The use of private aircraft eliminates the inconvenience of commercial flights, but clients do not normally call their CPAs in midflight to inquire about the tax ramifications of taking a detour with the family on the company jet to visit Aunt Margaret. Nevertheless, it is up to CPAs to sort it out and offer some planning tips to maximize the allowable tax deductions. New proposed regulations under Sec. 274 clarify old rules, introduce new ones, and require additional guidance on some of their applications.
In the American Jobs Creation Act of 2004, P.L. 108-357 (AJCA), Congress overturned Sutherland Lumber- Southwest Inc., 114 TC 197 (2000), aff’d, 255 F3d 495 (8th Cir. 2001), by enacting Sec. 274(e)(2)(B). In Sutherland, the Tax Court held that a company’s tax deduction in connection with the personal use of a company’s aircraft was not limited to the amounts included as fringe benefits in the compensation of passenger employees. Congress saw this as a tax shelter because the total costs deducted by employers were far in excess of the fringe benefits included in income. Congress therefore limited the deductibility of personal entertainment use by those with control over entity costs (referred to as “specified individuals”) to the amounts included in such persons’ income or to the amounts of reimbursement.
Specified individuals include officers, directors, more-than-10% owners, 10% shareholders, 10% equity partners/members, and managing partners/members of a partnership/LLC. In addition, specified individuals do not have to be employees of the aircraft owner if the owner is related to the employer under Secs. 267(b) or 707(b). Both Notice 2005-45 and Prop. Regs. Sec. 1.274-9(b)(6) indicate that use of an airplane by family members or by other persons flying due to a relationship with specified individuals is attributable to the specified individual.
The IRS initially provided temporary guidance in Notice 2005-45 on the limitation computation. On June 15, 2007, the Service issued Prop. Regs. Secs. 1.274-9 and 1.274-10 and amended Prop. Regs. Sec. 1.61-21 to clarify the limitation’s scope and the available computation options (REG-147171-05). The proposed regulations are not effective until they are finalized; however, taxpayers may rely on them before that time. In addition, until the proposed regulations are finalized, taxpayers may rely on either the proposed regulations or Notice 2005-45 if they contain different rules on a particular issue. However, if a rule in the proposed regulations is not included in Notice 2005-45, taxpayers cannot rely on the absence of the rule in Notice 2005-45 to apply a rule contrary to the proposed regulations.
The post-AJCA law disallows all variable and fixed aircraft operating costs (including depreciation and Sec. 179 deduction) allocated to a specified individual’s entertainment use to the extent such costs exceed the amount included as compensation or the amount of reimbursement received from the specified individual.
The methods of cost allocation under Notice 2005-45 (and Prop. Regs. Sec. 1.274-10(e)(2)) are based on occupied seat hours or occupied seat miles (defined as the total hours or total miles flown by passengers multiplied by the number of occupied passenger seats). The total aircraft operating costs for the tax year are then divided by occupied seat hours or occupied seat miles to arrive at cost per occupied seat hour or occupied seat mile. Prop. Regs. Sec. 1.274-10(e)(3) introduces another basis for allocation: the flight-by-flight method. This method divides the total aircraft operating costs for the tax year by the number of flight hours or flight miles for the year to determine cost per hour or cost per mile, and each flight is allocated cost based on its miles or hours. The cost per flight is then allocated to its passengers on a per capita basis.
One should note that the pilot’s seat (and apparently the co-pilot’s seat) does not count as a passenger seat under any of the allocation methods. Maintenance round-trip flights without passengers should also not be included. It remains unanswered whether a pilot and co-pilot (if required) flying as specified individuals without passengers for entertainment purposes would be deemed to be passengers.
Notice 2005-45 and Prop. Regs. Sec. 1.274-10(f)(3) also provide guidance on the treatment of empty flights to pick up passengers or empty return flights after dropping off passengers (deadhead flights). Under both the notice and the proposed regulations, deadhead flights are deemed taken with the same number of passengers aboard and for the same purposes as the occupied flight.
Some other clarifications under the proposed regulations are:
Under Prop. Regs. Sec. 1.274-10(d)(2), expenses allocable to a period during which the private aircraft is chartered to an unrelated party for full and adequate consideration in a bona fide business transaction are not considered for the limitation calculation. No guidance is given for the proper method of allocating operating costs to a charter period with mixed entertainment use by a specified individual.
Prop. Regs. Sec. 1.274-10(d)(3) intro-duces an election to compute depreciation on a straight-line basis solely for the purpose of the Sec. 274(e)(2)(B) disallowance rules, while continuing to compute depreciation under another method for tax purposes. This method avoids excessive disallowance when a taxpayer depreciates an aircraft under an accelerated method. The disallowed depreciation does not reduce the basis of the aircraft, and it appears that it is deducted from the accelerated depreciation deduction to arrive at the current deduction.
A specified individual’s business trip will not be subject to the Sec. 274(e)(2)(B) limitation even if that individual takes some personal time at the business destination if the trip is primarily for business. Travel by family members who are not doing business will definitely count as entertainment use, subject to limitations. Prop. Regs. Sec. 1.274-10(e)(2)(iii) clarifies that a detour from a business destination to another city on the way home will result in entertainment use equal to the excess of the total cost of the flight over the cost without the entertainment segment.
The preamble to the proposed regulations acknowledges that entertainment use does not include travel for business, medical purposes, attending a funeral, or participating in charitable events. Thus, if the primary purpose of a detour from New York City to Phoenix is to visit a very sick Aunt Margaret as opposed to family leisure, the trip will not be subject to limitation as long as the aircraft does not constitute an entertainment facility within the meaning of Sec. 274(a)(1)(B).
Based on the existing temporary guidance, the following strategies will maximize the deductibility of a private aircraft’s operating costs for income tax purposes:
- Specified individuals should maximize trips “primarily for business” and include personal use immediately before or after the business portion of the trip.
- The number of family members invited on board should be kept to a minimum because their travel will almost always result in disallowance of otherwise deductible costs.
- Defer expensive repairs to years of low entertainment use.
- Deadhead flights after a specified individual has taken a long flight for entertainment purposes should be avoided at all costs.
- Since aircraft are listed property, entertainment use by specified individuals should be kept below 50% to avoid recapture of excess accelerated depreciation over straight line.
- If a taxpayer wishes to share ownership of the plane, structuring it as a joint ownership instead of as a separate passthrough entity will avoid being tainted by other owners’ entertainment use.
- In most cases, taxpayers should elect straight-line depreciation for the limitation calculation.
- Taxpayers should consider chartering their aircraft to a flight school or to other unrelated third parties in periods of the owner’s reduced use.
In addition, since the personal or entertainment use provided to em-ployees (or independent contractors) who are not specified individuals is not limited, rewarding a high-performing employee who is not an officer or director with a trip on the private jet (and including the value of the trip in his or her compensation) will increase the numerator of the allowed occupied seat hours or miles, or the allowed per capita flight miles or hours, and thereby the total deductible expenses for the year. Such a strategy, however, could be challenged if the IRS broadly interprets the definition of persons flying “by virtue of a relationship with a specified individual” to include employees. It seems that if Congress intended to include employees in the definition of specified individuals, the Code itself would have reflected such intent. The final regulations should clarify whether employees and independent contractors with a business relationship with specified individuals are excluded from the above definition.
While the Service’s temporary guidance is helpful, additional clarification is needed as noted in this item. Despite the ambiguities, it appears that with some planning, the bulk of aircraft operating costs can be deductible.