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Grounded by the IRS?
Employers make corporate aircraft available for the sake of
convenience, efficiency, security or simply to provide a perk.
Some allow personal use of corporate aircraft. In this age of increased scrutiny of compensation — especially executive compensation — that may invite some extra attention from the IRS. Here’s a look at how this benefit is regulated.
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Grounded by the IRS?
By David R. Fuller The personal use of corporate aircraft was once a benefit only available to the wealthiest owners of closely held family businesses or senior executives in the largest corporations. But times change, and proxy statements indicate that the demographics of aircraft ownership and personal
usage have changed significantly due to several factors, not the least of which are:
1) the wide selection of aircraft types and takeoff weights;
2) creative and relatively economical ownership/charter structures (the most notable being fractional ownership); and
3) the increased safety, convenience and time savings offered by corporate aircraft, especially when contrasted to the commercial flight restrictions imposed in the wake of the Sept. 11 terrorist attacks.
With increased transparency of executive perquisites, these same proxy statements also indicate a pattern of personal use (and abuse in a few instances) by executives.
While markets and the public have renewed their focus on corporate governance issues, the IRS and Congress have followed suit with intensified scrutiny of the increased personal use of corporate aircraft after what the IRS itself refers to as a period of “benign neglect.” The IRS has initiated broad-based and aggressive executive compensation audits that have targeted executive perks as the “low hanging fruit” and that includes personal use of corporate aircraft.
The IRS is focusing on three elements of corporate aircraft usage: proper income inclusion, security-related travel and corporate deductions.
On June 14, 2007, the IRS unveiled its newest weapon against corporations and their executives — extremely narrow and draconian proposed regulations that impose broad disallowance provisions for both fixed and operating costs for entertainment flights, moving corporate deductions ahead of the other two issues as the primary audit target. And IRS scrutiny of this perk is not going away anytime soon.
Background There has never been any question that an employer is entitled to a compensation deduction for employees’ personal use of company aircraft. The question has always been the extent of the costs that may be deducted. At opposite ends of the spectrum are the amount of the compensation included in the executive’s income compared to the costs the employer incurs providing the benefit. In some instances, companies have been double-dipping by claiming both for the same flight! In a concept perhaps inartfully referred to as “SIFL arbitrage,” employers were David Fuller, a partner in the tax department of McDermott Will & Emery’s Washington, D.C. office,
is a contributing editor to the Employer’s Guide to Fringe Benefit Rules and Employer’s Handbook:
Complying With IRS Employee Benefit Rules. Both are published by Thompson Publishing Group.
2 Corporate Aircraft: Grounded by the IRS?
Unfortunately, in developing the actual valuation methodologies for implementing that requirement the IRS has overreached and imposed extremely burdensome methods that make little to no effort to ease administration or parallel current methodologies employers implement to satisfy existing IRS and SEC requirements. For example, there is no symmetry with the seating capacity rule, deadhead flights and security flights. Thus, existing rules and methodologies now require another layer of administration.
Reaction Versus Overreaction to SIFL Arbitrage
Congressional Reaction The IRS challenged the use of SIFL arbitrage in the now well-known Sutherland Lumber (see Box 2) litigation, which involved a fairly small SIFL arbitrage situation. It has always been a curiosity as to why that one taxpayer expended such significant resources (compared to the dollars at issue) on the case that essentially elevated what was an obscure issue to the national attention that ultimately led to Congressional legislation to shut down SIFL arbitrage. Whatever that taxpayer’s motivation to make this common corporate practice a national issue, the SIFL arbitrage concept ended up before the federal Tax Court and the 8th U.S. Circuit Court of Appeals soundly criticized the IRS’ position and the underlying legal rationale limiting the deduction to the SIFL income inclusion in the Sutherland Lumber decisions. The IRS reluctantly acquiesced to the Sutherland Lumber decisions and the use of SIFL arbitrage in 2002.
In the wake of highly publicized corporate abuses, and since SIFL arbitrage was no longer an obscure issue after the Sutherland Lumber decisions, Congress identified SIFL arbitrage as both an area of potential abuse and a revenue raiser. Congress put the issue at the forefront in the Fall of 2004 with the American Jobs Creation Act of 2004 (Jobs Act), which amended Section 274 to Box 2 The Sutherland Lumber Litigation In Sutherland Lumber-Southwest, Inc. v. Commissioner, (114 T.C. 197 (2000), aff’d, 255 F.3d 495 (8th Cir. July 3, 2001) the employer (Sutherland) allowed some employees to use its aircraft for personal vacations. Sutherland calculated and reported the amount of imputed income for the personal flights according to the SIFL rates and withheld the appropriate amount of federal income tax but deducted the full cost of the flights. The IRS disallowed the amount of the deductions that exceeded the amount Sutherland treated as compensation to the employees.
The Tax Court disagreed with the IRS, and held that an employer could deduct the full costs of letting company executives use the employer’s plane for vacations, even though they had properly reported a smaller amount than the employer sought to deduct.
