IRS Memo Triggers Federal Excise Tax Fears
The release of an Internal Revenue Service (IRS) memo on March 9 outlining guidance on how to apply the federal excise tax (FET) to fees paid to aircraft management companies adds to business aviation’s burden at a time when the industry continues to suffer from weak demand, high fuel prices and public criticism of this form of travel. This memo isn’t the first time the IRS has attempted to apply the 7.5-percent FET to non-commercial Part 91 flight operations. And it comes on the heels of the government’s attempt to apply FET to fractional operations and a counterclaim to a lawsuit filed by NetJets, justifying the government’s assertion that the company failed to pay years’ worth of FET on non-commercial flights. To top that off, a California bill has been proposed that would tax the sale of services at 4 percent, which industry experts fear could include aircraft management and charter services.
Clearly government agencies seeking to make up for budget shortfalls see business aviation as a target for generating revenue. And the FET memo, the government’s ongoing fight with NetJets and state efforts such as California Assembly Bill No. 1963 indicate that there is serious intent to extract more money from business aviation.
At the heart of the FET situation is the IRS (and thereby U.S. government) viewpoint that there is no difference between Part 121 commercial flights or Part 135 charter flights, which are subject to FET, and a non-commercial Part 91 operation in which the owner of an aircraft flies in his or her own aircraft for personal or business purposes. The IRS seeks to apply the FET to flights that are facilitated by aircraft management companies, not to flights operated by individual owners or companies’ flight departments, because the agency regards management services as the provision of taxable transportation.
In the words of the IRS memo: “Section 4261(a) of the Code imposes a tax on the amount paid for the taxable transportation of any person. ‘Taxable transportation’ is defined in § 4262(a)(1) to generally include transportation by air that begins and ends in the United States. Section 4261(d) provides that the tax is paid by the person making the payment subject to tax and § 4291 provides that the tax is collected by the person receiving the payment.”
Unfortunately, the term “transportation by air” does not distinguish clearly between commercial and non-commercial flights, although the code’s language does seem to favor airline-style flying, and so does language in the IRS chief counsel’s memo.
In the case of the NetJets lawsuit, filed on November 14 last year, NetJets accused the IRS of improperly attempting to collect $643 million in taxes and penalties, because the taxes were assessed on “the fees that aircraft owners pay to Plaintiffs to manage and maintain the owners’ aircraft.” The fees were paid by customers of NetJets subsidiaries NetJets Aviation, NetJets International, NetJets Large Aircraft and Executive Jet Management. And as NetJets pointed out in its lawsuit, “Section 4261 of the Internal Revenue Code, which is commonly referred to as the ‘ticket tax,’ imposes an excise tax on payments made in exchange for ‘taxable transportation’ by air. It is called the ‘ticket tax’ for good reason, because Congress intended it to apply to passengers who purchase a ticket (or the equivalent of a ticket) for transportation on a commercial or charter aircraft that is owned by others. Under those circumstances, the passenger is paying for ‘transportation,’ because the passenger has no ownership rights in the aircraft on which he is traveling; rather, his ticket simply provides him a temporary right to enter upon the aircraft for the limited purpose of being flown from point A to point B. The ticket tax was not intended to apply to private aircraft owners and the fees they pay to maintain and operate their aircraft.”
The IRS memo is not an official revenue ruling; however, it seeks clarification of issues that support previous revenue rulings and thus, according to one aviation charter/management expert with a background in accounting, justification for IRS auditors to impose the FET on the fees paid to management companies.
The memo responds to the IRS’s chief of the excise tax program regarding three scenarios at aircraft management companies. A key issue to which the chief seeks an answer is: “Are the monthly management fees paid to the aircraft management company in each of the three scenarios…‘amounts paid for taxable air transportation of persons,’ and thus taxable…?” The memo concludes that taxable air transportation of persons is occurring and thus “The monthly management fees, as well as the separately reimbursed amounts, paid to Management…are taxable.”
The above conclusion is sending shudders throughout the charter/management segment because those fees and reimbursed amounts add up quickly. For a client that pays $1 million to a management company for a year’s worth of all the fees involved in operating a business jet, the annual tax would be $75,000, according to Dave Weil, owner of Flight Department Solutions and former CFO at TAG Aviation and past chairman of the NBAA Tax Committee.
Management Company Fears
“What [the IRS has] attempted to do is take a simplistic issue and create a ruling without understanding all the potential variations that actually take place in the industry,” said Andrew Richmond, CEO of charter/management firm TWC Aviation. “I think they’re saying, ‘We are already receiving FET on Part 135 charters, how is a Part 91 flight different? They’re trying to interpret the service that a management company is providing and fit it into the existing tax code that entitles them to collect taxes.”
What mostly concerns Richmond is not the prospect of the IRS applying the FET to management fees but deciding that FET should be paid for an average hourly flight-time charge. Management fees typically might be up to $10,000 per month for a large jet. FET on that would be $750 a month. But FET for a Gulfstream flying 40 hours a month at an hourly rate of $4,000 would generate $12,000 per month in tax revenue. “That’s where there’s still a lot of discussion that needs to be had,” he said, “because since we don’t charge an hour of flight time, how would they determine what tax is due? Are they going to look at the charter rates and say it should be comparable? What if no invoice is being generated? Will they argue that it’s an imputed tax and that the invoicing and collection of the fee is not a requirement for the tax?”
Richmond also worries about how far back the IRS will reach during audits of management companies. “If the IRS wins [the NetJets claim] and prevails on collecting back taxes going all the way back to, say, 10 years, does that open the door to go to all management companies and demand 10 years of back taxes as well?”
