Are Your Lease Payments Still Deductible? The Confounding IRS Guidance Limiting the 'Entertainment' Use of Business Aircraft

In its zeal to eradicate perceived abuses and further clip the wings of executives who, based on press reports, took great pleasure in using the company's airplane for personal purposes, Congress amended section 274(e)(2) of the Internal Revenue Code (the “Code”) in the American Jobs Creation Act of 2004 (“AJCA”). Effective on the date of enactment (Oct. 22, 2004), these amendments effectively reversed the decisions of the Tax Court and Eighth Circuit in Sutherland Lumber-Southwest, Inc. v. Commissioner, 114 T.C. 197 (2000), aff'd 255 F.3d 495 (8th Cir. 2001), acq. AOD 2002-02 (Feb. 11, 2002), and prompted the Internal Revenue Service (“IRS” or the “Service”) to issue guidance containing a myriad of rule changes and hinting at others, leaving tax practitioners scratching their heads and companies running for cover.

On May 27, 2005, the IRS released Notice 2005-45, 2005-24 I.R.B. 1228 (June 13, 2005) (the “Notice”). The rules set forth in Notice 2005-45 create an administrative nightmare for taxpayers and potentially result in the loss of valuable company tax benefits when executives (so-called “specified individuals” and their guests) use the company's airplane for personal purposes. Unfortunately, the Notice, which applies to expenses incurred after June 30, 2005, is difficult to interpret and creates many traps for those attempting to comply with the new deduction disallowance rules.

Sutherland Lumber: Who Says the Good Old Days Weren't Good?

The personal use of a business's aircraft frequently results in an “entertainment” flight for the recipient of the benefit. Until the amendment of Code section 274(e)(2) by the AJCA, a company could fully deduct the costs associated with flights by its executives for personal purposes (even if the flight could be viewed as entertainment), provided the value of the flight was imputed in the flier's income as determined under the Standard Industry Fair Level or (“SIFL”) rules of Treasury Regulation “Treas. Reg.” '1.61-21(g). See Sutherland, 114 T.C. at 206; see also Chief Counsel Advice (“CCA”) 200344008 (July 1, 2003). Because the SIFL values imputed to executives are typically minimal in comparison with the actual costs associated with providing the personal flights, wide discrepancies existed between the permitted deductions taken by companies for providing the benefits and the amounts imputed in the executives' incomes. Although it mentioned this disparity as the reason for amending Code section 274(e)(2), Congress was well aware of this arbitrage opportunity when the SIFL rules were adopted for highly compensated employees in 1985. See 131 Cong. Rec. S6367-S6371 (Daily ed. May 16, 1985).

The Treasury Regulations acknowledge the frequent differences between an employer's cost to provide a fringe benefit and the value of the benefit received by the employee. Specifically, the Regulations provide that the cost to provide a fringe benefit is not relevant when determining the value of a taxable fringe benefit to impute in an employee's or independent contractor's income. Treas. Reg. ”1.61-21(b)(2) and 1.61-2T(b)(2). Moreover, the Regulations provide that the amount deductible by the employer is the cost to provide the benefit. See Treas. Reg. '1.162-25T. In other words, an employer may not deduct the value of the benefit when the value exceeds the cost. Id. Thus, until the passage of AJCA, the company's deduction and the employee's income have not been linked, and employers could deduct the cost of providing entertainment-related flights to employees or independent contractors, even though only the SIFL values of these personal flights were required to be included in the recipients' income.

The New Rules: The Expansive Definition of 'Specified Individual'

Revised Code section 274(e)(2) limits a taxpayer's deductions for the cost of providing entertainment-related flights to specified individuals, who are defined as:

… 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.

Under this definition, it would seem that only a few executives would be classified as specified individuals.

Not so fast.

The Notice dramatically expands the definition of “specified individual” beyond those one would traditionally consider as having the policymaking authority to control the use of the aircraft. The Notice specifically includes any person who: 1) is the direct or indirect owner of more than 10% of any class of registered equity security (other than exempted securities), 2) is a director or officer of the issuer of the security, 3) would be the direct or indirect beneficial owner of more than 10% of any class of a registered equity security if the taxpayer were an issuer of equity securities, or 4) is comparable to an officer or director of an issuer of equity securities.

