The corporate tax impact arising from executives’ personal use of company-owned aircraft, while already bothersome, may get much worse under recently finalized Internal Revenue Service regulations. Proper planning, however, can save companies bundles of cash.
Such aircraft usage results in taxable wages to the executive based on an IRS formula for determining what a first-class seat on a comparable commercial flight would have cost, called the standard industry fare level (SIFL). More to the point for companies, the newly finalized rules affirm IRS proposed guidance that prevents a company from claiming what might otherwise be a huge tax deduction (depending on who is on the flight and the reasons for their travel) for the cost of operating the aircraft.
Usually an employer can deduct the full cost of property used for business purposes. Indeed, that was the rule at one point with respect to all personal use of business aircraft. In the landmark Sutherland Lumber case, in 2000 the U.S. Tax Court allowed an employer to deduct all reasonable aircraft expenses associated with an executive’s personal travel even though only a portion of that cost had been reported as wages to the executive.
Four years later, Congress responded to the Sutherland Lumber decision on “public policy” grounds by enacting a punitive tax-deduction disallowance rule. When executives (or directors) travel on business aircraft for “entertainment, amusement, or recreational” purposes, tax deductions for the employer’s cost of providing that travel are limited to the amount reported to the executive as taxable income.
A good rule of thumb is that, using SIFL rates, the income attributed to an executive for such personal travel is only about $1 per mile. But a company’s per-mile cost for providing the benefit typically ranges from roughly $10 to $100, depending primarily upon the type of aircraft. The 2004 deduction-disallowance rule prevents the company from deducting the difference.
That is bad enough, but the final IRS regulations, effective for taxable years beginning after August 1, 2012, take the rule a significant step further. The taxing agency rejected what is called “the primary purpose of the trip” method for identifying whether expenses were incurred for entertainment, amusement, or recreational purposes. The result is that a business will pay dearly if even one passenger is aboard a business flight for entertainment purposes.
For example, consider an executive flying to London to meet with a subsidiary’s management team. Business aircraft costs associated with that trip are generally deductible. But if the executive’s spouse comes along strictly for personal entertainment purposes, under the final rules the company will take a serious tax-deduction hit. The company can attribute half of its cost for operating the flight to the executive (assuming there are two passengers, the executive and spouse) and deduct that amount, but it cannot deduct the other half except for the SIFL amount attributable to the spouse’s travel that is included in the executive’s income. And the operating costs can be very significant, considering that they include the yearly depreciable cost of buying the plane, prorated per the number of hours it is used during the trip.
The kicker is that while it costs the company nothing to have more people on board, this rule applies even if it can be demonstrated that the flight would have happened for business purposes had the spouse not come along. That may not be logical, but the intent of the deduction-disallowance rule is to effectively punish certain behaviors. Given the current public sentiment with regard to highly paid corporate executives, it’s not too surprising that the final regulations avoid taking a position that might be viewed to allow highly paid executives to take guests on pleasure trips paid for by taxpayers.
Also notable is that the final regulations do not specify when use of a business aircraft rises to the level of being for “entertainment” or “recreational” or “amusement” purposes. This lack of clarity strongly suggests that businesses should keep detailed records for all passengers in order to demonstrate the exact reason(s) for their travel on business aircraft.
In fact, although some companies don’t realize it, full tax deductions for personal travel may be allowed if it is not for entertainment, amusement, or recreation. In effect, tax rules subsidize compensatory personal travel so long as it is not too enjoyable.
Judgment calls will need to be made for all instances of personal travel. While the longstanding IRS description of “entertainment” provides a list of examples that is so out-of-date it refers to “cocktail lounges,” the following activities are likely to be fully tax deductible:
- Commuting from a residence to any work location;
- Pursuing private business activities or investigating personal investments;
- Attending funerals, visiting sick relatives, or attending to own medical care; and
- Being accompanied by a spouse or guest on any of the foregoing types of travel.
On the other hand, the following activities would likely be considered entertainment, amusement, or recreation and therefore not deductible:
- Attending private parties, such as weddings, birthday parties, and anniversaries, even those for customers; and
- Sightseeing, gambling, fishing, hunting, and golfing trips that are not for business purposes.
Equally troubling is that the scope of what is considered to be a nondeductible cost incurred with respect to entertainment travel is very broad. Consider interest expense that may be incurred in order to acquire a business aircraft. A surprising “clarification” in the final rules (that was not included in the proposed regulations) is that when part of the cost for a flight is identified as being for entertainment, a like portion of the interest expense allocated directly or indirectly to the purchase of the airplane is nondeductible.
Fortunately, the news is not all bad. There are opportunities to minimize the actual amount of depreciation that is allocable to entertainment travel (and thus nondeductible) by using a special depreciation schedule. In addition, if depreciation deductions for business aircraft are disallowed, such amounts can be used to reduce the gain on any later sale of the aircraft.
The tax-deduction impact of the Sutherland Lumber reversal is here to stay, with the final regulations confirming concerns that the IRS will not use the “primary purpose of the travel” principle to determine what travel is subject to the tax-deduction disallowance rule.
Given the extreme impact of the tax-deduction disallowance rule, the questions as to what type of travel triggers it, and the possibility for savings using depreciation rules, it is worth the effort to understand the nuances of the final regulations and establish appropriate protocols for personal use of business aircraft. Doing so may decrease the total amount subject to the deduction-disallowance rule and will help put the company in a good position on any later tax audit.
Andrew Liazos heads the executive compensation practice at law firm McDermott Will & Emery. Ruth Wimer is a partner in McDermott’s Washington, D.C., office who is a nationally recognized expert on corporate aircraft tax-deduction issues.