The 2004 American Jobs Creation Act could have entirely the opposite effect on business aviation due to an “overreaching” IRS interpretation that’s causing many companies to reconsider their corporate aircraft use. According to NBAA tax and finance manager Mike Nichols, the trickle-down effect of IRS Notice 2005-45, Deductions for Entertainment Use of Business Aircraft, issued May 27, could hurt not only the individual corporations paying more taxes but also nearly everyone in business aviation.
“There are some [NBAA member] companies that are discontinuing flying for any personal reason at all,” Nichols told AIN. “If you fly fewer hours, you require less maintenance, need fewer pilots, buy less fuel, and so on. So I think there’s going to be an overall effect on the economy that the IRS didn’t consider at all.”
Providing interim guidance on the deductibility of business expenses related to entertainment use of aircraft by “specified individuals,” IRS Notice 2005-45 specifically states that the American Jobs Creation Act provision is intended to overturn the Tax Court’s 2004 decision in the Sutherland Lumber-Southwest case. In that decision, the court held that taxpayers could deduct the full cost of a non-business flight taken by a corporate officer or employee as long as the recipient reimbursed the company for the flight or the corporation included the flight’s value in the recipient’s income as a fringe benefit.
Since the FAA does not allow Part 91 operators to accept reimbursement from passengers, nearly all corporate flight departments add the value of personal flights to the employee’s income using one of two methods: fair market value, basically equivalent to that flight’s charter cost; or the standard industry fare level (SIFL) set by the Department of Transportation and based on the cost of airline travel.
Many companies opt to use the standard industry fare level rates, which usually result in a lower taxable “fare” added to the employee’s compensation than the actual cost of the flight. For instance, a 1,500-mile flight on the company’s Global Express may result in only a $300 addition to the employee’s income, although the actual cost of that flight is far greater.
The provision overturns the Tax Court’s decision by introducing into law a limitation for expense deductions related to entertainment flights. Specifically, the taxpayer may only deduct expenses of entertainment-related flights to the amount included as compensation to the individual. All other expenses are disallowed. Although this sounds reasonable, as the aircraft is not being used for business purposes, the list of deductions excluded and the methods used for determining the percentage of entertainment are nearly punitive.
Rule Excludes Many Ownership Costs
IRS Notice 2005-45 specifically states that for purposes of calculating the amount of expenses disallowed for entertainment-related flights, the taxpayer must take into account all fixed and operating costs related to the flight.
In addition to the usual variable operating costs, the notice lists salaries of pilots, maintenance personnel and other personnel “assigned to the aircraft”; costs for maintenance and maintenance flights; on-board refreshments, amenities or gifts; hangar fees (at home or away); management fees; and depreciation as disallowed expenses.
NBAA called the IRS’s decision to include fixed costs such as depreciation in the list of disallowed expenses “overreaching.” “Disallowing all costs associated with ownership…is overreaching in NBAA’s opinion, because [the flight department] incurs the fixed costs no matter what. The deduction limitations should apply only to the direct operating costs associated with the entertainment flights,” Nichols said. “I’ve heard from corporate flight departments that had been considering buying new aircraft and have decided not to because of the requirement that they include depreciation in the deduction limitations.”
A new multimillion-dollar aircraft generates a significant depreciation expense, especially for companies that have recently taken delivery of their aircraft under the bonus depreciation rules set out in the Jobs and Growth Tax Relief Reconciliation Act of 2003 and extended in the 2004 American Jobs Creation Act. Depending on the percentage of entertainment-related flights leading to significant depreciation and other fixed cost disallowances, the additional taxes might lead companies to reconsider their business aircraft usage.
The General Aviation Manufacturers Association (GAMA) has also started to hear rumblings from its members about the effect of the IRS notice. “We’re starting to hear from groups that this may have an impact,” said Jeffrey Seral, GAMA general counsel and legislative affairs representative. “In our early assessment of this provision, the GAMA companies [involved] didn’t envision it hurting sales. Now, after the IRS released its notice, everybody in the industry is looking at this provision as potentially harmful.”
