Press Room: Tax Release

January 02, 2013

IRS on Entertainment Use of Business Aircraft

IRS Issues Final Regulations on Disallowance of Expenses Associated with Entertainment Use of Business Aircraft

On July 31, 2012, Internal Revenue Service (IRS) issued final regulations clarifying the tax treatment of personal use of business aircraft under the American Jobs Creation Act of 2004 and the Gulf Opportunity Zone Act of 2005. Generally, those provisions limit the amount of expenses deductible with respect to individuals using business aircraft for personal entertainment purposes.

These regulations finalize the 2007 proposed regulations with some modifications that are generally favorable to taxpayers. They are effective for tax years beginning on or after August 1, 2012. Interim guidance provided by Notice 2005-45 becomes obsolete for those tax years. Transition rules allow the application of these rules to taxable years prior to enactment.  

This alert discusses a few of the most important provisions in the final regulations.

Use by Specified Individuals

The final regulations provide that expenses for the entertainment use of a business aircraft by a specified individual are disallowed, except to the extent of the amount recognized as income by the specified individual or to the extent that the specified individual reimburses the business for the flight. Entertainment use does not include non-entertainment use such as travel to a funeral.

A specified individual is defined as an officer, director, or a direct or indirect beneficial owner of more than 10% of any class of registered security of a corporation taxed under subchapter C or subchapter S, or a personal service corporation.  For partnership purposes, a specified individual includes any partner that holds more than a 10% equity interest in the partnership, or any general partner, officer or managing partner of a partnership.

Use by Employees Who Are Not Specified Individuals

The disallowance provisions do not apply to employees who are not specified individuals to the extent the expenses related to entertainment air travel are properly included in employee compensation.

Non-employees Who Are Not Specified Individuals

The disallowance provisions do not apply to non-employees who are not specified individuals to the extent expenses are included in the income of such person and all required information reporting is provided.

Taxpayer Provided Aircraft

These rules apply to any aircraft owned by, leased to or chartered by a taxpayer or a related-party of a taxpayer.

Computation of Disallowed Expenses

The expenses subject to disallowance include variable costs such as fuel and landing fees, and fixed costs such as depreciation, hangar fees and pilot salaries. For purposes of this calculation only, an election is available to utilize straight-line depreciation. This election can be revoked only in compelling circumstances. Interest expense is subject to disallowance if the underlying debt is secured by or properly allocable to an aircraft used for entertainment. Expenses allocable to a lease or charter of an employer’s aircraft to an unrelated third party for adequate consideration in a bona-fide business transaction are not subject to disallowance. 

The final regulations provide the following special rules: two electable cost allocation methods based on occupied seat hours or miles for the taxable year; a flight-by-flight allocation rule; detailed rules on determining disallowed expenses on deadhead flights; and a new rule applicable to travel on regularly scheduled airlines. The final regulations do not include a number of provisions suggested by commentators including a primary purpose test, charter rate safe harbors, specific provisions for leases or charters or rules for charitable contributions of business aircraft. 

Treatment of Depreciation

Taxpayers may elect under these regulations to calculate depreciation on a straight-line basis over the class life of an aircraft for the current year and all future years for purposes of determining the amount of disallowed expenses, even if the taxpayer uses another method to compute depreciation for other purposes. The regulations include a favorable rule that limits the amount of disallowed depreciation to the amount of a taxpayer’s allowable tax depreciation for any tax year. In addition they provide that the basis of an aircraft is not to be reduced by the amount of depreciation disallowed under these provisions. 

The depreciation provisions are illustrated in the following example.

XYZ Company is a calendar-year taxpayer that owns an aircraft used for business and entertainment purposes. The aircraft is purchased and placed in service on July 1, 2012, of Year 1 and has an unadjusted depreciable basis of $10,000,000. XYZ Co. uses the 200% double declining balance (DDB) method of depreciation with a 5-year recovery period for tax preparation purposes. For purposes of determining the personal use of aircraft disallowance, XYZ Co. elects to use the straight-line method of depreciation and the class life of 6 years. In each year, the aircraft entertainment use subject to disallowance is 10% of the total use. The aircraft qualifies for 50% bonus depreciation.  XYZ Co. calculates the tax depreciation of the aircraft as follows:  

In the example above, at the end of Year 7 the basis of the aircraft is $458,320, which is the total amount of disallowed depreciation in Years 1 through 6.  Also, the rule that limits the disallowance to depreciation claimed in the tax year avoids a disallowance in year 7.