of the aircraft’s recovery period or method of depreciation.
The American Jobs Creation Act of 2004 (Pub. L. No. 108-357) substantially limited the deductibility of aircraft expenses attributable to entertainment use by certain owners and officers.25 Despite temporary guidance from the Internal Revenue Service, practitioners still had many questions regarding the application of the new disallowance rules. Therefore, more than seven years after the first temporary guidance on the matter, the Internal Revenue Service published long-awaited final regulations on July 31, 2012.26
The regulations did not provide any additional guidance defining entertainment use;27 however, they do provide in-depth mechanical rules in calculating the entertainment disallowance percentage (once the purpose of individual passengers’ travel is determined). The regulations provided two ways in which the entertainment disallowance percentage can be calculated: 1) the occupied seat method28 or 2) the flight-by-flight method.29 A taxpayer may chose the method that yields the most favorable result, but the same method must be used for all flights of all aircraft owned by a taxpayer during a taxable year.30
The occupied seat method can be determined based on occupied seat hours or occupied seat miles.31 In order to determine the disallowance, all expenses are allocated pro rata to all occupied seat miles or hours. Occupied seat miles or hours are calculated by the number of statute miles32 or flight hours33 for a particular flight multiplied by the number of passengers on each flight.34 Alternatively, the flight-by-flight method allocates all expenses to flight hours or miles of each flight. After allocating the expenses to each flight, the portion of the expenses attributable to entertainment use by specified individuals (and their guests) on each flight is disallowed. Certain anticipated uses, such as the length of flights, the number of passengers on each flight, and total hours of usage, all impact which method is more advantageous. Furthermore, these considerations become increasingly more complex once empty legs, maintenance flights, and multi-leg trips are incorporated into the calculation.
The final regulations provide two additional important planning opportunities. First, entertainment disallowances can be determined as if the aircraft was depreciated under the straight-line method and, second, expenses allocable to leases or charter of an aircraft to an unrelated third party for adequate and full consideration are excluded from the definition of expense.35
Impact of Rules on Flight Itineraries
All of the factors above must be considered together when determining the after-tax cost of an aircraft purchase. Furthermore, small adjustments in flight itineraries can significantly impact the overall deductibility of aircraft expenses.
As a brief example, assume that a new aircraft is purchased in 2016 by a large construction company that has active projects in Florida, Texas, and Michigan. The aircraft is operated as a noncommercial aircraft. During the first six months of 2016, the aircraft is used solely for business purposes (e.g., transporting executives and project managers between construction projects). Due to the requirement that managers and executives travel on short-notice, only two employees are present for each of 10 flights, and the flights averaged five flight-hours (round-trip). Therefore, during the first six months, the aircraft accumulated 100 hours of business use. At this point the aircraft is 100 percent deductible. Therefore, if the aircraft was purchased for $10,000,000, then the depreciation deduction would be $6,000,000 in 2016.36 Noticing the low utilization of the aircraft, the owners decide to use the aircraft to attend a conference in July. The conference is in California and serves a substantial business purpose to the owners; however, the conference falls over the 4th of July holiday, therefore, as is generally customary for conference attendees, each owner is accompanied by their spouse and two children. While the owners attend the conference, their families use the time sightseeing and exploring the city. The flight is 10 hours (round-trip). Under these circumstances, travel by spouses and children would likely be treated as entertainment use subject to the entertainment disallowance. Therefore, under the occupied seat method, 60 hours would have been allocated to entertainment use, resulting in a disallowance of approximately $2,000,000 of depreciation. On the flight-by-flight method, this entertainment disallowance would still be approximately $750,000. Finally, assuming the company properly elects to apply the disallowance on the straight-line method, the disallowance will be limited to approximately $105,000 (reduced by any income included in the owner’s gross income).
When depreciating aircraft, small adjustments in usage can have a significant positive or negative impact on allowable depreciation. Failure to plan accordingly can result in the loss of millions of dollars in allowable deductions and undercut the basic viability of owning a business aircraft. Therefore, the time to discuss these issues is well before your client ever hits the runway.