An Airline Modelfor Business Aviation
Exacerbating the impact of including fixed costs in the disallowed expenses, the IRS mandates the use of occupied seat hours or occupied seat miles to determine the percentage allocations of entertainment versus other flights. In addition to yielding significantly more disallowed deductions, this airline-style method of determining flight allocations requires corporate flight departments to create new accountingprocedures to comply with the IRS notice.
“The process of tracking occupied seat miles/hours is something you’d find in the Part 121 environment, but there’s no regulatory requirement for corporate flight departments to track this information,” Nichols said. “I don’t know of a single flight department currently set up to track passenger manifests to this detail. Corporate flight departments will need to create those processes so their tax and accounting departments have the information, not only for SIFL purposes, but also to determine which are entertainment flights and their associated deduction limitations.”
The IRS method of allocation does not take into consideration the purpose of each individual flight but rather calculates a total cost per occupied seat hour/mile for the tax year (all fixed and operating costs divided by the total number of miles/hours flown). The amount disallowed is the sum of the cost of each occupied seat hour/mile flown by an individual for entertainment purposes less the sum of the amount treated as compensation for that individual.
“Let’s say you have eight flights between Des Moines, Iowa, and Chicago on a King Air with just one passenger (the CEO) on board trying to close a deal, and then one flight with eight people on board where the CEO takes his family on a vacation,” Nichols explained. “Even though you had eight flights that were business and one flight that was personal, because of the seat-mile methodology, you lose 50 percent of your deductions.”
Nichols said that he’s had one NBAA member company do the math and find that although 75 percent of its flights were for business purposes, the company will lose 75 percent of its deductions as a result of the occupied seat mile/hour methodology. Many of these disallowed deductions stem from executives taking spouses and families along on business trips.
“Many executives and hands-on entrepreneurs are on the road a lot,” Nichols said. “One way that this lifestyle becomes palatable is that on occasion they bring their spouses or entire families on a business trip. There are seats available on the aircraft and it didn’t cost the company a penny more, really, to bring spouse and kids. Until now.”
While some companies have reportedly already stopped allowing family members to travel on corporate aircraft, for other companies there’s no choice. According to Nichols, several NBAA member companies require their top executives to use the corporate aircraft for all travel, both personal and business, for both security and communications reasons.
The IRS also extended the occupied seat/mile count to deadhead flights, which the rule treats as having the same number and character of occupied seat miles/hours as the legs of the trip on which passengers are aboard. In addition, the IRS requires companies to allocate costs of mixed business/entertainment segment flights to those specific miles/hours dedicated to business and entertainment. There are no “safe harbor” clauses or exceptions in the IRS notice.
“We think at this time the IRS regulations are a little cumbersome and there’s room for improvement,” Seral said. “The IRS didn’t provide for any provision that would allow [corporate flight departments] to incorporate an accounting method that was easy or provide some leeway so [they] weren’t recording every seat mile by its purpose. There’s probably a simpler way.”
Defining Personal and Entertainment Use
One issue somewhat in corporate aviation’s favor is that not all personal flights are considered entertainment flights. The American Jobs Creation Act provision specifically amended Internal Revenue Code § 274(e), which lists exceptions to the disallowance of expenses related to entertainment, amusement and recreation.
However, certain expenses are still allowed under the unmodified parts of Section 274(e), including expenses incurred by a taxpayer that are directly related to business meetings of its employees, stockholders, agents or directors; or participation in meetings of business leagues, chambers of commerce, real estate boards and boards of trade.
For example, if the CEO of XYZ company also sits on the board of a nonrelated or nonprofit corporation, using XYZ’s corporate aircraft to travel to those non-XYZ meetings constitutes personal use of the aircraft (and thus requires that the flight value be added to the CEO’s compensation) but does not constitute entertainment use of the aircraft.
