IRS increases corporate aircraft exams

Editor: Michael Wronsky, CPA, MST

The IRS, on Feb. 21, 2024, announced a campaign to investigate the use of corporate jets by large businesses and wealthy individuals (News Release IR-2024-46). This effort is part of the IRS’s bigger campaign to increase scrutiny of high-income taxpayers’ accounts. The Service’s focus on aircraft use is meant to ensure that “high-income groups aren’t flying under the radar with their tax responsibilities” (id. At ¶4).

IRS exams regarding business aircraft typically involve three issues. First is whether the taxpayer qualified for bonus depreciation, which is typically a legal issue surrounding the interpretation of Sec. 280F and the classification of each flight in order to meet the greater-than-50% qualified-business-use rule. Next is whether the taxpayer has substantiated its business deductions, and, lastly, whether the taxpayer has properly imputed income or properly calculated the expense disallowance for personal use of the aircraft. The second and third issues are fact-driven and focus on the taxpayer’s flight log and supporting documentation and classification of such flights.

Bonus depreciation

Sec. 280F establishes that a business aircraft, as listed property, can be depreciated under the modified accelerated cost recovery system, which includes bonus depreciation, when the aircraft is predominantly used in a qualified business use. “Predominantly used in a qualified business use” means the business-use percentage for a tax year exceeds 50% (Sec. 280F(b)(3)).

Under Sec. 280F(d)(6)(A), business-use percentage means the percentage of the use of any listed property during any tax year that is qualified business use. Qualified business use is defined in Sec. 280F(d)(6)(B) as any use in a trade or business. Under Sec. 280F(d)(6)(C)(i), however, qualified business use does not include three types of use of property by a 5% owner or related person:

1. Leasing to a 5% owner or related person;

2. Use of the property to provide compensation for the performance of services by a 5% owner or related person; or

3. Use of the property to provide compensation to a person not described in 2, unless such compensation is included in the gross income of that person.

However, under a special rule for aircraft (Sec. 280F(d)(6)(C)(ii)), the three types of business use by 5% owners or related persons described in Sec. 280F(d) (6) (C)(i) are included in qualified business use if at least 25% of the total use of an aircraft during a tax year is qualified business use other than those types of business use. Therefore, if the 25% threshold is met, any trade or business use is taken into account.

In Brown, T.C. Memo. 2013-275, the Tax Court found that any use by the taxpayer in a trade or business of the taxpayer is a qualified business use. The taxpayer, a sole proprietor, owned an insurance company that required him to constantly travel to meet clients and prospects. The taxpayer purchased a private aircraft in order to meet client needs. The aircraft, in turn, needed upgrades and modifications to meet the taxpayer’s business needs. The taxpayer took one flight on Dec. 30, 2003, for a business lunch, even though not all the modifications were complete.

The taxpayer asserted that the aircraft was placed in service and that the aircraft use met the requirements to deduct depreciation under the bonus depreciation method. The IRS originally asserted that the taxpayer’s use did not qualify for bonus depreciation on account of the outstanding status of the aircraft modifications and a failure to substantiate a business use. The IRS conceded the bonus depreciation argument and went on to argue that the aircraft was not placed in service and that the taxpayer did not substantiate the business flight.

The Tax Court found that:

[I]f Brown proved that he “used” the Challenger [the aircraft] in any way in his business in 2003 more than 50% of the time he flew it (i.e., if the majority of his flight miles on December 30 were used any way in his business), then the alternative depreciation system under section 168(g) wouldn’t apply, and the Challenger would be considered “qualified property” for bonus-depreciation purposes. [Brown, T. C. Memo. 2013-275 at *24–*25]

The taxpayer in Brown ultimately lost the depreciation deduction because the Tax Court found that the aircraft was not placed in service, as not all the requested modifications were complete by the year’s end.

Substantiation of business deductions

Next, any travel away from home requires the taxpayer to substantiate their costs. Furthermore, a taxpayer must meet the substantiation rules of Regs. Sec. 1.274-5, which require “an account book, diary, log, statement of expense, trip sheet, or similar record maintained by the employee in which the information as to each element of an expenditure or use … is recorded at or near the time of the expenditure or use, together with supporting documentary evidence” (Regs. Sec. 1.274-5(f)(4)(i)).

Taxpayers often record these factors in their flight logs. But exam experience indicates successfully complying with the regulations requires the supplementary documentation (such as calendars, emails, and itineraries) noted in the regulation.

Personal use of the aircraft

Lastly, the IRS intends to focus on the classification of business and personal use as it asserts that business expense deductions are allowed only for business purposes that can be substantiated.

Flight classification should fall into one of four categories: (1) business; (2) business entertainment; (3) personal nonentertainment; and (4) personal entertainment. These classifications can be subjective, but the primary purpose of each flight should be a driving factor in the classification.

Personal use of an aircraft by an employee or owner is a fringe benefit, and the employee or owner must include the fair market value of a personal-use flight (less any reimbursement made for the flight) in income. This is generally done following the standard industry fare level formula (Regs. Sec. 1.61-21(g)(5)).

The regulations also explain that if an employee, in one trip, combines personal and business flights on an employer-provided aircraft, the employee must include as income the excess of valuation of all the flights over the value of the flights that would have been taken had there been no personal flights (Regs. Sec. 1.61-21(g)(4)).

How a flight is classified can affect the deductibility of the flight by the company, even when income has been properly included in the income of the employee or owner.

Editor Notes

Michael Wronsky, CPA, MST, is managing director of Baker Tilly’s Washington Tax Council.

For additional information about these items, contact Wronsky at michael.wronsky@bakertilly.com.

Contributors are members of or associated with Baker Tilly US, LLP.