Personal Use of Corporate Aircraft Before and After the American Jobs Creation Act of 2004
In an era that places a premium on saving time and on obtaining a competitive advantage, however slight, use of “corporate jets” has become increasingly more attractive to business owners.1 The growing inconvenience of commercial air travel will likely continue this trend.2 An issue arises, however, because ownership and operation of an aircraft lies at the intersection of four complicated, distinct areas of law: federal tax rules, state tax rules, aviation law, and general liability rules. This article will focus on Code §274,3 which sets forth one of the more significant federal tax statutes impacting the deductibility of expenses associated with the operation of an aircraft.
Federal Income Tax Issues
The deductibility of an aircraft’s fixed and variable operating costs related to the business use of the aircraft generally is governed by the “ordinary, necessary, and reasonable” requirements for trade or business expenses under Code §162 or for investment use under Code §212.4 The “ordinary” test is generally not a barrier to deductibility in that the courts recognize that the use of corporation aircraft in the furtherance of a taxpayer’s business is a common practice. Similarly, the “necessary” requirement, which requires demonstrating a direct relationship between the expense and the furtherance of the business, is not typically a significant impediment to deductibility. The third test requires that the expense must be reasonable in relation to its purpose.5 The thrust of all three of these tests is that a taxpayer who seeks to deduct the costs of operating the aircraft as ordinary and necessary business expenses incidental to their primary business must document the direct relationship between the use of the aircraft and the furtherance of the primary business.6
Generally, taxpayers are most concerned about the depreciation rules, given their quantitative significance.7 While aircraft generally have a class life of six years, with a five-year recovery period under the accelerated method of depreciation,8 a complicated “qualified business use” rule must be carefully analyzed to determine the appropriate depreciation method.9
The most difficult issues in attempting to utilize the losses incurred in operating an aircraft are the entertainment facility rules contained in Code §274.
The general rule articulated in Code §274 is that no business deduction is allowed for any expenses paid or incurred for an entertainment, recreational or amusement facility. An entertainment facility is any property that a taxpayer owns, rents, or uses for entertainment. Examples of entertainment facilities include a hunting lodge, fishing camp, swimming pool, tennis court, bowling alley, car, apartment, hotel suite, a home in a vacation resort, and, importantly, airplanes.10
Absent the applicability of an exception, the general rule governing entertainment facility expenses under Code §274(a)(1)(B) is that their deduction is flatly prohibited (effective for taxable years after 1978).11 Under regulations that, by their title, apply to entertainment facilities prior to 1979, expenditures with respect to an entertainment facility include depreciation and operating costs such as rent and utility charges, expenses for maintenance, preservation and protection of a facility (e.g., repairs, painting, and insurance costs), salaries or subsistence expense paid to caretakers or watchmen, and losses realized on sale or other disposition. The Tax Court continues to apply this regulation for tax years after 1979. Thus, the §274 disallowance applies to depreciation, and operating costs such as rent, utilities, maintenance, and protection. In other words, no deduction means no deduction.
There are several exceptions to the strict disallowance rules contained in §274. Of particular relevance, there is a bright-line exception for expenses for goods, services, and facilities to the extent they are treated as compensation to an employee.12 For the past several years, this exception has been the topic of discussion in the airplane industry because of the case of Sutherland Lumber-Southwest, Inc. v. Commissioner, 114 T.C. 197 (2000), aff’d, 255 F.3d 495 (8th Cir. 2001), acq., AOD 2002-02 (February 11, 2002). Due to the significance of this case under prior and current law, as amended by the act, it is worth a more detailed discussion.