Further, the Notice concludes that a “specified individual” is an officer, director, or more than 10% owner of a corporation taxed as either a C corporation or an S corporation, or a personal service corporation. For partnership tax purposes, a “specified individual” includes any partner holding more than a 10% equity interest in the partnership, general partner, officer, or managing member of a partnership. A “specified individual” also includes an officer or director of a tax-exempt entity. The Service also expanded the application of the Notice to specified individuals employed by “related parties” of the taxpayer, within the meaning of Code sections 267(b) and 707(b). In short, there are a lot of individuals whose use of company aircraft now must be monitored for company deduction purposes.

The Deduction Disallowance for the Entertainment Use of Company Aircraft

For specified individuals benefiting from entertainment goods, services, or facilities, revised Code section 274(e)(2) limits a taxpayer's deduction to the amount treated as wages in the case of an executive, or to the amount reported as compensation income on Form 1099-MISC in the case of an independent contractor (eg, a corporate director). Thus, a taxpayer that incurs substantial expense related to the operation of a business aircraft may lose significant tax deductions if it fails to report the full charter value of any entertainment flights provided to specified individuals.

According to the Notice, the expenses of operating an aircraft include fuel; salaries for pilots, maintenance personnel, and other personnel assigned to an aircraft; meal and lodging expenses for flight personnel; take-off and landing fees; maintenance costs; hangar fees; management fees; depreciation; Code section 179 expenses; and, if applicable, lease payments ' in short, just about everything. Because these collective expenses always exceed the individual SIFL valuation imputed for a personal flight, this new deduction disallowance is especially harsh. In certain instances, the value of the lost deduction may be so significant that some may question whether the corporate officer or director benefiting from the entertainment use of an aircraft has breached his or her fiduciary duty to the company's shareholders.

Rather than using a flight-by-flight analysis, the Notice requires taxpayers to allocate aircraft expenses between business use and entertainment use for each taxable year by using either an occupied seat hour or occupied seat mile approach. Once the taxpayer elects to apply a particular method (ie, seat hours or seat miles), it must be applied consistently. The method essentially prorates the cost of maintaining and operating the aircraft among all aircraft passengers for the year. When the taxpayer determines its entertainment use percentage, it must multiply that percentage by the aggregate aircraft expenses for the year. The product is the amount of expenses subject to disallowance under Code section 274(e) for the taxable year.

There are serious problems related to the pro rata allocation method prescribed by the Service, particularly when an executive's spouse or other guest accompanies the executive on a business-purpose flight. In such an instance, the expense disallowance computed under the Notice (assuming SIFL imputation for the executive's spouse or guest) will be disproportionate. For example, assume that a company uses its business aircraft once during the taxable year for a business trip from New York to Los Angeles and back (a 10-hour roundtrip). Assume also that the aircraft has a seating capacity of 10 passengers. Further assume that two senior executives, both specified individuals, and six junior associates are traveling to attend a business meeting in Los Angeles. Both of the senior executives' spouses are accompanying the executives for personal purposes. Thus, a total of eight passengers are flying for business purposes, and two are flying for entertainment purposes. Under the allocation methodology set forth in the Notice, 80% of the occupied seat hours/miles relates to business use and 20% relates to entertainment use.

Importantly, under these facts because the aircraft is flying with at least 50% of its seats occupied by business passengers (ie, the two senior executives and the six junior associates), Treas. Reg. '1.61-21(g)(12) deems the value of the flights provided to the executives' spouses to be zero. However, Notice 2005-45 requires a 20% deduction disallowance for all expenses under the occupied seat hour (or mile) method because the executives' spouses traveled on the aircraft for entertainment purposes, even though the flight would have been fully deductible had they not accompanied the others on the flight. This method of pro rata deduction disallowance based on passengers is at odds with the policy behind the fringe benefits regulations that the valuation of personal flights turns on the overall characterization of a flight, which in the hypothetical above constitutes clearly a business flight.

