• An Update on Deductions for Personal Use of Aircraft
  • September 21, 2005 | Authors: Karla R. Hyatt; Richard A. Johnson; J. Leigh Griffith; Michael Stewart
  • Law Firm: Waller Lansden Dortch & Davis, LLP - Nashville Office
  • Five years ago, the Tax Court ruled in Sutherland Lumber S.W., Inc. v. Commissioner, 114 T.C. 197 (2000), that a company could deduct 100% of the cost of an aircraft used for both business and personal flights even though the officers and employees using the aircraft for personal flights only included the lower Standard Industry Fare Level (SIFL) rates in their compensation. This resulted in a benefit to individual owners of pass-through entities that owned or used aircraft for business purposes. These owners were allowed to take large deductions on their personal returns for the expense of the aircraft, but include much smaller amounts in their taxable income for personal use of the aircraft. When the IRS acquiesced to the holding in Sutherland Lumber, the issue appeared settled. However, when Congress overturned Sutherland Lumber by amending Section 274 of the Internal Revenue Code as part of the American Jobs Creation Act of 2004, the treatment of these aircraft deductions changed yet again.

    Under this Act, Sections 274(e)(2) and (e)(9) were amended to prohibit a company from deducting the operating costs of aircraft to the extent such costs were not included in the income of "specified individuals." In May of 2005, the IRS issued Notice 2005-45 as interim guidance on the limitations of deductibility until appropriate regulations can be drafted. This Notice specifically defines and broadens the term "specified individual" to include:

    "an officer, director, or more than 10% owner of a corporation taxed under subchapter C or subchapter S, or a personal service corporation. For partnership purposes, 'specified individual' includes any partner that holds a more than 10% equity interest in the partnership, general partner, officer or managing member of a partnership. 'Specified individual' also includes a director or officer of a tax-exempt entity."

    As a result of this change, companies will be prohibited from deducting the proportionate cost of aircraft used for personal purposes to the extent (a) the value of the use is not included in the compensation income of the specified individuals or (b) specified individuals do not reimburse the company for the cost of the flight. For these purposes, costs are fixed and operating costs, including but not limited to fuel costs, maintenance and personnel costs, take-off and landing fees, hangar fees, any depreciation, management fees, or any amounts deductible under Section 179. Moreover, this disallowance includes the cost of aircraft that are chartered or leased.

    In addition, the Notice provides a method for allocating the expense of flights for business and non-business use to determine the amount of costs that are non-deductible. The IRS permits companies to allocate expenses based on occupied seat hours or miles. This calculation is made using the sum of the total number of hours or miles flown by an aircraft multiplied by the number of seats occupied for each hour or mile. In the event flights are used for both business and personal purposes, the cost of the personal flight must be allocated based upon the amount the total cost of the flight (as determined by occupied seat hours or miles) exceeds the cost of the flight that would have been taken without the entertainment segment.

    The Notice also permits the taxpayer to use the fair market value of a flight, instead of the lower SIFL rate, in calculating the amount included in the compensation income of its specified individuals. Generally the fair market value of a flight is based on the cost the company would have paid to charter the same flight from a third-party. The company may, however, continue to use of the lower SIFL rate to calculate the amount of compensation income for flights of its non-specified individuals. This inconsistent treatment is permissible until such time that formal treasury regulations are promulgated. Please note that if the compensation income of a specified individual exceeds the cost of the aircraft to the company for a specific flight, the company will be limited to the deduction of its actual costs and not the compensation income of the specified individual.