Companies that own planes may be in for a bit of tax turbulence if the Administration has its way. During a press conference on June 29, the President called for, among other tax changes, “tax breaks for corporate jet owners” to be scaled back as part of Congress's deliberations over cutting the deficit and raising the debt ceiling. This Practice Alert surveys the current, complex rules for the company airplane and considers the implications of a potential change in the depreciation rules.
General rules. Expenses related to owning/leasing and operating company aircraft generally are subject to the same deduction rules that apply to other company assets. Out-of-pocket expenses related to the aircraft are deductible to the extent they are ordinary and necessary under Code Sec. 162. And, if purchased, a company plane may be depreciated via accelerated depreciation over a MACRS recovery period of five years (effectively six years because of the half-year convention). (Rev Proc 87-56, 1987-2 CB 674, Sec. 6) If it's new, the plane is eligible for bonus depreciation under Code Sec. 168(k) if timely bought and placed in service.
Observation: Although the Administration hasn't issued a detailed list of “revenue enhancers” it proposes to include in the deficit and debt ceiling negotiations, several reports have surfaced to the effect that the list includes an increase in the MACRS recovery period for company planes from five to seven years.
Observation: This relatively modest change likely would not have a big impact on company planes. Both five- and seven-year property may be recovered via 200% declining balance depreciation and (assuming IRS's depreciation tables are used) at the end of year 6, when 100% of the cost of five-year property already is recovered, only 13.39% of the depreciable basis of seven-year property remains unrecovered. Additionally, company planes already are subject to fairly strict deduction limitations where, as is typically the case, the planes are used for personal as well as business travel by key company execs. And, thus far, there's been no discussion of changes to the generally favorable rules that apply to personal usage of company planes.
Personal use of company plane. Under current law, strict limitations apply when the company plane is used for personal flights by company owners and key employees, such as visits to vacation homes, skiing vacations, and so forth. Owners or key employees may view such flights as justified, for example, because they take less time than commercial flights (leaving more time to work before or after the trip), but the flights have deduction consequences for the company because they are treated as “entertainment” and are “listed property” subject to special rules. Such flights also have income tax consequences for the fliers because they are making personal use of a valuable company-owned asset.
“Entertainment use” of company jet. Code Sec. 274(a)(1)(A) bars deductions for entertainment, recreation, or amusement unless the taxpayer can establish that the expense was directly related to or associated with the active conduct of its trade or business. Code Sec. 274(a)(1)(B) generally bars deductions for entertainment facilities, which, under the regs, include airplanes. (Reg. §1.274-2(e)(3)(i)) Before the American Jobs Creation Act (Jobs Act), P.L. 108-357, former Code 274(e)(2) and Code Sec. 274(e)(9) provided that the deduction disallowance rules of Code Sec. 274(a) didn't apply to expenses for goods, services, and facilities “to the extent that” the expenses were treated as compensation paid to an employee or as income to a non-employee (e.g., an independent contractor). Sutherland Lumber-Southwest, Inc. (CA8, 7/3/2001), 88 AFTR 2d 2001-5026, acq., 2002-6 IRB, dealt with a company that provided a jet for the personal use of employees and properly reported the personal use value as compensation income. It held that the company's deductions for operation of the jet in connection with the vacation flights weren't limited to the amount reported as compensation by its employees on account of the flight.
Effective for expenses incurred after Oct. 22, 2004, the Jobs Act overturned the holding in Sutherland Lumber, but only for the costs of entertainment-, amusement- or recreation-related goods, services and facilities provided to “specified individuals” (generally, officers, directors, and more-than-10% owners), or those who would be specified individuals if the taxpayer were an issuer of equity securities. (Code Sec. 274(e)(2)(B)) A technical correction made by the Gulf Opportunity Zone Act, P.L. 109-135, pulled into the definition individuals who are officers, etc. of a related entity or would be specified individuals if the related entity were an issuer of equity securities.
Observation: The essence of the convoluted statutory rules produced by Congress's override of Sutherland Lumber is that a company's deductions for the costs of entertainment, etc., provided to a specified individual are disallowed, except to the extent that the cost of the item is treated as compensation to that individual on his income tax return as originally filed (or as compensation reported on an information return, in the case of non-employees such as independent contractors). The amount disallowed is reduced by any amount that a specified individual reimburses the company.