The conflict between the fringe benefit and deduction disallowance rules is not the only issue arising from the allocation methodology adopted in the Notice. Questions with respect to other issues include the following:

• The distinction between business flights, non-entertainment personal flights, and entertainment flights;
• The meaning of “reasonable method of determining disallowed expenses” for those expenses incurred after Oct. 22, 2004, and before July 1, 2005, the effective date of the Notice;
• The treatment of deadhead flights (ie, flights without passengers, including maintenance flights);
• The interface of the Notice with the compensation deduction limits of Code section 162(m);
• The interplay of the Notice with other deduction disallowance provisions of Code section 274, such as those pertaining to spousal travel, luxury cruises, and meals;
• The application of the “double hammer” rule (loss of both the deduction and imposition of secondary liability for the failure to withhold income taxes) for entertainment flights improperly mischaracterized as business flights;
• Potential excise tax exposure under section 4261(a) of the Code for accepting reimbursements for entertainment flights from specified individuals;
• The lack of harmonization of longstanding depreciation and listed property rules that affect both depreciation and basis;
• The treatment of time-share agreements; and
• The use of aircraft by affiliates.

It is hoped that the Treasury and the Service will consider the comments that have been submitted on these issues by taxpayers and tax practitioners as they contemplate the issuance of proposed regulations in the near future.

The Cost of Compliance Involves Time and Money

While many are concerned about lost deductions and the failure to harmonize tax rules following the issuance of Notice 2005-45, the compliance burden associated with this new guidance is equally troubling. To adequately comply with the Notice's expense allocation method, taxpayers must compile information related to the passengers on each aircraft, the expenses related to each aircraft, and the amount of compensation imputed to each specified individual for entertainment flights. From a practical perspective and to withstand the scrutiny of IRS field examiners, taxpayers should carefully compile passenger and flight information throughout the year and prepare the schedules that will be required to support the aircraft deduction. Taxpayers waiting until year-end will likely be in for a rude awakening.

Taxpayers must know the identity and position of all individuals traveling on business aircraft for all flights and the corresponding reason why each individual is flying (ie, for business purposes, for entertainment purposes, or, in the case of specified individuals, for personal purposes not constituting entertainment). For trips that include both business and entertainment segments, the Notice requires taxpayers to evaluate the purpose of each flight, so recording this information becomes even more critical.

Taxpayers must maintain records of flight hours or flight miles for each aircraft. This information is generally maintained in accordance with FAA regulations, but taxpayers need to aggregate and apply this data on a flight-by-flight basis to each passenger on the aircraft to determine the total allocation for each taxable year. Taxpayers also must keep track of the amount of compensation imputed for, or amounts reimbursed by, each specified individual for the taxable year.

In addition to the foregoing details, taxpayers should compile detailed records of the expenses associated with operating and maintaining each aircraft for each taxable year. If it provides flights on more than one type of aircraft, the taxpayer must separately track the expenses for each aircraft to apply the allocation method discussed above unless the aircrafts are of “similar cost profiles,” an undefined term. Once all expense and use information is compiled, the taxpayer determines the entertainment use of the aircraft based upon the entertainment allocation percentage. The deduction disallowance for the entertainment use of the aircraft is then determined based upon the amount of income imputed to or reimbursed by the specified individuals and their guests flying for entertainment purposes.

Conclusion

The statutory amendments to Code section 274(e)(2) and the issuance of Notice 2005-45 dramatically overhaul the deduction rules related to the entertainment use of business aircraft. The Service has interpreted the Congressional overturn of Sutherland as a mandate to change corporate behavior, if not eliminate entertainment use of business aircraft altogether. To that end, the new deduction disallowance rules impose a significant administrative burden on taxpayers coupled with a substantial economic cost if specified individuals use business aircraft for entertainment purposes. The new rules ignore the primary purpose of the flight and penalize any personal use identified as entertainment use of an asset. The penalty comes either in the form of a substantial income inclusion for the specified individual or a deduction disallowance for the company.

Taxpayers should quickly take heed of the complexity and the reach of these new rules and consider the economic ramifications associated with entertainment use of business aircraft by all specified individuals. Moreover, taxpayers should consider commenting on future guidance and participating in the debate that is ongoing with respect to the meaning and scope of the new disallowance rules.