Sutherland Lumber-Southwest, Inc. v. Commissioner
Prior to Sutherland Lumber, there was little direct guidance on the amount of “personal” use that would taint the “business” use of an aircraft. Specifically, under the law prior to Sutherland Lumber, there was an issue as to when personal use became so substantial that it obviated the “business purpose” of the entity, thereby causing an airplane to be treated as an “entertainment facility” such that deductions for all expenditures incurred with respect to the plane would be disallowed. Indeed, many practitioners were concerned because, under a literal reading of IRC §274, the IRS could attempt to deny a taxpayer a deduction for all expenditures incurred “with respect to” an airplane that was used occasionally for entertainment purposes. However, notwithstanding this theoretical concern, it was believed that an “incidental” percentage of personal use would not taint the facility.13
In 2000, the good news for taxpayers (and for the aviation industry at large) was that the law became substantially more lenient (and clear) than the above-cited 80 percent test because of the Tax Court’s decision in Sutherland Lumber which decision was affirmed by the Eighth Circuit, and to which decision the IRS acquiesced.
This case focused on an exception to the entertainment facility rules for goods, services, and facilities “to the extent they are treated as compensation to the employee.”14 Specifically, in Sutherland Lumber the IRS challenged deductions for the use of a company owned aircraft by its employees for nonbusiness flights. More specifically, the IRS argued that the amount of the deduction was limited to the amount included in the employees’ compensation. This was significant because the corporation valued the personal use at a substantially reduced safe harbor valuation for gross income tax purposes known as the standard industry fare level (SIFL) formula.15 Thus, since the applicable SIFL valuation rule resulted in substantially less income to the employee than would result under the general valuation rule for charter flights, the employer’s allowable deduction, according to the IRS’s litigating position, was substantially less than its cost.
However, the Tax Court concluded that Congress intended that a proper inclusion in compensation would satisfy the exception to the disallowance rule and result in a full deduction. The Tax Court further held that the fact that the SIFL amount may be substantially less than the offsetting deduction is irrelevant and that taxpayers may take as a deduction the full cost of allowing their executives to use corporate aircraft for personal purposes.
Even more significantly, in 2002, the IRS acquiesced to the Eighth Circuit’s determination in Sutherland Lumber, and indicated that it would no longer litigate the applicability of the entertainment facility rules where a taxpayer has properly included in compensation the value of an employee’s vacation flight.16
In the post-Sutherland Lumber world, therefore, taxpayers became comfortable taking a full deduction for personal use of corporate aircraft when the appropriate SIFL amount was included in income. Indeed, the IRS’s stance softened even further in November 2003, when it issued Chief Counsel Advice 200344008. Sutherland Lumber had left open several issues, including the issue as to how much “personal/nonbusiness” use of a facility could occur and what effect “nonemployee” use would have on a taxpayer’s ability to deduct expenses.17
The facts of CCA 200344008 were noteworthy. The taxpayer was a Subchapter S corporation that documented business use of the aircraft at approximately five percent with the remaining 95 percent being personal use by the shareholders and two nonfamily employees. The taxpayer reported deductible expenses that were more than 10 times the value of the income included by the shareholders and employees (pursuant to the SIFL methodology). The net effect of this treatment was that the shareholders claimed a very large deduction for the expenses of the personal use of the S Corporation’s aircraft (much of which was attributable to use by them or other family members). In an extremely pro-taxpayer opinion, chief counsel concluded that Code §274(a)(1)(A) did not disallow an S corporation’s deductions for the expenses of providing corporate aircraft for personal use of shareholders or employees, if the S corporation included the value of each flight in the shareholder’s or employee’s income, even though 95 percent of the use of the aircraft was for employees’ personal use. Chief Counsel Advice 200344008 also made it clear that the status of employees or nonemployees was insignificant as long as the nonemployee shareholders/partners include the value of the flights under the SIFL rates. For obvious reasons, taxpayers (and practitioners advising taxpayers) interpreted this to mean that employers taking the full deduction for personal use of corporate aircraft were probably safe from IRS attack under Code §274 notwithstanding the amount of personal use (provided that the SIFL amount was included in income).18
American Jobs Creation Act of 2004
Recently, without any warning,19 the American Jobs Creation Act of 2004, which was enacted on October 22, 2004,20 dramatically changed the landscape and legislatively overruled the Sutherland Lumber decision.