“The IRS was very careful in the notice’s title and throughout the text, to use the term ‘entertainment’ and not ‘personal,’” Nichols said. “Personal is broader than entertainment…there’s a distinction between the two.” Nichols cited a CEO flying to a funeral as another example of a personal flight not falling under Section 274.
Due to this distinction and the need to still record personal flights for income taxation, Nichols said corporate flight department manifests will need to track three flight purposes: business, personal and entertainment.
Punishing Corporate Abuses and Raising Revenue
The extreme methodology used in determining disallowed deductions may be, in part, a punitive measure condoned by Congress and aimed at some of the corporate scandals involving jetsetting CEOs. “What we’re seeing when we talk about this issue on Capitol Hill or to the IRS is a lot of backlash to some of the negative press to jettsetting CEOs or CEOs after retirement that have access to corporate aircraft,” Seral said.
One such example is retired General Electric CEO Jack Welch, who received approximately $2.5 million in benefits during his first year of retirement, including $1.2 million in access to GE aircraft. “The corporate jet is often viewed as a luxury item and if it’s used as such, that’s something the IRS can point to as abuse and needs to correct,” Seral concluded.
Seral also noted that there was “strong disagreement” between corporate aircraft operators and the IRS over the Sutherland case. “I don’t know that [the IRS] intentionally set out to correct [the court’s decision] in this manner,” he said. “I think there’s been a misunderstanding on how business aircraft are used, and that’s part of what we’re trying to correct so that the perception doesn’t become reality. Corporate aircraft are not just used by CEOs of major corporations to jet out to the Bahamas or Aspen; they’re business tools that are relied upon to get business done.”
The IRS likely didn’t instigate the change to the entertainment use of business aircraft tax laws; it just followed Congress’s lead in trying to present a balanced American Jobs Creation Act that included as many tax revenue raisers as tax cuts. “This was simply a revenue raiser that was sitting on the list of revenue raisers, and Congress needed to balance the books to pay for another tax cut on the Jobs Act,” Seral said.
The 2005 act included $145 billion in tax cuts and the same amount in revenue-raising provisions, making the net cost of the new law zero. However, while most of the tax cuts are temporary, the revenue provisions, including the entertainment use of business aircraft provision, are permanent.
According to the Winter 2004 issue of Crowe Mid-Market Advantage Newsletter, the entertainment use of business aircraft provision and other revenue raisers, such as limits on vehicle and intellectual property donations to charities, are together expected to raise approximately $35 billion per year in new tax revenues.
IRS Notice 2005-45 is effective for all expenses relating to entertainment use of a business aircraft incurred after June 30 this year, although it states that the IRS will not challenge “a reasonable method of determining disallowed expenses incurred after Oct. 22, 2004, and before July 1, 2005.”
Companies that had been using SIFL to calculate fringe benefits cannot simply start using the fair market value methodology to increase the amount they can deduct this year. According to Internal Revenue Code §1.61-21(g)(14)(i), companies that have used SIFL to value any flight for fringe-benefit taxation must use SIFL to value all flights provided to employees during that calendar year.
The notice does not apply only to a company-owned aircraft, but also to leased and chartered aircraft as well, according to paragraph b(2). For chartered aircraft, all costs billed for the charter, including amounts for flight time, waiting time, fuel and overnight expenses are disallowed. Lease payments for any equipment leased, including aircraft, must also be included in the disallowed expenses.
Currently the disallowance only applies to “specified individuals,” including corporate officers and directors as well as any person holding more than 10 percent of that corporation’s stock. Subchapter C, Subchapter S and personal-service corporations also fall under this rule, as do the officers and directors only of tax-exempt entities.
However, the Federal Highway Bill (HR 3) currently winding its way through Congress may have another revenue-raisingprovision attached that would expand the disallowance to entertainment flights made by any employee. While the government says that this provision would raise $53 million per year in taxes, Seral doesn’t agree it would raise much tax revenue at all.
“How often do you get a middle manager who’s going to use the corporate airplane to take his family skiing?” Seral asked. “It doesn’t happen.”