Notice 2005-45: the IRS takes aim at executives' entertainment use of company aircraft.

• Author: Dyson, Marianna G.

Some might say that it is a classic case of the revenge of the nerds. As a result of the legislative change to section 274(e)(2) of the Internal Revenue Code in the American Jobs Creation Act of 2004 (AJCA), the same able lawyers within IRS Chief Counsel who had unsuccessfully advocated the government's position in Sutherland Lumber-Southwest, Inc. v. Commissioner (1) found themselves empowered to write guidance implementing the new deduction disallowance with respect to such expenses. In May of this year, the Internal Revenue Service (IRS) released Notice 2005-45, (2) which, if nothing else, clearly communicates to taxpayers who the real winners of the case ultimately were.

But Notice 2005-45 is more than that. Because of its method of pro rata allocation of aircraft expenses based on passenger use, Notice 2005-45 goes well beyond simply reversing the Sutherland. In its apparent zeal both to issue guidance quickly and also to change company behavior by imposing a deduction disallowance on all "entertainment" use of company aircraft by "specified individuals," the IRS conjured a methodology for allocating expenses to any entertainment use that can yield surprising results. Moreover, the IRS left open a number of questions of how this methodology is to be applied and how it interacts with the historical body of law surrounding fringe benefits, the valuation and deduction treatment of travel expenses, including the application of section 274 of the Code, and the accelerated depreciation rules.

This article summarizes the main points of the Notice, which took effect on July 1, with particular attention to the issues raised by the new expense allocation method and its application.

1. Background

   1. Pyrrhic Victory in Sutherland

      Reacting with indignation to the taxpayer's victory in Sutherland (and to media reports of excessive executive use of corporate aircraft for personal purposes), in 2004 Congress amended section 274(e)(2) of the Code to staunch the perceived abuse. (3) Section 274(e)(2) operates as an exception to the general deduction disallowance rule applicable to entertainment expenses in section 274(a) of the Code. Section 274(a) limits the deductibility of expenses otherwise deductible under section 162, barring the deduction of expenses for (i) an activity generally considered to be entertainment, amusement, or recreation, unless the taxpayer proves that the expense is directly related to or, in certain cases, associated with the taxpayer's trade or business, or (ii) a facility used in connection with such entertainment activity. Section 274(e)(2) provides in very general terms that the bar on deduction of entertainment expenses in section 274(a) will not apply to expenses that are reported as compensation to the employee.

      Section 274(e)(2) of the Code was the centerpiece of the dispute in Sutherland, which involved the taxpayer's deduction of expenses for its executives' entertainment flights on company aircraft that were valued for compensation purposes using the special valuation rules for flights on noncommercial aircraft. At issue was whether section 274(e)(2) (before its 2004 amendment) allowed the employer to deduct all the expenses related to the executives' personal use of the corporate aircraft, even though the value of the personal trips for compensation purposes that was reported as income to the executives was less than the cost of providing the trips. (4) The Tax Court held that if a plane is an "entertainment facility" potentially subject to deduction disallowance under section 274(a) of the Code, then section 274(e)(2) operates as an exception, as long as the value of the personal use of the aircraft is properly imputed to the employee and reported as compensation on the company's return. In Sutherland, the taxpayer had used the special valuation rules applicable to flights on noncommercial aircraft under Treas. Reg. [section] 1.61-21(g) (known as the Standard Industry Fare Level or SIFL rules) to determine the value of the executives' entertainment trips. The result was that the expenses deducted by the company far exceeded the income imputed to the executives.

