Proposed Regulations on Deductions for Entertainment Use of Business Aircraft
Employee Benefits Alert
More than two years after the issuance of Notice 2005-45, the Internal Revenue Service has finally issued proposed regulations addressing the deductibility of entertainment expenses under section 274(e)(2) of the Internal Revenue Code, as amended by the American Jobs Creation Act of 2004 (and later technical amendments legislation). Effective for expenses incurred after October 22, 2004, section 274(e)(2) limits deductions for entertainment goods, services and facilities provided to “specified individuals” to the amount that the company treats as compensation to the recipient and reports as compensation on its return. Though section 274(e)(2) is potentially more broadly applicable, the proposed regulations, like Notice 2005-45, are aimed at aircraft entertainment use and at overriding the Tax Court’s holding in Sutherland Lumber-Southwest, Inc. v. Commissioner, which sustained the taxpayer’s deduction of expenses for its executives’ entertainment flights on company aircraft that were valued for compensation purposes using the special valuation rules for flights on noncommercial aircraft, known as the SIFL rules.
In most respects, the proposed regulations reflect a “stick-to-your-guns” attitude on the part of the Service, as they reject almost all taxpayer pleas to change the basic approaches to measuring income, determining the amount of deduction disallowance, and identifying entertainment use, as reflected in Notice 2005-45. Nevertheless, the proposed regulations do contain some helpful changes. Following are highlights:
- Compensation (or Reimbursement) Treatment and Interface with Consistency Rules. The Service has turned a deaf ear to pleas from companies to be permitted to impute compensation to a “specified individual” for entertainment flights by reference to allocated costs for the purpose of being able to eliminate the deduction disallowance. As a result, the cumbersome disconnect between imputed income, which must continue to be measured (under the consistency rules) based on fair market value (charter) or SIFL values, and company costs, which must be measured under the disallowance formulas, is perpetuated. The fringe benefit consistency rules have been slightly relaxed for purposes of applying section 274(e)(2) to permit fair market charter value to be applied to entertainment use by specified individuals while applying SIFL to non-entertainment use by specified individuals and all use by non-specified individuals. However, consistency within these groupings is required, so that, for example, if a company values the entertainment use of aircraft by one specified individual under the fair market value rule, it may not value the entertainment use of aircraft for any other specified individual under the SIFL rules.
- Expenses. The proposed regulations reject suggestions that only variable or incremental expenses should be counted, continuing the Service’s position in Notice 2005-45 that all expenses for entertainment use by specified individuals, both fixed and variable, including depreciation, are subject to the disallowance rules. However, there are some clarifying and helpful changes. The proposed regulations establish a pro rata rule for allocating any disallowance between fixed and variable expenses (and presumably to items within those categories as well). They clarify that the basis of an asset is not reduced for depreciation disallowed under section 274(e)(2). In a very important concession to commentators (at least someone at the National Office is listening!), the proposed regulations permit a separate computation of the amount of disallowed depreciation for purposes of section 274(e)(2) only. Accelerated depreciation on the aircraft may be taken for other purposes. Specifically, the proposed regulations permit a company to elect to calculate depreciation on a straight-line basis over the class life of the aircraft for purposes of the entertainment use disallowance. If this election is made, it will apply to all of the taxpayer’s aircraft for the current year and all future years.
- Entertainment. Here also, the Service has basically dug in its heels by refusing to define this term beyond the existing definition found in existing Treas. Reg. § 1.274-2(b)(1) and also rejecting the particular application put forward by commentators of a primary purpose flight-by-flight test, while offering a few useful clarifications at the edges. The Preamble helpfully indicates that entertainment does not include travel for reasons such as attending to business other than that of the employer, medical purposes, attending funerals, and participating in charitable activities. Thus, for example, it may be possible for an employer to characterize the use of company aircraft to attend a board of directors meeting of another unrelated company as not constituting entertainment.
- Specified Individuals. A broad definition of specified individuals, including the attribution to the specified individual of entertainment use by a spouse, other family members and others (e.g., guests) having a relationship with the specified individual, has been carried forward from Notice 2005-45, although the Service has invited comments on how the regulations could more specifically define passengers aboard a flight by virtue of their relationship with a specified person. Reflecting the technical correction in the Gulf Opportunity Zone Act of 2005 clarifying that the related party rules of sections 267(b) and 707(b) apply to section 274(e)(2), the proposed regulations provide that a specified individual of a taxpayer includes a specified individual of a party related to the taxpayer under those related party rules. A critical question, seemingly unanswered by the proposed regulations, remains namely, how the concept that “an individual who would be subject to section 16(a) [of the 1934 Securities Act] if the taxpayer were an issuer of equity securities referred to in that section” applies to officers of subsidiaries. Are the specified individuals only the officers of the top-tier company who are subject to section 16(a) or also the officers of each related subsidiary as if the subsidiary were an issuer subject to that section?