Specifically, Code §274(e) was amended by §907 of the act so that it now limits companies’ ability to deduct aircraft costs attributable to flights provided to “specified individuals” for “entertainment” purposes.21 The term “specified individuals” in Code §274 makes reference to §16(a) of the Securities Exchange Act of 1934, which, in turn, generally includes officers (as defined by §16(a)),22 directors, and 10 percent or greater owners of private and publicly held companies. Because of the broad definition of “specified individuals,” and because the act applies to privately held companies as well as publicly owned companies (including C corporations, S corporations, partnerships, and limited liability companies),23 it has closed the “loophole”24 created by Sutherland Lumber for expenses incurred after the October 22, 2004, date of enactment.25 virtue of the act, a company can no longer deduct the costs of operating an aircraft attributable to a “specified individual’s” entertainment use of an aircraft except to the extent of the amount the “specified individual”26 must report as a taxable fringe benefit on his personal income tax return.
It is the author’s understanding that guidance (likely in the form of a notice) from the IRS/Treasury will be forthcoming (with regulations to follow), which should clarify the scope of these rules.27 However, until then, taxpayers are well advised to provide proper substantiation, as required by §274(d),28 properly integrate aircraft usage directly into an active business, and otherwise operate as they did in the pre-Sutherland Lumber days.29
The foregoing is necessarily only a broad brush treatment of one of the more significant tax hurdles to deductibility of expenses associated with corporate aircraft. It is not intended to constitute an exhaustive discussion of all of the federal tax issues potentially implicated by the acquisition and operation of corporate aircraft. Indeed, there are substantial other barriers to deductibility that must be considered in proposing a structure that positions a taxpayer to take advantage of the potential federal tax benefits of aircraft ownership, which can be significant. For example, note that it is important to consider basis issues, the effect of the at-risk rules, the passive activity rules, and the hobby loss rules. To complicate matters further, it is critical to consider certain complicated excise tax rules, state tax considerations, and aviation rules.
In conclusion, when advising clients who are considering acquiring a corporate aircraft, practitioners must analyze the American Jobs Creation Act of 2004 legislative reversal of a case that has given practitioners (and their clients) a substantial degree of comfort on minimizing the potentially adverse federal income tax consequences with regard to limiting the deductibility of the expenses incurred with respect to the aircraft. Similarly, practitioners should alert their clients that currently own corporate aircraft that it may be necessary to revisit their policies with regard to making their aircraft available to owners, officers, and directors, and to implement alternative structures that properly address the act.
1 Recent National Business Aviation Association figures reflect that, in the U.S., more than 10,000 companies own more than 15,000 business aircraft and that nearly 6,000 more companies own fractional shares in aircraft.
2 Recently published March 2005 Bureau of Transportation Statistics indicated that the 19 largest carriers reporting on-time performance recorded an overall on-time arrival rate of 71.4 percent in January, down from January 2004’s 74.9 percent rate. The carriers canceled 4.20 percent of their scheduled flights in January, up from both January 2004’s 3.0 percent rate and December 2004’s 2.80 percent rate. Chicago O’ Hare airport alone reported more than 58,000 delays in the first half of 2004.
3 All statutory references in this article are to the Internal Revenue Code of 1986, as amended (the “Code”).
4 The analysis contained herein is the same whether the ownership involves a fractional interest in an aircraft or ownership of the entire aircraft. Of course, in the context of fractional ownership, the tax benefits will flow through to a fractional owner only to the extent of the fractional owner’s share in the aircraft.
5 See Kurzet v. Comm’r., 222 F.3d 800 (10th Cir. 2000) (reversing for clear error the Tax Court’s factual finding that expenses for use of an airplane were unreasonable).
6 This requires taxpayers to keep contemporaneous, detailed records that corroborate the “business” purpose of the trip (including, but not limited to, the purpose of the trip, the identity of the passengers, and whether the trip’s purpose was accomplished).
7 Prior to the American Jobs Creation Act of 2004 (also referred to as the “act” or the “JOBS act”), aircraft purchasers were also eligible for “bonus depreciation.” Note, however, that bonus depreciation on noncommercial aircraft generally expired in 2004 (i.e., the relevant aircraft must have been acquired after September 10, 2001, and placed in service before January 1, 2005) except for property acquired pursuant to a written binding contact before January 1, 2005, and placed in service before January 1, 2006. Code §168(k), as amended by §336 of the act. Because of the obvious limitations on the “extension” of eligibility for bonus depreciation, it will not be discussed further herein.