Observation: Under current law, Code Sec. 274(e)(2)(B) doesn't apply to entertainment, etc., items provided to employees or independent contractors who aren't specified individuals. Thus, for example, a company that rewards a high-performing regular employee with an entertainment flight on its airplane may, under the Sutherland Lumber holding, deduct all of its costs relating to that flight if the personal use value of the flight is properly treated as compensation to the employee.
Which expenses to allocate. Proposed reliance regs issued in 2007 (all references to proposed regs below refer to these reliance regs), which have yet to be finalized, carry detailed rules on applying the Code Sec. 274(e)(2)(B) limits. In determining the nondeductible portion of airplane expenses relating to entertainment use by a specified individual, all fixed and variable expenses of maintaining and operating a plane must be taken into account. This includes items such as fuel, crew's salaries, take-off, landing and hangar fees, insurance, depreciation or lease payments, and amounts expensed under Code Sec. 179. (Prop Reg §1.274-10(c)) However:
(1) Expenses allocable to the period a taxpayer's aircraft is chartered to an unrelated third-party in a bona-fide business transaction for adequate and full consideration are not taken into account. (Prop Reg §1.274-10(d)(2))
(2) A taxpayer may elect to calculate depreciation on a straight-line basis over the class life of an aircraft for all of its aircraft for the current year and all future years. (Prop Reg §1.274-10(d)(3)) This method, which applies for Code Sec. 274(e)(2)(B) purposes only, avoids excessive disallowance results if the taxpayer writes off its aircraft under an accelerated depreciation method. (Preamble to Prop Reg 06/14/2007) The basis of the aircraft is not reduced by any depreciation disallowed due to entertainment use by specified individuals. (Prop Reg §1.274-10(f)(1))
Method of allocating expenses to flights. In general, expenses for each tax year are allocated by using either occupied seat hours or occupied seat miles flown by the aircraft, and the chosen method must be used consistently for all usage for the tax year. Occupied seat hours or miles is the sum of the hours or miles flown by an aircraft multiplied by the number of seats occupied for each hour or mile. For example, a flight of six hours with three passengers aboard results in 18 occupied seat hours. Alternatively, a taxpayer may choose to aggregate all expenses for the tax year and divide the total by the number of flight hours or miles for the tax year to determine the cost per hour or mile. The taxpayer then allocates expenses to each flight by multiplying the number of miles or hours for the flight by the expense per hour or mile and then allocates expenses for the flight to the passengers on the flight on a per capita basis. (Prop Reg §1.274-10(e)(3))
Illustration: ABX Corp's CEO uses the company's jet to fly to a popular vacation spot. His girlfriend comes along and her expenses are attributed to the CEO for Code Sec. 274(e)(2)(B) purposes (as well as for determining the compensation charged to him for the trip). We'll assume that the allocation method chosen by ABX allocates $17,500 of jet-related expenses to the CEO's personal trip, that the amount treated as compensation paid to him on account of the trip is $4,500, and that he doesn't reimburse ABX for any of the costs. Under the proposed reliance regs, ABX may deduct only $4,500 of the expenses related to the CEO's personal trip using the company jet; the $13,000 balance of trip-related expenses is disallowed.
Trips involving business and pleasure. Where a specified individual's flight includes a business segment and entertainment segment (e.g., flight to City A for business purposes, continuing to City B for personal purposes, then returning home), the entertainment cost is the excess of the total cost of the flights (by occupied seat hours or miles or the flight-by-flight method) over the cost of the flights that would have been taken without the entertainment segment or segments. (Prop Reg §1.274-10(e)(2)(iii))
Observation: The Code Sec. 274(e)(2) deduction limit for entertainment use of planes by specified individuals doesn't apply to flights to one destination that are made primarily for business, even if the specified individual takes some personal time at the destination. For example, if a company's CEO flies on its chartered jet to Palm Springs, California, for a three-day business trip or convention, the tough rule doesn't apply if he stays one extra day to get in some golf. In this situation the flight isn't treated as “entertainment” for Code Sec. 274 purposes.
