Eight years after the enactment of the deduction limitation in section 274(e)(2) of the Internal Revenue Code and five years after the issuance of proposed regulations, the IRS has issued final regulations on the entertainment use of company aircraft. The regulations are effective August 1, 2012, and are applicable to tax years beginning after that date. 77 Fed. Reg. 45480 (Aug. 1, 2012). 

The immediacy of the effective date of the final regulations serves as the first clue that the Service has rejected most of the taxpayer comments received on the 2007 proposed regulations and Notice 2005-45. The final regulations reaffirm the Service's commitment to classifying aircraft expenses based on each passenger's reason for being on a flight, as opposed to applying a primary flight purpose test for identifying disallowed entertainment expenses. Moreover, with few and quite limited exceptions, the final regulations fail to adopt other taxpayer comments, such as requests for rules that would limit expenses subject to disallowance to the direct or variable costs, or incremental costs, of a flight without disallowance of fixed costs, or that would allow an aircraft-by-aircraft straight-line depreciation election (as opposed to aggregating aircraft with "similar cost profiles"). Judging from the Service's rejection of most taxpayer comments and the decision to include interest in the list of disallowed costs, it may be fortunate that the final regulations do not expand on the definition of what constitutes "entertainment" and do not include specific rules for the use of aircraft as entertainment facilities. 

In response to one issue of robust comment and discussion, the final regulations fail to include a charter rate safe harbor as an alternative to determining actual expenses but at least do not close the door entirely. The Preamble notes that while commentators generally endorsed the inclusion of a charter rate safe harbor, the difficulty of determining accurate and reliable charter rates continues to be viewed by the Service as an impediment to establishing a charter rate safe harbor. Consequently, the final regulations authorize the Service to adopt charter rate or other safe harbors in future published guidance.

The final regulations clarify that in any taxable year the depreciation disallowance cannot exceed the amount of otherwise allowable depreciation, and they provide examples illustrating how taxpayers determine depreciation and basis under the straight-line election. Also, as noted above, the final regulations clarify that interest deductions are disallowed if the underlying debt is secured by or allocable to an aircraft used for entertainment. The final regulations also clarify the rules addressing the pro rata allocation of disallowed expenses and any amounts reimbursed or treated as compensation, and also provide examples of how expenses for a deadhead flight should be calculated. Lastly, the final regulations provide some relief for specified individuals on regularly scheduled flights of employers that are commercial passenger airlines by providing a special rule that treats expenses of entertainment flights by specified individuals in the same manner as expenses of entertainment flights by non-specified individuals under certain circumstances.

For further information, please contact any of the following lawyers:

Lee Spence, lspence@milchev.com, 202-626-5965

Marianna Dyson*

*Former Miller & Chevalier attorney

The information contained in this communication is not intended as legal advice or as an opinion on specific facts. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. For more information, please contact one of the senders or your existing Miller & Chevalier lawyer contact. The invitation to contact the firm and its lawyers is not to be construed as a solicitation for legal work. Any new lawyer-client relationship will be confirmed in writing.

This, and related communications, are protected by copyright laws and treaties. You may make a single copy for personal use. You may make copies for others, but not for commercial purposes. If you give a copy to anyone else, it must be in its original, unmodified form, and must include all attributions of authorship, copyright notices, and republication notices. Except as described above, it is unlawful to copy, republish, redistribute, and/or alter this presentation without prior written consent of the copyright holder.