On August 1, 2012, the Internal Revenue Service published final regulations on disallowance of deductions for personal entertainment use of business aircraft by so-called “specified individuals.” Click here to download a copy of the final regulations as published in the Federal Register. The final regulations are effective for tax years beginning after August 2, 2012. For calendar-year taxpayers, the regulations will be effective on January 1, 2013.
The final regulations implement provisions of the American Jobs Creation Act of 2004 (“AJCA”), which made important changes to Section 274(e)(2) of the Internal Revenue Code to disallow deductions for entertainment use of business aircraft. More specifically, any entertainment use of a business aircraft by “specified individuals,” which are defined as directors, officers, and 10 percent or greater owners of any class of an equity security, results in a disallowance of deductions by the company related to the aircraft. In addition, the term “specified individuals” includes directors, officers, or 10 percent or greater owners of any class of an equity security of a “related party” to the company, as described in Section 267(b) or Section 707(b) of the Internal Revenue Code. Note that the definition of “officer” is quite broad under SEC regulations. See Rule 16a-1 under the Securities Exchange Act of 1934.
The IRS initially provided guidance on the AJCA on June 13, 2005 in Notice 2005-45. Later, the IRS proposed regulations implementing AJCA on June 15, 2007. The final regulations are substantially similar to the initially proposed regulations from 2007. A redline comparison of the final regulations to the proposed regulations can be accessed here.
The final regulations raise a number of important issues for operators of business aircraft, including:
- Business aircraft owners must keep track of the use of their aircraft on a seat by seat basis, and must clearly identify which passengers are traveling for business and which for personal entertainment. The IRS has imposed this requirement since issuing Notice 2005-45.
- Existing guidance on what is entertainment use is vague and far from comprehensive. Unfortunately, the final regulations do not provide any additional guidance on how these rules apply to aircraft.
- The regulation does not define when aircraft may be deemed to be “entertainment facilities” whose expenses may be totally subject to disallowance of deductions. In other words, even though the taxpayer follows the regulations and disallows deductions for entertainment use by specified individuals, if the aircraft is used too much for entertainment—or even if they are used too much for personal non-entertainment—the IRS could still disallow deductions for use of the aircraft.
- Even if a specified individual is traveling for business, entertainment guests he invites along will result in disallowance of deductions.
- The final regulations provide four different methods for determining the amount of aircraft deductions subject to disallowance. Taxpayers should compute all four methods to determine which one results in the least disallowance. Note that costs for deadhead legs are also subject to disallowance based on complicated formulae.
- The final regulations clarify that interest expenses properly allocated to the aircraft under the interest-tracing rules under Treasury Regulation §1.163-8T are subject to disallowance. Indeed, all aircraft expenses (fixed costs, variable costs, interest, as well as tax depreciation) are subject to disallowance.
- The regulations take the position that chartering or leasing the aircraft to a specified individual, even at an arm’s length rate, will still result in disallowance of deductions. The IRS concludes that 274(e)(8) is only available to taxpayers that are in the business of providing entertainment. This raises the question of whether an equipment lessor taking tax depreciation must account for entertainment use of aircraft by its lessee.
- Taxpayers have the opportunity to elect, for purposes of applying the entertainment disallowance regulations, to apply a straight-line method of depreciation for aircraft, in order to limit the impact of the rules. This could have dramatic benefits depending on how a company has depreciated its aircraft.
Unfortunately, the final regulations are nearly as punitive and perhaps even more complicated than the previous IRS rulings in this area. Please contact Kevin Austin, Nate Pietila, or Tim Austin at Aero Law Group, PLLC at +1 425 456 1800, or firstname.lastname@example.org, email@example.com, or firstname.lastname@example.org, if you need more advice or information.
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