      Effective for expenses incurred after October 22, 2004, section 907 of the AJCA revised section 274(e)(2) to limit the deduction for expenses for entertainment goods, services and facilities (including airplanes used for certain personal reasons) provided to "specified individuals" to the amount that the company treats as compensation to the recipient and reports as compensation on its corporate return. (5) In other words, in the case of a "specified individual," the amount of the company's deduction for entertainment is limited to the amount treated as wages for income tax withholding purposes with respect to the employee receiving the entertainment goods, services, or facilities or, in the case of a director or other independent contractor, the amount reported as compensation income on a Form 1099-MISC. Moreover. these amounts must be reported on the company income tax return as compensation. (6) Although the amendment was "intended to overturn the decision in Sutherland," (7) the restriction on deductibility now codified in section 274(e)(2) is not limited to expenses attributable to corporate aircraft and has a much broader reach, including potentially the personal use of automobiles. Moreover, in its current form, it could be extended to other expenses already addressed in section 274, including (a) the 100-percent deduction disallowances applicable to spousal travel and luxury cruises and (b) the 50-percent deduction disallowance applicable to business meals and entertainment, thereby forcing a deduction disallowance with respect to any affected expenditures that exceed the value treated as compensation paid to the specified individual.

   2. Congress Is "Shocked, Shocked" to Find a Mismatch between Deduction and Income

      Congress's motivation in amending section 274(e) is reflected in the conference report on the AJCA as concern over the arbitrage aspect of the mismatch between the income reported for personal flights (when the flights are valued using the SIFL rules) and the deductibility of the costs associated with providing such taxable fringe benefits. (8) The conference report expresses seeming surprise about this mismatch--"a deduction multiple times larger than the amount required to be included in income"--though there is no doubt that this potential for mismatch was clearly understood and acknowledged by Congress 20 years ago when the SIFL rules for income imputation were first introduced. (9)

   3. Historical Treatment of Fringe Benefit Value and Costs--"East Is East and West Is West"

      This mismatch or lack of correlation between the (i) value of the fringe benefits for purposes of imputing income to employees and independent contractors and (ii) the cost of the fringe benefits to the employer for deduction treatment has been clearly recognized, and even required, in the fringe benefits regulations. The fringe benefit regulations specifically provide that cost is irrelevant when determining the value of a fringe benefit to be taxed to the employee or independent contractor, (10) while mandating that the employer may only deduct the cost (not the value) of a fringe benefit. (11) In no event, under these rules, may the amount of the deduction exceed the actual cost of providing the benefit, even if the value of the fringe benefit included in the service provider's income is greater than the cost of providing the benefit. (12)

   4. What Congress Did (and Didn't Do) in the AJCA

      With the AJCA amendment to section 274(e)(2), Congress altered this approach and provided a limited exception, in the case of "specified individuals," to the rule that deductions for the cost of providing fringe benefits to recipients are conceptually separate and distinct from the value of the benefit that is included in the recipients' income. In so doing, Congress eliminated any risk of a company's deducting more in entertainment expenses than the amount imputed in the specified individual's compensation.

      In describing congressional concern about the mismatch between income and deduction inherent in the Sutherland case and the intent to overturn the Tax Court's decision, the AJCA Conference Report offers the following example of how new section 274(e)(2) should operate to disallow all or a portion of the expenses associated with using the aircraft for entertainment purposes:

      For example, a company's deduction attributable to aircraft operating costs for a covered employee's vacation use of a company aircraft is limited to the amount reported as compensation to the employee. (13) In other words, the legislative history illustrates the situation in which the executive controls the destination of the aircraft and, pursuant to that control, uses the aircraft for an entertainment purpose, that is to say, a vacation.

      It is important to note, however, what Congress did not do. The legislative history does not identify as an abuse the situation in which the aircraft is flying for bona fide business purposes, and a specified individual happens to "hitchhike" a ride on the aircraft for personal purposes. (14) Nor does it identify as abusive the situation in which the executive is flying for business purposes, and his or her spouse flies along for personal purposes. In both of these cases, the plane is flying for business purposes, and allowing the hitchhiker or the guest of the specified individual to board the flight results in little or no incremental cost to the company. (15) Thus, it may be argued that in amending section 274(e)(2), Congress did not purport to revise what constituted entertainment use of corporate aircraft or to create a new method for determining what expenses are attributable to entertainment.

      In other words, Congress did not intend the exception in section 274(e)(2) to become more powerful than the general disallowance rule...