8 Note, however, that aircraft used primarily for commercial purposes (including aircraft used primarily in charter service under FAR Part 135) are classified as seven-year property with cost recovery allocated over an eight-year period.
9 If the aircraft is not used sufficiently for “qualified business use purposes,” then the cost of the aircraft must be depreciated under the straight-line method, rather than the accelerated method. “Qualified business use” includes any use in a trade or business but does not include any of the following: 1) leasing the property to certain related parties; 2) using the property to compensate certain related parties for their services; and 3) using the property to compensate other persons without including the use in income and withholding the necessary federal income tax. The amount of qualified business use generally must exceed 50 percent in order to permit full deductions of payments for business use; however, a special rule for aircraft reduce this percentage to 25 percent, and permits consideration of the three excluded categories of business use listed in this footnote above in order to satisfy the greater-than-50 percent threshold.
10 Treas. Reg. §1.274-2(e)(2)(i).
11 The provisions of §274 have no effect on any deductions that are allowable regardless of any connection with the taxpayer’s trade, business or for-profit activity. For example, interest, taxes and casualty losses on an entertainment facility are deductible, even though other expenses associated with the facility are not deductible as entertainment expenses. Treas. Reg. §1.274-2(e)(3)(iii)(c). See Stechcel, 520 Tax Management Portfolio, Entertainment, Meals, Gifts, and Lodging—Deduction and Recordkeeping Requirements for a detailed discussion of these (and other) exclusions from the entertainment facility limitations.
12 Code §274(e)(2) contained an exception for “Expenses for goods, services, and facilities, to the extent that the expenses are treated by the taxpayer, with respect to the recipient of the entertainment, amusement, or recreation, as compensation to an employee on the taxpayer’s return of tax under this chapter and as wages to such employee for purposes of chapter 24 (relating to withholding of income tax at source on wages).” Code §274(e)(9), discussed infra, contains a similar exception for “nonemployees.”
13 See Private Letter Ruling 9608004 (20 percent personal use did not taint the 80 percent of aircraft expenditures associated with business use).
14 I.R.C. §274(e)(2).
15 The SIFL formula takes into account the weight of the aircraft, the miles flown, the applicable terminal charges, and the employee’s status as a control or noncontrol employee. The SIFL formula is generally intended to approximate the cost of a first-class ticket on a commercial aircraft.
16 In such cases, the IRS indicated that it would allow the taxpayer a full deduction for the cost of the flight. The IRS stated that it would continue to apply Code §274(a) to cases in which the value of an employee vacation flight was not included in compensation and in cases where the expense represented a dividend or unreasonable compensation.
17 The historical concern stemmed from the fact that Code §274(e)(9) contains slightly different language than Code §274(e)(2) and from the fact that the scope of the Tax Court decision and the IRS acquiescence thereto were expressly limited to 274(e)(2), which deals with “employees” (and did not expressly extend to 274(e)(9), which extends the compensation exception to “nonemployees”).
18 Subsumed in this parenthetical was a significant point—that while the IRS did not intend to litigate the theoretical position, it had publicly stated that it would be looking at compensation, and particularly, valuing the fringe benefits for the personal use of corporate aircraft. Specifically, in a Webcast on November 13, 2003, the IRS listed this as one of eight key areas within the general topic of executive compensation arrangements that it would closely scrutinize.
19 The House bill did not contain any provision that would affect Code §274, while the Senate amendment proposed a change that would have affected only “covered employees,” which were defined under §162(m)(3) to include the chief executive officer (or an individual acting in such capacity) and the four highest compensated officers of publicly-traded corporations.
20 The American Jobs Creation Act of 2004 passed the House on October 7, 2004, by a 280-141 vote, and was approved by the Senate by a 69 to 17 majority.
21 Specifically, Code §274(e) as amended, now reads as follows:
“ (2) Expenses treated as compensation.