The Tax Court later issued similar rulings in National Bancorp of Alaska, Inc. v. Commissioner (T.C.
Memo. 2001-202, No. 6388 (Aug. 1, 2001)) and Midland Financial Co. and Subsidiaries v. Commissioner, (T.C. Memo. 2001-203, Nos. 12302-99 and 4754-00 (Aug. 1, 2001) cases that also concerned whether employers were limited to deducting the amount employees reported as imputed income that arose from their personal use of corporate aircraft. In each ruling, the Tax Court refused to overturn its holding in Sutherland.
The 8th Circuit agreed with the Tax Court that the deductions Sutherland claimed for employee vacation flights were not limited under Code Section 274 to the value reported by its employees.
Corporate Aircraft: Grounded by the IRS?
IRS Proposed Regulations After almost two years to the day after the Aircraft Notice was published, the IRS attempted to more fully address the deduction disallowance issues by issuing proposed regulations under Section 274 on June 14, 2007. While those proposed regulations certainly answer and further clarify the IRS’ position on certain key issues, there is still uncertainty on some issues. Of course, other issues were addressed in such a draconian manner that many corporations would rather revert back to the pre-existing uncertainty since at least a good-faith interpretation of the statute was acceptable to the IRS before it issued the proposed regulations.
Affected Employees The Jobs Act limits a company’s deduction for the costs associated with the personal entertainment use of the corporate aircraft by a “specified individual.” The proposed regulations define a “specified individual” as any one subject to the requirements of Section 16(a) of the Securities Exchange Act of 1934. These specified individuals include officers, directors and owners (including indirect owners) of more than a 10-percent equity interest in the company.
The proposed regulations fail to define who an officer is. It is possible that any final regulations will define an “officer” as the president, principal financial officer, principal accounting officer, any vice president in charge of a principal business unit, division or function or any other officer who performs a policy-making function. The proposed regulations also fail to address how to treat specified individuals who have retired or otherwise separated from service.
Neither the Jobs Act nor the proposed regulations limit the deduction for employees who are not “specified individuals” even though they may otherwise be control employees for SIFL purposes. The Joint Committee has suggested expanding the deduction disallowance to include entertainment flights by all employees. The preamble to the proposed regulations appears to adopt this stance by providing that both the IRS and Treasury have concluded that Congress “intended all entertainment flights to be subject to the deduction disallowance requirements.” The preamble suggests that deductions for all entertainment flights should be disallowed apparently because the IRS believes that all such passengers are specified individuals or their guests. Accordingly, the proposed regulations adopt a “friends and family plan” approach, i.e., the definition of “specified individuals” is expanded beyond the SEC definition to include their spouses, dependents and other friends and family members. While it does not arise frequently, there have been cases in which passengers on board an entertainment flight are neither specified individuals nor their guests. Some contend the IRS suggestion in the preamble goes too far and should be viewed as an improper interpretation of the statute.
Affected Employers Although the SEC definition of “specified individuals” applies only to publicly traded corporations, the proposed regulations specifically extend the definition to comparable individuals at nonpublic companies. Furthermore, the deduction disallowance provisions apply to partnerships, LLCs, nonprofit organizations, etc., and the individuals employed by or associated with such entities. The precise impact on nonprofit organizations is still uncertain since business deductions are generally irrelevant except for unrelated business income tax (UBIT) purposes. However, since many of these organizations maintain fractional ownership interests, the proposed
Entertainment Use Versus Personal Use The legislative history indicates that the Section 274 amendments target “a nonbusiness activity generally considered to be entertainment, amusement or recreation.” When defining entertainment activities, the proposed regulations explicitly reference the somewhat outdated Section 274(a) regulations. Those regulations provide that “entertainment” means any activity of a type that is “generally considered to constitute entertainment, amusement or recreation such as entertaining at night clubs, cocktail lounges, theaters, country clubs, golf and athletic clubs, sporting events and on hunting, fishing vacation and similar trips, including activities relating solely to the employee and the employee’s family.” The IRS will apply an objective test to determine whether an activity is of a type generally considered to constitute entertainment.
It is important to note that the proposed regulations specifically provide that the deduction disallowance provisions do not apply to deductions for expenses incurred for business entertainment air travel. Nor do the entertainment deduction disallowance rules apply to the nine statutory exceptions listed in Section 274(e).
Many employers, executives and even tax professionals believe that deduction disallowance rules apply to all personal travel. That is clearly not the situation. Although all personal use of an employer’s plane or helicopter is subject to income inclusion, not all personal aircraft use will constitute nondeductible entertainment use. The proposed regulations recognize this as they state “entertainment does not include personal travel that is not for entertainment purposes.” While the proposed regulations would appear to concede that personal commuting should not be considered entertainment, the regulations fail to address the commuting issue or other typical examples of personal use that do not specifically arise to the level of entertainment use.