1 All references are to the Internal Revenue Code of 1986, as amended.
2 The Tax Court has previously held that depreciation pursuant to §168 is not subject to the requirements of §162 that expenses be ordinary, necessary, and reasonable in amount. Noyce v. Commissioner, 97 T.C. 670 (1991).
3 Treas. Reg. §1.167(a)-2.
4 See Strother v. Commissioner, T.C. Memo 1957-102.
5 See CCA 200344008.
6 Employers can elect to value personal use of private aircraft by employees and independent contractors at rates substantially below charter rates. This method of calculating this alternate value is known as the standard industry fare level (SIFL) formula. Barring the application of the entertainment disallowance rules, the SIFL valuation rules result in substantially less income being includable for employees without a correspondence reduction in an employer’s allowable deductions.
7 Noyce, 97 T.C. at 676.
8 Id. at 681.
9 Importantly, Intel had a policy in place that did not provide employees reimbursement for travel expenses. If reimbursement was available, then deductions would have been reduced by the amount allowable as a reimbursement to the taxpayer.
11 Sutherland Lumber-Southwest, Inc. v. C.I.R., 114 T.C. 197, opinion aff’d, 255 F.3d 495 (8th Cir. 2001), recommendation regarding acquiescence, AOD-2002-2.
13 Rev. Proc. 87-56 1987-2 CB 674.
15 CCA 201228036.
17 Treas. Reg. §1.168(i)-4(d)(4)(i) and (ii).
18 Treas. Reg. §1.168(i)-4(d)(3)(i)(A).
19 See Treas. Reg. §1.168(i)-4(d)(6), example 2.
20 I.R.C. §280F(b)(1). A separate effect that is often not well understood is the requirement that the taxpayer include in income any excess depreciation taken in years prior to the first year the aircraft is deemed to have not been predominately used in a qualified trade or business. Thus, if the taxpayer took bonus depreciation and accelerated depreciation deductions in prior years, the first year in which §280F applies can result in a substantial tax adjustments. I.R.C. §280F(b)(2)(B).
21 The Protecting Americans from Tax Hikes (PATH) Act of 2015 (Pub. L. No. 114-113) extended the application of bonus depreciation for property placed in service before January 1, 2020. Bonus depreciation allows for the immediate depreciation of up to 50 percent of the depreciation base of property if the original use of the property is with the taxpayer. In the context of aircraft, this generally requires that the aircraft be a new aircraft purchased from the manufacturer or an associated broker. Despite, the disallowance of §179, the impact is generally minimal due to the $2 million limit on asset placed in service during the taxable year.
22 Treas. Reg. §1.280F-6(d)(2)(ii).
23 Treas. Reg. §1.280F-6(d)(2)(B).
24 See TAM 200945037.
25 For a complete discussion of the impact of the legislative change, see David L. Koche, Personal Use of Corporate Aircraft Before and After the American Jobs Creation Act of 2004, 79 Fla. B. J. 7 (Jul/Aug 2005).
26 The final regulations were published as Treas. Reg. §1.274-10.
27 Entertainment is defined in Treas. Reg. §1.274-2(b)(1). The definition is dated and lacks the necessary specificity to apply the definition to many circumstances involvement the use of business aircraft.
28 Treas. Reg. §1.274-10(e)(2).
29 Treas. Reg. §1.274-10(e)(3).
30 Treas. Reg. §1.274-10(e)(1).
31 Treas. Reg. §1.274-10(e)(2)(i).
32 Flights miles are calculated as “statute miles,” which equal 1.15 times the nautical flight miles for a trip.
33 Flights hours are calculated at the time when aircraft leaves to runway to the time the aircraft lands (excluding the time it takes to taxi to and from the gate).
34 Treas. Reg. §1.274-10(e)(2)(ii).
35 Treas. Reg. §1.274-10(d)(2) and (3).
36 ($10,000,000 x 50 percent) + ($5,000,000 x 20 percent) = $6,000,000.
Christopher R. Dingman is a tax attorney at the Tampa law firm of Barnett, Bolt, Kirkwood, Long & Koche. He received his J.D. and his LL.M. in taxation from the University of Florida.
This article is submitted on behalf of the Tax Law Section, James Herbert Barrett, chair, and Michael D. Miller, Benjamin Jablow, and Christine Concepcion, editors.