Personal use of corporate aircraft before and after the American Jobs Creation Act of 2004: The American Jobs Creation Act of 2004 dramatically changed the rules with regard to deducting expenses associated with personal use of corporate aircraft by legislatively overruling the favorable Sutherland Lumber decision.

• Author: Koche, David L.

In an era that places a premium on saving time and on obtaining a competitive advantage, however slight, use of "corporate jets" has become increasingly more attractive to business owners. (1) The growing inconvenience of commercial air travel will likely continue this trend. (2) An issue arises, however, because ownership and operation of an aircraft lies at the intersection of four complicated, distinct areas of law: federal tax rules, state tax rules, aviation law, and general liability rules. This article will focus on Code [section] 274, (3) which sets forth one of the more significant federal tax statutes impacting the deductibility of expenses associated with the operation of an aircraft.

Federal Income Tax Issues

The deductibility of an aircraft's fixed and variable operating costs related to the business use of the aircraft generally is governed by the "ordinary, necessary, and reasonable" requirements for trade or business expenses under Code [section] 162 or for investment use under Code [section] 212.4 The "ordinary" test is generally not a barrier to deductibility in that the courts recognize that the use of corporation aircraft in the furtherance of a taxpayer's business is a common practice. Similarly, the "necessary" requirement, which requires demonstrating a direct relationship between the expense and the furtherance of the business, is not typically a significant impediment to deductibility. The third test requires that the expense must be reasonable in relation to its purpose. (5) The thrust of all three of these tests is that a taxpayer who seeks to deduct the costs of operating the aircraft as ordinary and necessary business expenses incidental to their primary business must document the direct relationship between the use of the aircraft and the furtherance of the primary business. (6)

Generally, taxpayers are most concerned about the depreciation rules, given their quantitative significance. (7) While aircraft generally have a class life of six years, with a five-year recovery period under the accelerated method of depreciation, (8) a complicated "qualified business use" rule must be carefully analyzed to determine the appropriate depreciation method. (9)

Code [section] 274

The most difficult issues in attempting to utilize the losses incurred in operating an aircraft are the entertainment facility rules contained in Code [section] 274.

The general rule articulated in Code [section] 274 is that no business deduction is allowed for any expenses paid or incurred for an entertainment, recreational or amusement facility. An entertainment facility is any property that a taxpayer owns, rents, or uses for entertainment. Examples of entertainment facilities include a hunting lodge, fishing camp, swimming pool, tennis court, bowling alley, car, apartment, hotel suite, a home in a vacation resort, and, importantly, airplanes. (10)

Absent the applicability of an exception, the general rule governing entertainment facility expenses under Code [section] 274(a)(1)(B) is that their deduction is flatly prohibited (effective for taxable years after 1978). (11) Under regulations that, by their title, apply to entertainment facilities prior to 1979, expenditures with respect to an entertainment facility include depreciation and operating costs such as rent and utility charges, expenses for maintenance, preservation and protection of a facility (e.g., repairs, painting, and insurance costs), salaries or subsistence expense paid to caretakers or watchmen, and losses realized on sale or other disposition. The Tax Court continues to apply this regulation for tax years after 1979. Thus, the [section] 274 disallowance applies to depreciation, and operating costs such as rent, utilities, maintenance, and protection. In other words, no deduction means no deduction.

There are several exceptions to the strict disallowance rules contained in [section] 274. Of particular relevance, there is a bright-line exception for expenses for goods, services, and facilities to the extent they are treated as compensation to an employee. (12) For the past several years, this exception has been the topic of discussion in the airplane industry because of the case of Sutherland Lumber-Southwest, Inc. v. Commissioner, 114 T.C. 197 (2000), aff'd, 255 F.3d 495 (8th Cir. 2001), acq., AOD 2002-02 (February 11, 2002). Due to the significance of this case under prior and current law, as amended by the act, it is worth a more detailed discussion.

Sutherland Lumber-Southwest, Inc. v. Commissioner

Prior to Sutherland Lumber, there was little direct guidance on the amount of "personal" use that would taint the "business" use of an aircraft. Specifically, under the law prior to Sutherland Lumber, there was an issue as to when personal use became so substantial that it obviated the "business purpose" of the entity, thereby causing an airplane to be treated as an "entertainment facility" such that deductions for all expenditures incurred with respect to the plane would be disallowed. Indeed, many practitioners were concerned because, under a literal reading of IRC [section] 274, the IRS could attempt to deny a taxpayer a deduction for all expenditures incurred "with respect to" an airplane that was used occasionally for entertainment purposes. However, notwithstanding this theoretical concern, it was believed...