Taxing Corporate Aircraft Use

By Roy Whitehead, Pam Spikes, and Marilyn Clarkson

Most corporations allow the use of their corporate aircraft for purposes other than corporate business. Often corporate aircraft are used by directors and executives for business related to outside directorships, vacation, or charitable purposes. Recently, the IRS has disputed a number of deductions related to expenses incurred in operating company aircraft. The controversy centers on whether the corporation can deduct the entire expense incurred when operating company aircraft for the benefit of employees, or whether the deduction is pegged solely to the value of the use of the aircraft to the employee—that is, the taxable amount reportable by the taxpayer’s employees. The question is how IRC section 274 applies to the cost of operating the corporate aircraft for employee travel unrelated to the corporation’s principal business.

Discussion

Sutherland Lumber—Southwest v. Comm’r [114 T.C. 197, aff’d. per curium 255 F.3d 495 (8th Cir. 2001)] demonstrates the thorny issues involved. This case is important because it was considered controlling by the tax court in two other recent cases involving the use of corporate aircraft, Midland Financial Co. v. Commissioner [T.C. Memo. 2001-203 (August 1, 2001)] and National Bancorp of Alaska v. Commissioner [T.C. Memo. 2001-202 (August 1, 2001)]. Sutherland, principally engaged in the retail lumber business, owned a Learjet used for travel related to the business and for air charter service operated out of Kansas City. Dwight and Perry Sutherland, president and vice president, respectively, of Sutherland, also used the plane for travel related to their positions as directors of other businesses, for other business purposes, charitable purposes, and vacation. In 1992, the plane was used about 30% of the time for charter business, 23% for directors’ flights, 18% for nonvacation flights, 24% for vacation flights, and 5% for other purposes.

Use of the aircraft for directors’ flights, nonvacation flights, and vacation flights was properly reported by the Sutherlands as compensation in connection with their employment with the corporation. The corporation also calculated and reported the amount of imputed income for Dwight and Perry Sutherland in accordance with the evaluation formula found in Treasury Regulations section 1.61-21(g). The corporation deducted its total costs incurred in operating the aircraft, including directors’, nonvacation, and vacation flights. The IRS determined an income tax deficiency of over $300,000 for Sutherland’s 1992 tax year. Sutherland asked the tax court for summary judgment with respect to the disallowance of its claimed deduction for expenses to operate the aircraft. The court was confronted with IRC section 274, which provides special rules for the disallowance of certain deductions in connections with entertainment, amusement, or recreation activities, instead of IRC sections 31, 162, and 132, where the answers are usually found. To simplify matters, the parties agreed that the value of the vacation use of the aircraft is reportable by the employees as compensation and that the corporation is entitled to amounts in connection with that use. The primary question under IRC section 274 is whether Sutherland may deduct its aircraft operating costs in full or whether the deduction is limited to the amount reportable as compensation by Dwight and Perry Sutherland.

IRC section 162(a) generally gives a taxpayer a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business. An expenditure is ordinary and necessary if the taxpayer establishes that it is directly connected with, or proximately related to, the taxpayer’s activities. As an ordinary expense for carrying on a trade or business, a taxpayer may deduct the expenses paid as compensation for personal services. If the compensation is paid in the form of a noncash fringe benefit, like vacation travel on an airplane, the regulations provide that an employer may take the deduction for expenses incurred in providing the benefit if the value of the noncash fringe benefit is includable in the employee’s gross income (Treasury Regulations section 1.162-25T). A key fact here is that the employer may not deduct the amount included by the employees as compensation, but is required to deduct the employer’s costs incurred in providing the benefit (Treasury Regulations section 1.162-25T).

The controversy in this matter arises because some deductions previously allowable under IRC section 162 were disallowed by IRC section 274. This section was enacted to eliminate perceived abuses with respect to business deductions for entertainment, travel expenses, and gifts. Although IRC section 274(a) is designed generally to prohibit deductions for certain entertainment expenses, IRC section 274(e)(2) provides that the deduction disallowance provided for in IRC section 274(a) will not apply to the following:

Expenses for goods, services, and facilities, to the extent that the expenses are treated by the taxpayer, with respect to the recipient of the entertainment, amusement, or recreation, as compensation to the employee on the taxpayer’s return of tax under this chapter and as wages to such employee for purposes of Chapter 24 (relating to the withholding of income tax, sources and wages) [emphasis added].

The critical question about IRC section 274(e)(2) is whether Congress intended “to the extent” to make an exception for taxpayers from section 274(a) or whether it intended to limit a taxpayer’s deduction to the amount of income specifically includable by the employee. Congress has provided specific evaluation rates for certain benefits, including employer-provided flights on noncommercial aircraft, for purposes of computing the amount of income taxable to the employee. The rates do not bear a direct correlation to the actual cost incurred by the aircraft’s owner; they are derived from commercial flight rates. The rates used are 125% of the standard industry rate for coach and 200% of the standard industry rate for first-class [50 Fed. Reg. 52281, 52283 (December 23, 1985)]. The use of this bright-line approach can result in uneven or differing treatment, and in some cases an employee might be required to report a smaller value as income while the employer would be allowed to deduct a larger amount. The opposite result could also occur if the value of the employee’s use or benefit is greater than the cost to the employer. In such a situation, the employer would be limited to deducting the actual cost, even though the employee would be required to report income in excess of the employer’s allowable deduction.

IRC section 274(e) contains specific exemptions to the application of IRC section 274(a). Congress’ intention was to have such enumerated items continue to be deductible to the same extent as allowed by existing law.

IRC section 274(e)(9), concerning deductions for expenses for nonemployees, is helpful because it contains the same “to the extent” language. The legislative history of this section contains the example of a manufacturer allowing use of an entertainment facility by a nonemployee dealer; as long as the reporting requirements are met, “the manufacturer will not be subject to the deduction limitations if the value of the entertainment facilities is includable in the income of the dealer.” IRC section 274 does not apply, and there are no restrictions with respect to otherwise allowable deductions by the employer as long as the value of the benefit is included in the nonemployee dealer’s income. The allowable deduction is not limited to the value of the benefit to the employee.

The court confronted the issue of disparity between the value of the benefit to the employee and the actual cost of conferring the benefit. The court stated that the IRS’ argument missed the mark. Dwight and Perry Sutherland were properly taxed for the benefits they actually received by using the plane. The corporation received no tax-free benefits. The total expenses of operating the aircraft are no more or less than the employer was entitled to deduct under IRC section 162. Finally, the application of the benefit provision might result in the employee reporting more imputed income than the employer is entitled to deduct. The court found that the taxpayer’s interpretation of the “to the extent” language of IRC section 274(e)(2) was more appropriate and was more likely Congress’ intent. The decision provides needed predictability and utility for taxpayers.

The IRS is expected to continue to challenge such rulings in an attempt to get the issue to the Supreme Court.

Roy Whitehead, JD, LLM, is an associate professor of business law,
Pam Spikes, PhD, CPA, is an associate professor of accounting, and
Marilyn Clarkson, CPA, is an instructor of accounting, all at the University of Central Arkansas, Conway, Ark.