Exempted travel. The Code Sec. 274(e)(2)(B) deduction limit does not apply to:
... Business entertainment air travel, i.e., air travel directly related to the active conduct of the taxpayer's trade or business or related to an expense directly preceding or following a substantial and bona fide business discussion and associated with the active conduct of the taxpayer's trade or business. (Prop Reg §1.274-10(b)(3))
Illustration: Following successful merger talks with Company B, Company A's directors and officers accompany B's directors and officers on A's corporate jet to a nearby golfing resort. The cost of the flight is fully deductible as a business entertainment expense (and doesn't result in compensation income to A's personnel because it's business entertainment) because it is associated with the active conduct of A's business.
... Personal travel by specified individuals that can't be characterized as “entertainment.” This would include, for example, flights to attend a family member's funeral. (Prop Reg §1.274-10(b)(3))
Observation: Presumably, flights to secure medical treatment or to visit a sick relative similarly would not be treated as “entertainment” flights.
Company jet as listed property. Airplanes are listed property under Code Sec. 280F(d)(4). Thus, if, for the year a plane is placed in service, it is used 50% or less in a qualified business use (i.e., it isn't used predominantly on an annual basis in a qualified business use), the plane: (1) doesn't qualify for Code Sec. 179 expensing (Reg. §1.280F-3T(c)(1)), (2) is depreciable only under straight-line, and (3) is ineligible for the bonus first-year depreciation allowance (Code Sec. 168(k)(2)(D)(i), Code Sec. 280F(b)(1)) If the more-than-50% requirement isn't met in a post-acquisition year (during the property's normal recovery period), the plane becomes, retroactively to acquisition, straight-line property. (Reg. §1.280F-3T(c)(2)) And if the plane is leased, the lessee must take an “inclusion amount” into income for the first year the property ceases to be used predominantly in a qualified business use. (Reg. §1.280F-5T(f))
“Qualified business use” generally is any use in a trade or business of the taxpayer but under Code Sec. 280F(d)(6)(C)(i) does not include:
(1) Leasing property to any 5% owner or related person.
(2) The use of listed property as compensation for services by a 5% owner or a related person.
(3) The use of listed property as compensation for services by any person other than a 5% owner or a related person, unless the provider of the property includes the value of the compensation in the recipient's gross income, properly reports it and, where necessary, treats it as wages subject to withholding. (Code Sec. 280F(d)(6)(C))
However, the Code Sec. 280F(d)(6)(C)(i) restrictions do not apply to any aircraft if at least 25% of its total use during the tax year consists of qualified business use not described in (1) through (3), above. (Code Sec. 280F(d)(6)(C)(ii), Reg. §1.280F-6(d)(2)(ii)(B))
Compensation issues related to personal use of company plane. Personal use of a company airplane is a taxable fringe benefit. (Reg. §1.61-21(a)(1)) The employer may use general fair market value principles to value such flights. Under fair market valuation, the value of the flight is the amount that an individual would have to pay in an arm's-length transaction to charter the same or a comparable piloted aircraft for that period for the same or a comparable flight. (Reg. §1.61-21(b)(6)(ii)) Alternatively, the employer may use special valuation methods detailed in the regs. Under these rules for noncommercial flights, the “seating capacity rule” provides that if at least half of the employer-provided aircraft's regular seating capacity is occupied by employees whose flights are primarily for the employer's business, the value of the flight to other employees (but not directors or independent contractors) is zero. (Reg. §1.61-21(g)(12)(i)(A))
If the seating capacity rule doesn't apply, the value of a noncommercial flight for personal purposes on an employer-provided aircraft is determined by multiplying the Standard Industry Fare Level (SIFL) formula that is in effect at the time of the flight by the appropriate aircraft multiple, and then adding the applicable terminal charge. (The SIFL formula is calculated by the Department of Transportation and is revised every six months.) Aircraft multiples are higher for “control employees” than for “non- control employees.” (Reg. §1.61-21(g)(5))
A “control employee” is an employee who is either: (1) a board- or shareholder-appointed, confirmed, or elected officer of the employer (however, limited to the lesser of 1% of all employees, or ten employees); (2) among the top 1% most highly-paid employees of the employer (limited to a maximum of 50 employees); (3) an owner of a 5% or greater equity, capital, or profits interest in the employer; or (4) a director of the employer. (Reg. §1.61-21(g)(8)(i))
Observation: While the SIFL rate is derived from commercial airline rates, the rate bears no connection to the actual costs incurred by a corporation to operate its aircraft. Thus far, there's been no discussion of changing the rules to require control or all employees to include a higher amount in compensation for the personal use of a company aircraft.
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