Corporate taxpayers beware: The Internal Revenue Service has published final rules that not only limit the amount of expenses companies can deduct for personal use of corporate aircraft, they also create a bunch of new compliance headaches.
The rules, which took effect this month, implement a provision in the 2004 American Jobs Creation Act, which mandated the changes. The IRS proposed the rules in 2007, but is just finalizing them now.
The final rules clarify when corporate taxpayers may claim tax deductions under Section 274(e) of the federal tax code as it relates to aircraft usage. When "specified individuals" use corporate aircraft solely for business purposes, the company may deduct 100 percent of the costs related to the maintenance and operation of the aircraft. Federal tax law general defines "specified individuals" as officers, directors, individuals with more than 10 percent ownership or shares of the company, and managing partners.
Under the final rules, however, when a company allows its aircraft to be used for "personal entertainment" purposes, a percentage of otherwise allowable deductions get tossed out. These include variable costs, such as fuel and landing fees, and fixed costs such as depreciation, hangar fees, and pilot salaries.
The only time the company may deduct such expenses for entertainment use is if they treat the cost of providing the aircraft as compensation to that individual, or if the individual reimburses the company for use of the aircraft.
http://media.complianceweek.com/images/2012/08/10/hubbard-dan_286395_286396.gif The National Business Aviation Association says the final rules are too onerous. "NBAA-member companies that use an airplane for business have always been fully ready to comply with whatever tax laws apply to their flights," says Dan Hubbard, NBAA's vice president of communications. With the final rules, however, the IRS has placed "a very onerous compliance burden" on companies, he says.
For the last several years, the NBAA has submitted suggestions to the IRS on ways to ease the process for companies. "Unfortunately the IRS has chosen to set aside just about every suggestion we've made," says Hubbard.
In comments to the IRS, the NBAA had requested that the IRS disallow only variable costs attributed to personal aircraft use, contending that since fixed costs don't change no matter the purpose of the flight, they shouldn't be included in the calculation.
The IRS didn't see it that way, reasoning that federal tax code does not differentiate between fixed and variable expenses and that such an interpretation would deviate from Congressional intent of the law.
Creating more turbulence, the final rules also include interest in the calculation of disallowed expenses if the underlying debt is secured by an aircraft occasionally used to provide entertainment. Until now, "the IRS has been silent on interest deduction," says Glenn Hediger, president of Aviation Financial Consulting.
The change is more of a compliance worry than a financial one. A lot of companies don't currently look at their interest expenses, Hediger says. "They're going to have to do an additional level of compliance to determine how much of their corporate interest and corporate debt is allocable to their aircraft assets."
http://media.complianceweek.com/images/2012/08/10/wimer-ruth_286399_286400.gif Companies will also have to pay far more attention to the purpose of business travel using corporate jets. "One of the most challenging aspects of the final rules is to know which travel is subject to the deduction disallowance," says Ruth Wimer, a partner in the employee benefits practice at law firm McDermott, Will & Emery.
"One of the most challenging aspects of the final rules is to know which travel is subject to the deduction disallowance."-Ruth Wimer, Employee Benefits Partner, McDermott, Will & Emery
Not all personal use of corporate aircraft is considered entertainment use and therefore non-deductable. Examples of personal travel that may still be deductible include travel for medical purposes, to attend a funeral, or to participate in charitable events.
http://media.complianceweek.com/images/2012/08/10/horowitz-gary_286403_286404.gif "In your recordkeeping you need to distinguish between 'personal use' and 'personal entertainment' use," says Gary Horowitz, special counsel for aviation and tax at law firm Wiley Rein. Otherwise, you'll be taking more of a deduction disallowance than you otherwise need to, he says.
The final rules further maintain that corporate taxpayers must disallow expenses for entertainment travel even for security purposes. "Section 274(e) does not provide an exception to disallowance for expenses related to the use of a private aircraft for bona fide security concerns," the agency said.
Calculating Deductions
In the final rules the IRS further provides the methodology for determining deduction disallowances. Companies must allocate aircraft expenses on either a person-by-person or flight-by-flight basis between the business use and entertainment use of its aircraft under an "occupied-seat-hours" or "occupied-seat-miles" method.
"What that means is that you're looking at the proportion of passengers on the entertainment flight to passengers on business flights," says Scott O'Brien, NBAA senior manager of finance and tax policy. "So if you happen to have one flight that has a lot of entertainment passengers, it can really increase your proportion of entertainment flight to business flight."