In its zeal to eradicate perceived abuses and further clip the wings of executives who, based on press reports, took great pleasure in using the company's airplane for personal purposes, Congress amended section 274(e)(2) of the Internal Revenue Code (the “Code”) in the American Jobs Creation Act of 2004 (“AJCA”). Effective on the date of enactment (Oct. 22, 2004), these amendments effectively reversed the decisions of the Tax Court and Eighth Circuit in Sutherland Lumber-Southwest, Inc. v. Commissioner , 114 T.C. 197 (2000), aff'd 255 F.3d 495 (8th Cir. 2001), acq. AOD 2002-02 (Feb. 11, 2002), and prompted the Internal Revenue Service (“IRS” or the “Service”) to issue guidance containing a myriad of rule changes and hinting at others, leaving tax practitioners scratching their heads and companies running for cover.

On May 27, 2005, the IRS released Notice 2005-45, 2005-24 I.R.B. 1228 (June 13, 2005) (the “Notice”). The rules set forth in Notice 2005-45 create an administrative nightmare for taxpayers and potentially result in the loss of valuable company tax benefits when executives (so-called “specified individuals” and their guests) use the company's airplane for personal purposes. Unfortunately, the Notice, which applies to expenses incurred after June 30, 2005, is difficult to interpret and creates many traps for those attempting to comply with the new deduction disallowance rules.

Sutherland Lumber: Who Says the Good Old Days Weren't Good?

The personal use of a business's aircraft frequently results in an “entertainment” flight for the recipient of the benefit. Until the amendment of Code section 274(e)(2) by the AJCA, a company could fully deduct the costs associated with flights by its executives for personal purposes (even if the flight could be viewed as entertainment), provided the value of the flight was imputed in the flier's income as determined under the Standard Industry Fair Level or (“SIFL”) rules of Treasury Regulation “Treas. Reg.” '1.61-21(g). See Sutherland, 114 T.C. at 206; see also Chief Counsel Advice (“CCA”) 200344008 (July 1, 2003). Because the SIFL values imputed to executives are typically minimal in comparison with the actual costs associated with providing the personal flights, wide discrepancies existed between the permitted deductions taken by companies for providing the benefits and the amounts imputed in the executives' incomes. Although it mentioned this disparity as the reason for amending Code section 274(e)(2), Congress was well aware of this arbitrage opportunity when the SIFL rules were adopted for highly compensated employees in 1985. See 131 Cong. Rec. S6367-S6371 (Daily ed. May 16, 1985).

The Treasury Regulations acknowledge the frequent differences between an employer's cost to provide a fringe benefit and the value of the benefit received by the employee. Specifically, the Regulations provide that the cost to provide a fringe benefit is not relevant when determining the value of a taxable fringe benefit to impute in an employee's or independent contractor's income. Treas. Reg. ”1.61-21(b)(2) and 1.61-2T(b)(2). Moreover, the Regulations provide that the amount deductible by the employer is the cost to provide the benefit. See Treas. Reg. '1.162-25T. In other words, an employer may not deduct the value of the benefit when the value exceeds the cost. Id. Thus, until the passage of AJCA, the company's deduction and the employee's income have not been linked, and employers could deduct the cost of providing entertainment-related flights to employees or independent contractors, even though only the SIFL values of these personal flights were required to be included in the recipients' income.

The New Rules: The Expansive Definition of 'Specified Individual'

Revised Code section 274(e)(2) limits a taxpayer's deductions for the cost of providing entertainment-related flights to specified individuals, who are defined as:

… 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.

Under this definition, it would seem that only a few executives would be classified as specified individuals.

Not so fast.

The Notice dramatically expands the definition of “specified individual” beyond those one would traditionally consider as having the policymaking authority to control the use of the aircraft. The Notice specifically includes any person who: 1) is the direct or indirect owner of more than 10% of any class of registered equity security (other than exempted securities), 2) is a director or officer of the issuer of the security, 3) would be the direct or indirect beneficial owner of more than 10% of any class of a registered equity security if the taxpayer were an issuer of equity securities, or 4) is comparable to an officer or director of an issuer of equity securities.