“It goes without saying that this could be devastating for the aircraft management business,” a top executive at a large charter/management firm told AIN. “It also could have potential industry safety impacts as aircraft owners are forced to go in-house (and ostensibly to less controlled environments).”
The reason that owners elect to have their airplanes managed is because of the advantages offered over running their own flight operations, said Gil Wolin, a long-time charter/management executive who also has worked for TAG Aviation and other companies. And as the buying trend has shifted to larger, more complex business jets, that advantage becomes even greater.
The advantages include the economies of scale of the management company, which can negotiate lower prices on insurance, fuel, maintenance and so on. But another advantage is professional safety oversight. The lack of experienced aviation managers has fueled the growth of management programs, Wolin asserts.
One test that has proved useful in the past when FET questions arise is whether the person providing transportation has possession, command and control of the aircraft. NBAA, in fact, has repeatedly asked the IRS to clarify this and update its guidance to auditors. The last time the IRS Audit Technique Guide was updated was in 2008.
From the IRS’s perspective, however, Wolin explained, “Pilots are employed by the management company, scheduling goes through the management company, so who [appears to be] in charge here? And we’ve a got a government hungry for tax revenue.”
The Lawyers’ Views
Legal experts have already expressed their opinions about the FET situation and the IRS memo, with alerts sent to clients and other missives.
“The first question is has possession, command and control shifted,” said Keith Swirsky, tax expert and attorney at GKG Law. If the answer is yes, at least in the IRS’s eyes, then what funds are subject to the FET? “The IRS is saying that all expenses that are necessary and integral to the operation of the aircraft are subject to federal excise taxes.” That includes the management fees, hangar, insurance, maintenance, fuel, subscription services, cleaning and crew salaries.
Swirsky points out that the subject of FET for air transportation isn’t new and was codified in an IRS revenue ruling that dates to 1958 (58-215). So he noted, the IRS memo isn’t a retroactive application of the FET. Rather, “This is a restatement of rulings that have come down for the last 50 years.”
As to whether an IRS audit can seek retroactive FET from a management firm, he added, “It’s all years subject to the open statute of limitations or the statute of limitations period. And the statute of limitations period for a management company filing their IRS Form 720 is three years from the later of the date the return was due or the actual date that the return was filed.”
Swirsky continued, “I think there is going to be an evolution of thought process on this, [but] one thing is clear: that the pace of IRS audits of aircraft management companies has already accelerated and will continue to accelerate. I don’t think the March 9 [memo] has changed anything. I believe the IRS is incorrect in its understanding of what the relationship is between a management company and an owner and what possession, command and control is and what the relationship is under the contract. It’s an agency relationship and it’s an agency engagement. The management company is not acting as an independent principal in performing a transportation service for the owner. They’re acting as an agent on behalf of the owner and performing a variety of services that the owners engage them to perform.”
Jonathan Levy, an attorney and legal director at Advocate Consulting, regards the IRS memo as definitely something that the business aviation industry needs to worry about. “This memo makes it likely [an IRS auditor] would point to it and say, ‘The chief counsel’s office says the tax applies here so I’m going to make the assessment.’ It doesn’t change the law but it’s likely to guide enforcement.” And because the memo doesn’t change the law, he agreed that the FET could be applied retroactively. He isn’t sure whether that means three years, or longer if no returns were ever filed.
“I do think this is worrisome and it is likely to result in litigation that ultimately the IRS is likely to lose,” Levy said. “But what do I know? This is one of those things that nobody can predict. It’s unfortunate because this ruling tends to constrict the appropriate efficient free-market relationships that companies would want to enter into. It is an ugly prospect that they’re raising here.”
What To Do?
Opinions vary as to how quickly the IRS might turn its memo musings into action. Some believe that IRS auditors might already be flexing their muscles to extract more taxes from management firms, while others believe that it might take some time for the memo’s impact to be felt. Most had some ideas about how to minimize the impact. Nobody thought it would be a good idea for the aircraft owner to employ pilots directly because that’s one of the key elements that makes aircraft management attractive.
“There are some tough decisions that have to be made,” said former TAG CFO Weil. “I think there are creative ways to structure things, it’s just how much you want to change your existing model to do it. If I were a management company I would be thinking about how I would revise procedures to give the client more command and control. There are ways, but they’re contrary to how a lot of management companies are structured. They’re set up to pay expenses and rebill them. If I were a client, I would make sure I understood what my potential exposure is and talk to [an expert].”
“The most appropriate response,” said attorney Levy, “is to change the management agreement to say there’s control and there’s agency, and to try and minimize the tax base by minimizing the amount that’s being paid to the management company. And provide for the operator to pay whatever expenses it can directly.”
TWC Aviation CEO Richmond said, “We’re going to be educating our owners about the events as they transpire, but we’re not in a position yet where it’s clear what it is we need to do. It’s something we all have to watch.”
NBAA is meeting with the IRS chief counsel’s office this month to discuss the issues raised by the March 9 memo. NBAA also issued a statement to members: “[This type of memo] does not constitute binding precedent, but it represents the opinion of IRS counsel. This [memo] suggests that the IRS intends to aggressively assert excise taxes on payments to aircraft management companies, even where there is no Part 135 charter use of the aircraft by the manager.”
The National Air Transportation Association is also concerned about how the IRS memo will affect its charter/management company members and planned a meeting of the NATA Air Charter Committee on March 30. “NATA is deeply concerned, but not surprised, by the recent IRS document related to the applicability of commercial federal excise taxes on fees charged for aircraft management. For the last few years the IRS has increasingly sought to impose the tax on management fees.Fortunately, most operators have been successful in defending against what the association believes to be an incorrect application of the tax.”