Recently, the Internal Revenue Service ("IRS") published final regulations concerning the deductibility of the use of business aircraft for personal purposes. The final regulations reflect statutory amendments required by the American Jobs Creation Act of 2004 and the Gulf Opportunity Zone Act of 2005. The regulations are effective for tax years beginning after August 1, 2012.
Generally, Internal Revenue Code ("Code") Section 162(a) allows a corporation to deduct all ordinary and necessary expenses paid or incurred during a taxable year in carrying on a trade or business. This generally would include the costs of operating company property, such as aircraft, used for business purposes. However, under Code Section 274, when executives or directors and other "specified individuals" travel on company aircraft for entertainment, amusement, or recreation purposes, a company's deduction is limited to the amount includible as compensation in such individual's income.
The final regulations define a "specified individual" as any individual who is subject to the requirements of Section 16(a) of the Securities Exchange Act of 1934 with respect to the corporation or any subsidiaries of the corporation as well as any individual who would be subject to the Section 16 reporting rules if the corporation (or any of its subsidiaries) were subject to these reporting rules. This would generally include officers (as defined for Section 16 purposes), directors, and 10% shareholders of corporations.
For partnership purposes, a specified individual includes any partner that holds more than a 10% equity interest in the partnership and any general partner, officer, or managing partner of the partnership. Specified individuals of other partnerships that are under common ownership with the partnership will also be treated as specified individuals of the partnership.
In addition, a "specified individual" is treated as using company aircraft if such use is provided to another individual because of his or her relationship to the specified individual and such use is a fringe benefit to the specified individual under Code Section 61(a)(1).
What costs are disallowed?
Despite commentator requests that the disallowance only extend to direct variable costs of operating the aircraft such as fuel and landing fees, or costs paid or incurred for aircraft leased or chartered to the taxpayer, the final regulations provide that expenses subject to disallowance also include fixed costs such as hangar fees, pilot salaries, management fees, maintenance, insurance, registration, certificate of title, depreciation, interest on debt secured by or properly allocable to an aircraft and other items not related to any specific, individual flight. The final regulations also rejected commentator requests for a charter rate safe harbor method for determining costs. Expenses of aircrafts of similar cost profiles may be aggregated to calculate expenses subject to the disallowance.
Note that the regulations permit a taxpayer to elect to calculate depreciation expenses on a straight line basis for all of the taxpayer's aircrafts for all taxable years for purposes of calculating disallowed expenses, even if the taxpayer uses another method to compute depreciation for other purposes. In order to ensure that the sum of allowable and disallowed depreciation will not exceed 100 percent of an aircraft's tax basis, the regulations provide that the amount of the depreciation disallowance in any given year may not exceed the amount of the allowable depreciation for that taxable year. Special transition rules apply for aircraft placed in service before this election was made.
What costs are allocable to a specified individual?
In the final regulations, the IRS rejected a proposed "primary purpose test" for determining whether a flight is for "entertainment, amusement, or recreation purposes." The primary purpose test would have disallowed only the additional or incidental costs associated with specified individuals traveling for entertainment purposes, if the primary purpose of the flight was for business purposes. Under the final regulations, even if the primary purpose of a flight is for business reasons, the company may not deduct the portion of the cost of the flight allocable to specified individuals traveling aboard the flight for entertainment purposes.
For example, assuming that a spouse accompanies an executive on a business trip, the company may not deduct one half of the cost of that business trip (assuming only the two passengers are aboard), except to the extent that the amount attributable to the spouse's travel is includible in the executive's income. Generally, a corporation's actual cost of a flight will significantly exceed the IRS's standard industry fare level or fair market valuation amount that is includible in an executive's taxable wages for that flight.
The final regulations provide that taxpayers may use either the "occupied seat hours or miles method" or the "flight-by-flight method" for allocating expenses to personal use flights. The method chosen must be used for all flights of all aircraft for the taxable year. Deadhead flights (i.e., flights without passengers en route to pick up or after discharging passengers) are generally treated as having the same number and character of passengers as the leg of the trip on which passengers were on board.
Occupied seat hours or miles method
Under the occupied seat hours or miles method, the taxpayer determines the total expenses for the year, the number of occupied seat hours or miles (i.e., the product of the number of hours or miles flown and the number of seats occupied), the cost per occupied seat hour or mile (i.e., the total expenses divided by the number of occupied seat hours or miles), and then the number of hours or miles of entertainment flown by a specified individual.
Under the flight-by-flight method, the taxpayer totals all expenses for the taxable year and then divides this number by the number of flight hours or miles for the taxable year, to determine the cost per hour or mile. Expenses are allocated to each flight by multiplying the number of miles for the flight by the cost per mile or the number of hours for the flight by the cost per hour. Expenses are allocated to each individual on a per capita basis.