Further, the Notice concludes that a “specified individual” is an officer, director, or more than 10% owner of a corporation taxed as either a C corporation or an S corporation, or a personal service corporation. For partnership tax purposes, a “specified individual” includes any partner holding more than a 10% equity interest in the partnership, general partner, officer, or managing member of a partnership. A “specified individual” also includes an officer or director of a tax-exempt entity. The Service also expanded the application of the Notice to specified individuals employed by “related parties” of the taxpayer, within the meaning of Code sections 267(b) and 707(b). In short, there are a lot of individuals whose use of company aircraft now must be monitored for company deduction purposes.

The Deduction Disallowance for the Entertainment Use of Company Aircraft

For specified individuals benefiting from entertainment goods, services, or facilities, revised Code section 274(e)(2) limits a taxpayer's deduction to the amount treated as wages in the case of an executive, or to the amount reported as compensation income on Form 1099-MISC in the case of an independent contractor (eg, a corporate director). Thus, a taxpayer that incurs substantial expense related to the operation of a business aircraft may lose significant tax deductions if it fails to report the full charter value of any entertainment flights provided to specified individuals.

According to the Notice, the expenses of operating an aircraft include fuel; salaries for pilots, maintenance personnel, and other personnel assigned to an aircraft; meal and lodging expenses for flight personnel; take-off and landing fees; maintenance costs; hangar fees; management fees; depreciation; Code section 179 expenses; and, if applicable, lease payments ' in short, just about everything. Because these collective expenses always exceed the individual SIFL valuation imputed for a personal flight, this new deduction disallowance is especially harsh. In certain instances, the value of the lost deduction may be so significant that some may question whether the corporate officer or director benefiting from the entertainment use of an aircraft has breached his or her fiduciary duty to the company's shareholders.

Rather than using a flight-by-flight analysis, the Notice requires taxpayers to allocate aircraft expenses between business use and entertainment use for each taxable year by using either an occupied seat hour or occupied seat mile approach. Once the taxpayer elects to apply a particular method (ie, seat hours or seat miles), it must be applied consistently. The method essentially prorates the cost of maintaining and operating the aircraft among all aircraft passengers for the year. When the taxpayer determines its entertainment use percentage, it must multiply that percentage by the aggregate aircraft expenses for the year. The product is the amount of expenses subject to disallowance under Code section 274(e) for the taxable year.

There are serious problems related to the pro rata allocation method prescribed by the Service, particularly when an executive's spouse or other guest accompanies the executive on a business-purpose flight. In such an instance, the expense disallowance computed under the Notice (assuming SIFL imputation for the executive's spouse or guest) will be disproportionate. For example, assume that a company uses its business aircraft once during the taxable year for a business trip from New York to Los Angeles and back (a 10-hour roundtrip). Assume also that the aircraft has a seating capacity of 10 passengers. Further assume that two senior executives, both specified individuals, and six junior associates are traveling to attend a business meeting in Los Angeles. Both of the senior executives' spouses are accompanying the executives for personal purposes. Thus, a total of eight passengers are flying for business purposes, and two are flying for entertainment purposes. Under the allocation methodology set forth in the Notice, 80% of the occupied seat hours/miles relates to business use and 20% relates to entertainment use.

Importantly, under these facts because the aircraft is flying with at least 50% of its seats occupied by business passengers (ie, the two senior executives and the six junior associates), Treas. Reg. '1.61-21(g)(12) deems the value of the flights provided to the executives' spouses to be zero. However, Notice 2005-45 requires a 20% deduction disallowance for all expenses under the occupied seat hour (or mile) method because the executives' spouses traveled on the aircraft for entertainment purposes, even though the flight would have been fully deductible had they not accompanied the others on the flight. This method of pro rata deduction disallowance based on passengers is at odds with the policy behind the fringe benefits regulations that the valuation of personal flights turns on the overall characterization of a flight, which in the hypothetical above constitutes clearly a business flight.

