Under new IRS regulations, passengers onboard a business flight for personal reasons can cause per-capita disallowance of aircraft expenses.
Are you claiming your aircraft as a business expenses? If so, new 2013 rules require you to be sure not only that your purpose in flying the aircraft is the furtherance of your business, but also that none of your passengers are coming along for entertainment purposes.
When a person is traveling for business, it has long been common that he or she might be accompanied by a guest traveling for entertainment purposes. A business-aircraft operator who is already planning to fly to a destination for business might readily agree to let an acquaintance who would enjoy going to the destination catch a ride. “Why not?” the operator may ask. “It doesn’t cost anything.”
While it may certainly be true that this additional tag-along passenger does not increase the operator’s aircraft expenses, under a new Treasury regulation (Reg. 1.274-10) the extra passenger will probably have a negative impact by way of lost tax deductions.This article provides a simplified explanation of the rule, as well as three planning tips that those utilizing business aircraft should consider.
The crux of the new rule lies in how the expenses attributable to the entertainment passenger are calculated. Under the historical rule, these expenses were the ones caused by the additional passenger; under the new rule, the entertainment passenger is allocated a per capita share of total expenses. The new rule does not significantly change the fact that expenses attributable to entertainment passengers are generally non-deductible, but it changes the allocation method to significantly increase the expenses deemed to be associated with tag-along passengers.
Three Takeaways
Personal use of a business aircraft has negative tax effects. Personal entertainment passengers on business flights will most likely cause lost tax deductions for those flights.
An election is available to calculate aircraft depreciation, solely for purposes of entertainment disallowance, according to a straight-line schedule. Essentially all aircraft owners are better-off making this election.
If employees receive fringe benefits in the form of entertainment flights, make sure those benefits are properly reported to take advantage of their ability to offset expense disallowance created by entertainment use.
The Historical Rule: Additional Expenses Disallowed
Expenses attributable to personal travelers have generally been viewed as non-deductible personal expenses (federal tax regulation 1.162-2(c)). However, the historical rule has defined these expenses attributable based on the amount by which the additional passenger increases the total expenses of the trip. This is illustrated in IRS Publication 463 (2012), explaining travel expenses, with the following example:
Jerry drives to Chicago on business and takes his wife, Linda, with him [for personal reasons]. . . . Her expenses are not deductible.
Jerry pays $199 a day for a double room. A single room costs $149 a day. He can deduct the total cost of driving his car to and from Chicago, but only $149 a day for his hotel room. If he uses public transportation, he can deduct only his fare.
Thus, the Publication illustrates, the expenses attributable to the personal companion are not deductible, and are measured by reference to the expenses that would have been necessary, even without her presence. As discussed below, this method no longer applies to aircraft carrying passengers for personal entertainment purposes, and has been replaced by a new per capita allocation method.
New 2013 Rule for Aircraft: Per Capita Disallowance
On August 1, 2012, the US Department of Treasury enacted new regulations for entertainment use of aircraft (Reg. 1.274-9, -10). How noteworthy these regulations are is reflected in how rare such types of rules are. Treasury has a general power to issue regulations interpreting the tax code (§7805). However, with respect to entertainment expenses, Congress has given Treasury a special power to create new rules through regulations that are “legislative,” as opposed to “interpretive” in nature (§274(o)). The 2012 regulations were issued legislatively under §274(o), which is a vast departure and may represent the first time in the 50 years since §274 was adopted, that Treasury has exercised its §274(o) legislative-rulemaking power.
Under the new regulations, tag-along passengers onboard aircraft for personal entertainment cause per capita disallowance of aircraft expenses. For example, if a flight has three passengers, two of whom are onboard for business purposes, and one who is onboard for personal entertainment, the expenses of that flight will be at most two-thirds deductible (subject to some narrow limitations and exceptions).
The rule further specifies how to determine the cost of the flight—i.e., to what amount does the hypothetical one-third disallowance apply. Under the rule, the taxpayer must add together the full cost of owning, chartering/leasing, and/or operating the aircraft for the entire taxable year. Such expenses include, among other things: crew salaries, maintenance, hangar, fuel, insurance, depreciation, and interest. These aggregated expenses are then divided up evenly across all use of the aircraft during the tax year. Some elections are available in determining how to carve up the expenses across the use, but these do not much change the basic rule.
Planning Opportunities and Exceptions
Exceptions to the per capita disallowance rule apply in a number of cases, including bona fide sales of aircraft use to unrelated third parties, and scheduled airline flights where at least 90 percent of the seats are available for sale to the public. Further, entertainment cost disallowance can be reduced by recognition of income to the deemed flight recipient (under the aircraft fringe-benefit rules) and/or payment for the flight (subject to FAA limitations on compensated carriage).
The regulations provide a special election to calculate aircraft depreciation, solely for entertainment-disallowance purposes, on a straight-line schedule. This election not only avoids the harsh consequence of disproportionate expense disallowance in early-ownership years for aircraft on front-loaded depreciation schedules, but also will remove some fraction (often substantial) of the depreciation expense from eligibility for entertainment disallowance.
Passengers who fall outside of the category of “specified individuals” also receive favorable treatment, such that their entertainment travel will often not result in cost disallowance at all. The definition of “specified individual” is lengthy, but as a rule of thumb, it applies to those who are owners or high-ranking employees of the aircraft company or a related company, as well as to guests in situations where such individuals are allowed to invite guests as a fringe benefit. The new regulations do not target use of aircraft for other purposes, such as business, or personal endeavors that do not fall within the categories of entertainment, amusement or recreation.
Conclusion
The new regulations significantly increase the negative tax effect of allowing specified individuals who are traveling for entertainment purposes to “tag along” on business trips. It should lead companies to curtail such “tag-along” passengers, and to inquire as to the nature of their personal purpose and, in the case of non-entertainment, non-business passengers, to retain documentation to support the passengers’ non-entertainment characterization.
This article is intended as a brief introduction to a complex area; it is not comprehensive, and may not address other related issues that have a bearing on taxpayers.
Jonathan Levy, Esq. is Legal Director of Advocate Consulting Legal Group, PLLC, a law firm whose practice is limited to serving the needs of aircraft owners and operators relating to issues of income tax, sales tax, federal aviation regulations, and other related organizational and operational issues.
IRS Circular 230 Disclosure: New IRS rules impose requirements concerning any written federal tax advice from attorneys. To ensure compliance with those rules, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under federal tax laws, specifically including the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
