Proposed regulations on entertainment use of company aircraft: still a tough IRS line, but notice 2005-45 is eased.

• Author: Dyson, Marianna G.

The passage of two years since the issuance of Notice 2005-45 has not significantly dampened the enthusiasm of the Internal Revenue Service in its mission to stamp out executives' entertainment use of company aircraft. (1) The newest tool in the IRS's arsenal is the deduction limitation set forth in amended section 274(e)(2) of the Internal Revenue Code. (2) That limitation, which the IRS interprets as conditioning a company's deductions for aircraft expenses on each executive's reason for being on the flight, rather than the primary purpose of the flight, arises out of legislative changes to section 274(e)(2) by the American Jobs Creation Act of 2004. (3)

Taxpayers who have been struggling with the 2005 Notice's preliminary guidance, which took effect on July 1, 2005, now have additional guidance in the form of Proposed Regulations published on June 15, 2007. (4) Whether or not this latest guidance can be characterized as helpful to taxpayers is in doubt, because the IRS has not only been unrelenting in rejecting the primary purpose test, but, in doing so, has cherry-picked among the historical statutory and regulatory principles applicable to entertainment expenses since 1962.

The IRS's reaffirmation of its decision to classify aircraft expenses based on a passenger's reason for being on a flight is particularly open to question. The IRS has rejected taxpayers' pleas, based on existing law, for primary purpose or incremental cost approaches in determining both the trigger for the entertainment deduction disallowance of section 274(e)(2) and the amount of expenses that should be disallowed. Indeed, the Proposed Regulations reflect a continuing vigorous effort by the IRS to penalize taxpayers for the entertainment use of aircraft by their executives (and others also deemed to be "specified individuals"), rather than implementing workable disallowance rules designed to address the primary purpose for using the aircraft, the costs fairly allocable to entertainment use, and the discrepancy between the income reported for personal flights (when valued under the standard industry fair level, or SIFL, rules) and deductibility of the costs associated with providing such taxable fringe benefits.

The Proposed Regulations also attempt to have it both ways regarding the interplay between sections 274(e)(2) and 162(m) (the $1 million deduction limitation applicable to certain executive compensation). They side-step difficult issues such as how section 274(e)(2) relates to such matters as the rules pertaining to entertainment facilities under section 274(a)(1)(B) and the other disallowance provisions within section 274, as well as the valuation of fringe benefits. In the end, the Proposed Regulations represent a reiteration of the IRS's position that section 274(e)(2), which structurally is merely a limitation on an exception to the disallowance of entertainment expenses and facilities, is a stand-alone disallowance provision in its own right.

Nevertheless, the Proposed Regulations do contain some helpful clarifications and changes, including a flight-by-flight alternative for calculating allocable costs, as opposed to the occupied seat method announced in the 2005 Notice.

Under special transition rules, taxpayers may rely on the Proposed Regulations or the 2005 Notice pending issuance of the final regulations and may themselves even cherry pick between the rules. The Preamble to the Proposed Regulations also invites taxpayer comment on various issues, such as the issue of aircraft as entertainment facilities, the criteria for aggregating aircraft with similar cost profiles, and the viability of a charter rate safe harbor rule for establishing costs. (5)

This article describes the main points of the Proposed Regulations and highlights the differences from the 2005 Notice. It also summarizes several areas where additional guidance is badly needed. In drafting the final regulations, Treasury and the IRS will optimally heed taxpayers' comments on operational problems with the rules and will provide more examples of how the rules actually apply to common fact patterns.