The conflict between the fringe benefit and deduction disallowance rules is not the only issue arising from the allocation methodology adopted in the Notice. Questions with respect to other issues include the following:

• The distinction between business flights, non-entertainment personal flights, and entertainment flights;
• The meaning of “reasonable method of determining disallowed expenses” for those expenses incurred after Oct. 22, 2004, and before July 1, 2005, the effective date of the Notice;
• The treatment of deadhead flights (ie, flights without passengers, including maintenance flights);
• The interface of the Notice with the compensation deduction limits of Code section 162(m);
• The interplay of the Notice with other deduction disallowance provisions of Code section 274, such as those pertaining to spousal travel, luxury cruises, and meals;
• The application of the “double hammer” rule (loss of both the deduction and imposition of secondary liability for the failure to withhold income taxes) for entertainment flights improperly mischaracterized as business flights;
• Potential excise tax exposure under section 4261(a) of the Code for accepting reimbursements for entertainment flights from specified individuals;
• The lack of harmonization of longstanding depreciation and listed property rules that affect both depreciation and basis;
• The treatment of time-share agreements; and
• The use of aircraft by affiliates.

It is hoped that the Treasury and the Service will consider the comments that have been submitted on these issues by taxpayers and tax practitioners as they contemplate the issuance of proposed regulations in the near future.

The Cost of Compliance Involves Time and Money

While many are concerned about lost deductions and the failure to harmonize tax rules following the issuance of Notice 2005-45, the compliance burden associated with this new guidance is equally troubling. To adequately comply with the Notice's expense allocation method, taxpayers must compile information related to the passengers on each aircraft, the expenses related to each aircraft, and the amount of compensation imputed to each specified individual for entertainment flights. From a practical perspective and to withstand the scrutiny of IRS field examiners, taxpayers should carefully compile passenger and flight information throughout the year and prepare the schedules that will be required to support the aircraft deduction. Taxpayers waiting until year-end will likely be in for a rude awakening.

Taxpayers must know the identity and position of all individuals traveling on business aircraft for all flights and the corresponding reason why each individual is flying (ie, for business purposes, for entertainment purposes, or, in the case of specified individuals, for personal purposes not constituting entertainment). For trips that include both business and entertainment segments, the Notice requires taxpayers to evaluate the purpose of each flight, so recording this information becomes even more critical.

Taxpayers must maintain records of flight hours or flight miles for each aircraft. This information is generally maintained in accordance with FAA regulations, but taxpayers need to aggregate and apply this data on a flight-by-flight basis to each passenger on the aircraft to determine the total allocation for each taxable year. Taxpayers also must keep track of the amount of compensation imputed for, or amounts reimbursed by, each specified individual for the taxable year.

In addition to the foregoing details, taxpayers should compile detailed records of the expenses associated with operating and maintaining each aircraft for each taxable year. If it provides flights on more than one type of aircraft, the taxpayer must separately track the expenses for each aircraft to apply the allocation method discussed above unless the aircrafts are of “similar cost profiles,” an undefined term. Once all expense and use information is compiled, the taxpayer determines the entertainment use of the aircraft based upon the entertainment allocation percentage. The deduction disallowance for the entertainment use of the aircraft is then determined based upon the amount of income imputed to or reimbursed by the specified individuals and their guests flying for entertainment purposes.

Conclusion

The statutory amendments to Code section 274(e)(2) and the issuance of Notice 2005-45 dramatically overhaul the deduction rules related to the entertainment use of business aircraft. The Service has interpreted the Congressional overturn of Sutherland as a mandate to change corporate behavior, if not eliminate entertainment use of business aircraft altogether. To that end, the new deduction disallowance rules impose a significant administrative burden on taxpayers coupled with a substantial economic cost if specified individuals use business aircraft for entertainment purposes. The new rules ignore the primary purpose of the flight and penalize any personal use identified as entertainment use of an asset. The penalty comes either in the form of a substantial income inclusion for the specified individual or a deduction disallowance for the company.

Taxpayers should quickly take heed of the complexity and the reach of these new rules and consider the economic ramifications associated with entertainment use of business aircraft by all specified individuals. Moreover, taxpayers should consider commenting on future guidance and participating in the debate that is ongoing with respect to the meaning and scope of the new disallowance rules.