AIRCRAFT AGGREGATION
Below is an excerpt from the IRS rule on entertainment use of business aircraft regarding aircraft aggregation:
The proposed regulations provide that a taxpayer may aggregate expenses for aircraft of similar cost profiles to calculate expenses subject to disallowance. The proposed regulations require that aircraft have the same engine type and number and suggest other factors relevant to whether aircraft are of a similar cost profile.
A commentator requested that the final regulations make the aircraft aggregation rules less restrictive. The commentator opined that taxpayers should be allowed to aggregate the expenses of all aircraft to alleviate the administrative burden of computing and allocating expenses to entertainment use of the aircraft. The commentator stated that, alternatively, the rules inappropriately require similar cost profiles to include the same number of engines and require an unduly detailed analysis of the aircraft characteristics.
The final regulations retain the aircraft aggregation rules. Aggregating the expenses of all aircraft regardless of cost characteristics would create unacceptable distortions in the amount of expenses allocated to the use of each aircraft. The rules are sufficiently broad and flexible for taxpayers to easily apply them.
Allocation of Costs to Flights
A. Primary Purpose Test The proposed regulations provide two alternative methods for allocating the costs associated with the use of an aircraft to provide entertainment to specified individuals. The occupied seat hours or miles allocation method divides the total expenses for the year by the number of occupied seat hours or occupied seat miles to determine a per seat or per mile rate, and it applies the rate to the number of hours or miles of entertainment use. The flight-by-flight method allocates expenses to a flight and then to the passengers on the flight according to the entertainment or non-entertainment character of the travel.
Commentators suggested that the final regulations adopt a primary purpose test for identifying disallowed expenses. Under a primary purpose test, the primary purpose of a flight would determine whether any costs associated with specified individuals traveling for entertainment on that flight are disallowed. Generally, if the primary purpose of a flight is business, no more than the additional or incidental costs associated with specified individuals traveling for entertainment aboard that flight would be disallowed. Some commentators suggested that if the primary purpose of a flight is business, no costs should be allocated to entertainment. One commentator advocated that the final regulations include a primary purpose test as a safe harbor for smaller aircraft.
The final regulations do not adopt a primary purpose test. Section 274(e)(2) applies if a taxpayer provides entertainment, amusement, or recreation to a specified individual and does not depend on either the reason the taxpayer provides the entertainment or the overall use of the aircraft. Disregarding entertainment use by a specified individual is contrary to Congressional intent in amending section 274(e)(2) to disallow expenses allocable to entertainment use of aircraft by specified individuals.
Source: Internal Revenue Service.
To figure out the cost of each flight based on occupied seat hours or occupied seat miles, you would calculate the total hours-or total miles-flown and multiply it by total occupied seats. To arrive at the cost per occupied seat hour or occupied seat mile, you divide the total aircraft operating costs for the tax year by occupied seat hours or occupied seat miles.
For example, if a plane carrying 10 passengers operates for five hours at $10,000 per hour, that cost can be distributed to $5,000 per person. If three of those people are traveling for entertainment, $15,000 out of the $50,000 total flight would be subject to deduction disallowance.
Now do the math for every single flight. This effectively means companies must maintain "very complex spreadsheets in order to do this deduction disallowance calculation," says Wimer. "You have to keep a record of the exact reason of travel for every single person on the plane for every single flight," she says.
Silver Lining?
The news isn't all bad. According to Wimer, with the rules the IRS has adopted "surprising favorable and well thought out rules regarding depreciation." The new rules continue to allow taxpayers to elect to use the straight-line depreciation method for purposes of the disallowance calculation, meaning that depreciation is calculated from the airplane's original value, not the adjusted value as it depreciates.
For taxpayers that choose to use the straight-line depreciation method, the rules provide that the disallowed depreciation in any year will not exceed the allowable depreciation for that year.
In order to minimize the overall tax burdens imparted by the rules, aviation tax experts suggest that companies clearly document the business purposes for each trip."Documentation of the business use of the company airplane is paramount," says Hediger. "You have to be able to substantiate the deduction."
Horowitz also recommends that companies create policy and procedure guidelines for when and how the aircraft can be used. The policies should include details on when aircraft use is permitted for non-business purposes and clear definitions of business, personal, and personal entertainment use.
Then you have to keep additional records for its non-business use:
What was the purpose of the flight? Who was on board? For what purposes was each passenger on board? Was the company reimbursed for any of those trips?
Hubbard says small and mid-size businesses, which make up a large portion of business aircraft operators, will undergo the most onerous administrative burdens. "They're not large companies with teams of attorneys or accountants." They don't have the staff and resources, he says, to spend the amount of time the IRS is requiring in order to make the "best-faith effort possible to comply."
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