“(A) In general. Except as provided in subparagraph (B), expenses for goods, services, and facilities, to the extent that the expenses are treated by the taxpayer, with respect to the recipient of the entertainment, amusement, or recreation, as compensation to an employee on the taxpayer’s return of tax under this chapter and as wages to such employee for purposes of chapter 24 (relating to withholding of income tax at source on wages).
“(B) Specified individuals.
“(i) In general. In the case of a recipient who is a specified individual, subparagraph (A) and paragraph (9) shall each be applied expenses by substituting ‘to the extent that the expenses do not exceed the amount of the expenses which’ for ‘to the extent that the.’
“(ii) Specified individual. For purposes of clause (i), the term ‘specified individual’ means any individual who—
“(I) is subject to the requirements of section 16(a) of the Securities Exchange Act of 1934 with respect to the taxpayer, or
“(II) would be subject to such requirements if the taxpayer were an issuer of equity securities referred to in such section.”
22 The term “officer” is defined as the president, principal financial officer, principal accounting officer (or, if there is none, the controller), any vice president in charge of a principal business unit, division, or function (such as sales, administration, or finance), any officer who performs a policy-making function, or any other person who performs similar policy-making functions.
23 While the application to privately held companies is not expressly stated, it is the clear intent of the subjunctive wording in new Code §274(e)(2)(B)(2)(ii)(II) (“would be subject to such requirements if the taxpayer were an issuer of equity securities referred to in such section”). Also, note that the act similarly amended the §274(e)(9) exception with respect to nonemployees.
24 On October 12, 2004, Senate Finance Committee Chair Grassley, in the floor speech on the tax loophole closers in the JOBS Act, stated as follows: “I am very pleased that we deal in this bill with the situation of executives who take corporate aircraft for personal travel. Legislation in this bill will put significant limitations on corporations being able to write off such high living.”
25 Theoretically, taxpayers who acquired aircraft after the effective date but prior to the 2004 year-end (and therefore were eligible for bonus depreciation) could have jeopardized the deductibility of expenses to the extent the aircraft was “used” only in a few flights that were personal in nature. In this regard, note that while §274 does not mandate the use of a specific method for allocating costs between entertainment and nonentertainment uses of an aircraft (nor does it require employers to calculate the amount of the allowable deduction on a flight-by-flight basis, there have been various Tax Court cases where an employer has used an allocation method to assign a percentage of either total flight miles or hours attributable to business use and personal use.
26 Thus, the act does not impact the practice of using company aircraft for bonus, award, or incentive compensation for “non-specified” individuals. Note, however, that on January 27, 2005, at the request of the Senate Finance Committee chair and ranking member, the Congressional Joint Committee on Taxation published a study entitled, “Options to Improve Tax Compliance and Reform Tax Expenditures,” which provided a host of options for tax reform, including expansion of the act’s limitations on the personal use of business aircraft from “specified individuals” to “all” employees.
27 It is particularly unclear how “mixed” use flights (i.e., flights where some passengers are flying for business purposes, but one or more passengers are flying for entertainment purposes) will be treated under the act. For this reason, the General Aviation Manufacturers Association (GAMA) and the National Business Aviation Association, Inc. (NBAA) requested guidance from the Treasury Department in November 2004, with respect to this (and other) issues relating to the act. However, as of the date that this article was written, Treasury had not yet responded.
28 At a minimum, the following items must be documented: 1) the amount of the expense, 2) the time, place, and use for the plane, 3) the business purpose for which the flight was taken, and 4) the business relationship between the taxpayer and the other parties on board. I.R.C. §274(d)(4).
29 Note that other more sophisticated solutions to the “hurdle” posed by new Code §274 are properly the topic of another article.
David L. Koche is a member of the law firm of Barnett, Bolt, Kirkwood, Long & McBride. He received his B.A. from Cornell University, his J.D. from Georgetown University, and his LL.M. in taxation from the University of Florida.
This column is submitted on behalf of the Tax Section, William D. Townsend, chair, and Michael D. Miller, Benjamin A. Jablow, and Normarie Segurola, editors.