Background

1. Amendment of Section 274(e)(2)--Intended to Stop Perceived Abuses

   Section 274(a) is a limitation on expenses otherwise deductible under section 162 of the Code. It bars the deduction of expenses for (i) an activity generally considered to be entertainment, amusement, or recreation, unless 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) operates as an exception to the general entertainment deduction disallowance rule of section 274(a). Prior to amendment by the 2004 tax law, section 274(e)(2) allowed the taxpayer to deduct all the expenses related to its executives' personal (including entertainment) use of its aircraft, even though the value of the personal trips reported as income to the executives was less than the cost of providing the trips. Specifically, in Sutherland Lumber-Southwest, Inc. v. Commissioner, (7) the Tax Court held that if an aircraft is used for entertainment and thus is potentially subject to deduction disallowance under section 274(a), section 274(e)(2) operates as a complete exception to the disallowance as long as the value of the personal use of the aircraft is properly imputed to the employee and reported as compensation on the taxpayer's return. In that case, the taxpayer had used the special SIFL valuation rules applicable to flights on noncommercial aircraft under Treas. Reg. [section] 1.61-21(g) to determine the value of the executives' personal trips--the result being that the expenses deducted by the company far exceeded the income imputed to the executives.

   In reaction to the taxpayer's victory in Sutherland Lumber and media reports of excessive executive use of corporate aircraft for personal purposes, Congress amended section 274(e)(2) to stanch the perceived abuse. Consequently, effective for expenses incurred after October 22, 2004, section 274(e)(2) limits the taxpayer's deduction of expenses for entertainment goods, services, and facilities (including airplanes used for entertainment) provided to "specified individuals" to the amount that the taxpayer treats as compensation to the recipient. (8) In other words, in the case of a "specified individual," the amount of the taxpayer's deduction for entertainment cannot exceed 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 taxpayer's income tax return as compensation. (9) The excess of the taxpayer's allocable costs is disallowed under section 274(a). Although the 2004 amendment was "intended to overturn Sutherland Lumber ... with respect to covered employers," (10) the restriction on deductibility in section 274(e)(2) is not limited by its terms to expenses attributable to corporate aircraft, and has a much broader reach, including potentially the personal use of automobiles.

2. Issuance of Notice 2005-45--The IRS Takes Aim

   Notice 2005-45 was published on May 27, 2005, and became effective July 1, 2005, (11) to provide guidance to taxpayers on how the deduction disallowance rules should apply pending the issuance of final regulations. In contrast to the conference report's single example of vacation use of a company aircraft by a specified individual, the 2005 Notice adopted an "occupied seat" analysis, which effectively pro-rates the cost of maintaining and operating the aircraft for the year among all aircraft passengers on all passenger-occupied flights in order to determine the costs associated with specified individuals' entertainment use.

   The IRS's speedy issuance of the 2005 Notice was matched by a prompt and vigorous taxpayer response. Commentators expressed surprise at the IRS's rejection of the centerpiece of existing long-standing law applicable to transportation facilities capable of being used for entertainment purposes--namely, the primary purpose test. Quite simply, the 2005 Notice's per-passenger, per-seat approach created many new issues for taxpayers, some of which are addressed in the Proposed Regulations but regrettably not in a manner consistent with existing law.

   Analysis of the Proposed Regulations

1. "Specified Individuals"--Apparently Still the Many, Not the Few

   The definition of "specified individual" in section 274(e)(2)(B)(ii) is any individual who is subject to the reporting requirements of section 16(a) of the Securities Exchange Act of 1934 with respect to the taxpayer or a related party, or who would be subject to those requirements if the provider of the benefit were publicly traded. In other words, the statutory definition is aimed at a fairly small group of individuals with policy-making authority over the taxpayer. The Proposed Regulations, however, expand the statutory definition to include every person who:

   (a) is the direct or indirect beneficial owner of more than 10 percent of any class of any registered equity security (other than an exempted security),

   (b) is a director or officer of the issuer of the security,

   (c) would be the direct or indirect beneficial owner of more than 10 percent of any class of a registered equity security if the taxpayer were an issuer of equity securities, or

   (d) is comparable to an officer or director of an issuer of equity securities. (12)

   The Proposed Regulations explain that a specified individual is an officer, director, or more than 10-percent owner of a corporation taxed under subchapter C or subchapter S of the Code, or a personal service corporation. For partnership purposes, a specified individual includes any partner holding more than a 10-percent...