For several years the IRS has aggressively targeted small airline companies with investigations and audits for unpaid excise taxes. Multi–million dollar tax assessments, penalties, and interest are not uncommon, forcing many small airlines to sell – it they are able – or go out of business. Perhaps considering it an untapped source of revenue, the aggressive auditing practices have particularly targeted small carriers providing indirect charter flights to third parties. As explained in more detail below, an indirect charter flight is where the carrier’s customer sells transportation to passengers.
Section 4261 of the Internal Revenue Code (“Code”) imposes a 7.5% excise tax on the air transportation of passengers. With the exception of rural airports, a flat tax of $4.00 is also imposed on each domestic segment of air transportation. The passengers for all such flights are liable for paying the tax.
As provided in Code Section 4291, whoever receives payment for the air transportation is responsible for collecting and remitting the tax to the IRS. However, where the tax is not collected at the time payment for transportation is made, the tax must be paid by the carrier providing the initial flight segment. In theory this system of taxing air transportation appears straightforward; but in practice becomes quite problematic when the law is misapplied by IRS auditors to certain types of flights.
Indirect charter flights are a favorite target of overzealous auditing practices by IRS examiners. Indirect charter flights are typically with charter brokers, public charter operators, and other airlines that contract with the carrier through “wet leases”. Pursuant to a wet lease, the carrier provides the aircraft, crew, maintenance and insurance (“ACMI”). The carrier invoices the charterer/customer at a fixed hourly rate, not per passenger. More importantly, the charterers directly sell transportation to their passengers, and are responsible for collecting excise taxes at the point of sale – which is not always done. The carrier has no contact or privity with the passengers obligated to pay excise tax, until immediately prior to boarding. In addition to selling transportation directly to its passengers, the charterers maintain operational control over every aspect of the flights, and dictate flight schedules, times, duration and destination. The carrier is solely responsible for providing ACMI when demanded by the charterer.
The most common indirect charter flights being targeted by the IRS are: (1) aircraft provided to foreign and domestic airline customers (where the airline needs extra capacity or replacement aircraft for sold flights); (2) charter flights sold through independent brokers (i.e. flights for university athletic teams and governmental agencies like ICE); and (3) public charter operators (independent transportation providers or large travel agents). With all indirect chartered flights, the third–party charterers maintain operational control of the flights and statutorily should be required to collect taxes from its passengers at the point of sale.
IRS agents incorrectly assess carriers by applying the excise tax rate to passengers listed on carrier’ monthly reports filed with the US Department of Transportation. If the IRS has no record that the carrier paid the taxes for the identified passengers, it will assess taxes regardless of whether the carrier’s customer or a third party has collected and remitted taxes.
In support of the improper assessments, IRS auditors misinterpret Treasury Regulation Section 49.4261–7(h)(1) for the premise that an amount paid for the charter of an aircraft for transportation is subject to excise tax. For direct charter flights the carrier would be responsible for collecting excise tax from its direct charter customer. However, the Regulations further provide that a charterer (carrier’s customer) who sells transportation to other persons is responsible to collect and account for the excise tax under certain circumstances. Treas. Reg. §49.4261–7(h)(2). It is important for the carrier to advise its customers of their obligation to collect and remit excise tax, as the IRS will ultimately look to the carrier or airplane owner if the taxes have not been collected.
In light of its funding woes, the IRS will likely continue its aggressive audit practices in industries with potential for generating significant revenue. Small airline companies – particularly those offering indirect charter flights – should be diligent in complying with contractual requirements that shift the tax burden to its customers, and vigorously defend its practices if audited.