- Aggregation of Aircraft. The proposed regulations continue the choice provided by Notice 2005-45 to calculate expenses separately for each aircraft or to aggregate aircraft of similar cost profiles (e.g., jet or prop and same number of engines), and they provide additional characteristics (payload, passenger capacity, fuel consumption rate, age, maintenance costs, and depreciable basis) for determining whether aircraft have similar cost profiles, and invite further comments on this aspect.
- Section 162(m). Although the proposed regulations are silent on the matter, in the Preamble the Service reiterates its position in Notice 2005-45 that “expenses treated as compensation” for purposes of section 274(e)(2) are subject to potential disallowance under section 162(m). The Service rejected comments pointing out that Treas. Reg. § 1.162-25T makes clear that the value of non-cash fringe benefits included in an employee’s gross income may not be deducted as compensation for services but only as costs incurred. In taking this position, while declining to allow taxpayers to depart from the fair market value or SIFL choice in imputing compensation, the Service seems to be literally trying to “have it both ways.” The amounts imputed as income under the fair market value or SIFL rules are simply not “expenses treated as income.” We plan to continue to press this point with the Service as part of our written comments on behalf of our clients.
- Allocation Methods. The Service has retained in the proposed regulations the basic occupied seat hour or mile formula of the Notice, but has added a modified flight-by-flight alternative. The basic formula multiplies the hours or miles flown by an aircraft by the number of occupied seats for each occupied flight for the year, aggregates all fixed and variable expenses of the aircraft (or group of aggregated aircraft) for the year, and divides the total expenses by total occupied seat hours or miles to compute the cost per occupied seat hour or mile. The costs attributable to entertainment use by each specified individual are then determined by taking the number of hours or miles occupied for entertainment by the specified individual and multiplying that number by the cost per occupied seat hour or mile, as the case may be. The amounts treated as compensation (or reimbursed by the specified individual) are then subtracted to come up with the total amount of expenses to be disallowed. Responding to comments regarding the potential distortions this formula can produce in certain fact settings, the Service has offered a modified flight-by-flight alternative. This alternative starts with the same annual accumulation of costs as under the regular formula, but instead of dividing those costs by occupied seat hours or miles, first divides them by the total number of flight hours or miles, to determine the cost per mile or hour. Then the expenses for each flight are determined by multiplying the number of miles or hours for the flight by the expenses per hour or mile. The expenses for each flight are then allocated to the passengers per capita. Availability of the modified flight-by-flight alternative can result in tax savings in certain situations. At this point, we simply urge clients to use a sharp pencil and to keep in mind that they must use the chosen method for all flights of all aircraft for the taxable year.
- Deadhead Flights. The proposed regulations continue, as the Notice, to count deadhead flights (i.e., non-passenger return or pick-up flights) as entertainment flights to the same extent as the related passenger-occupied flight, i.e., the aircraft is treated as having made both legs of the trip with the same passengers on board for the same purposes. In response to requests for further clarifications, the proposed regulations set forth a special allocation rule for when a deadhead flight occurs between two unrelated flights involving more than two destinations.
- Entertainment Facilities. The proposed regulations, like the Notice, rationalize that the Congressional purpose behind section 274(e)(2) overrides the incongruity of treating section 274(e)(2), which is structurally an exception to the disallowance of entertainment facility expenses, as a disallowance provision in its own right, irrespective of whether the aircraft is an entertainment facility. The proposed regulations limit coverage to the operation of section 274(e)(2) with respect to entertainment use of aircraft and duck the question of the interaction between sections 274(a) and 274(e)(2).
- Leasing of Taxpayer Aircraft. The proposed regulations permit expenses attributable to bona fide arm’s length leases of a company’s aircraft to an unrelated third party to be excluded from the disallowance formula computations. They leave uncertain the treatment of intra-group arrangements.
- Possible Charter Rate Safe Harbor. In the Preamble, the Service indicates that consideration is being given to offering the option of allowing companies to determine the amount of their expenses for entertainment flights by reference to undiscounted charter rates instead of using actual costs. Under such a method, an undiscounted charter rate for a comparable flight would be allocated to the individuals on the flight in lieu of the occupied seat or modified flight-by-flight methods. The implication is that Treasury and the Service thought seriously about including this alternative in the proposed regulations but decided to defer and invite comments.
- Effective Date. Although the regulations will not be effective until finalized, companies are permitted to rely on either the proposed regulations or Notice 2005-45 for taxable years beginning before publication of the Treasury Decision containing the final regulations. To the extent that the proposed regulations and Notice 2005-45 provide rules for the same particular issue, the company may pick and choose between them; however, where an issue is covered only by the proposed regulations, the company may not rely on the absence of a rule in Notice 2005-45 to apply a rule contrary to the final regulations.
We will be submitting written comments (which are due by September 13) on the proposed regulations on behalf of our interested clients and we plan to testify at the hearing to be held on October 25. We would welcome your company’s participation in the group of interested clients. If interested in participating, please contact one of the members of our employee benefits group.
For further information, please contact any of the following lawyers:
Marianna Dyson, firstname.lastname@example.org, 202-626-5867
Michael Lloyd, email@example.com, 202-626-1589
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