“"Not everything can fly. We will not install a swimming pool or a fireplace. That is not possible."”
New rules affect entertainment use of business aircraft
Proposed regulations on deductions for entertainment use of business aircraft, issued by the IRS in June, are meant to help aircraft owners comply with changes to the Internal Revenue Code that were introduced in the 2004 Jobs Act. Those changes disallow tax deductions if certain top executives, called "specified individuals," use the aircraft for "entertainment."
The proposed regulations don't clarify the meaning of "entertainment" or how aircraft as "entertainment facilities" fit into the requirements of the Jobs Act. One thing is clear, however: if your business aircraft is used for anything but business, especially if it is used for something that might be considered "entertainment, amusement or recreation," you need to understand how the proposed regulations may affect your ability to deduct associated costs for tax purposes.
So what exactly does the IRS consider "entertainment"?
In business aviation, we don't ordinarily think of airplanes as being entertaining, although when used in other ways they can be. Recently, I paid a tidy sum for a ride in a de Havilland DH.89 Dragon Rapide at the Duxford Airport in England. The Rapide, a canvas bi-wing model carrying eight passengers, was a popular short-haul commercial aircraft in the 1930s. It was a beautiful day, with bright sunshine and no clouds or wind, and the short flight over the countryside near Cambridge was breathtaking. Now that was entertainment.
My ride in the Rapide is a good example of an airplane flight being an end in itself. Flying simply for the sake of flying is common among general aviation enthusiasts, epitomized by the crowd that attends the Experimental Aircraft Association's AirVenture every July in Oshkosh, Wis., and the weekend pilots who fire up their single-engine Cessnas, Pipers and Mooneys to find that "hundred-dollar hamburger" at some small airport across the state.
Most commercial and business flights are, on the other hand, a means to an end. Few people would consider sitting in a confined space at 40,000 feet for a few hours "entertainment," no matter how luxuriously appointed the cabin is. This is true even under the rather circular definition of "entertainment" served up by the IRS: "any activity which is generally considered to constitute entertainment, amusement or recreation." Fortunately, the tax agency bolsters this unenlightening language with helpful examples: "entertaining at nightclubs, cocktail lounges, theaters, country clubs, golf and athletic clubs, sporting events and on hunting, fishing, vacation and similar trips." Riding on airplanes is not on this list.
But airplanes are on another IRS list-one of potential entertainment facilities. The Internal Revenue Code defines those as, basically, facilities used in connection with entertainment (another IRS definition that's hard to argue with). The classic example of an entertainment facility is a hunting or fishing lodge, which seems rather unlike a business aircraft. As Sen. Sam Brownback (R-Kan.) observed during the debate on the Jobs Act, "An aircraft is purchased by a business because they have a business need to be served. It is not the same thing as a hunting lodge." Nevertheless, the IRS regards a private aircraft as just such a facility, if it's used for entertainment purposes.
To the extent that the proposed regulations issued in June contain new rules, they effectively displace the prior IRS Notice 2005-45 on how to calculate the disallowance of deductions. Though few tears will be shed over the demise of that notice, few cheers will greet the IRS' latest effort. The proposed regulations are too complicated and raise too many issues to summarize quickly. But here are some highlights.
A major disappointment in the proposed regulations is that they fail to adopt the "primary purpose" test advocated by many industry commentators. The IRS does not agree that there should be no disallowance of deductions when an "entertainment" passenger rides along on a flight that was going somewhere for business purposes anyway. On a flight like that, the IRS still expects you to allocate expenses between business and entertainment components, and still offers the notorious seat-hour/seat-mile method of the original IRS Notice for doing so.
The proposed regulations, however, do provide a major concession: the ability to apply that method on a flight-by-flight basis. Assume, for example, that a company's total aircraft expenses for the year are $1 million and that there are 10 flights that year of 10 hours each-nine business flights with one passenger and one entertainment flight with nine passengers who are "specified individuals" and their guests. Under the "seat-hour" method, half the aircraft expenses for the year will be disallowed because nine business and nine entertainment passengers each flew the same number of hours.
The IRS apparently recognized that this result makes no sense. The proposed regulations permit the taxpayer to divide total expenses for the year by total flight hours (or miles-an option few are likely to use). In our example, the $1 million of expense would be divided by the 100 hours of flight time (10 flights of 10 hours) to determine a cost per hour of $10,000. Then, instead of disallowing half the expenses ($500,000) based on seat hours, the regulations would disallow only $100,000 because all $900,000 of expense arising from the nine business flights would be deductible.
What if one of the flights carried both business and entertainment passengers? In that case, you would have to allocate the expenses of that flight based on seat hours. For example, if instead of nine entertainment passengers on the "entertainment flight," there were six entertainment passengers and two business passengers, three quarters of the expense of the trip ($75,000) would be disallowed.
Another piece of good news in the proposed regulations is that the IRS is considering implementation of a charter-rate safe harbor where "taxpayers could elect to treat as the amount of expenses for entertainment flights an undiscounted charter rate for each flight in lieu of calculating actual expenses." Thus, a company that imputed taxable income to specified individuals at the retail charter rate would eliminate the effect of the Jobs Act altogether. The IRS requests comments on whether and how to adopt such a safe harbor.
Apart from some clarifications regarding depreciation expense, the proposed regulations' treatment of many other issues is less encouraging for business aviation. The tax agency rejects bona fide security concerns as a justification for classifying entertainment flights as business flights. It also dismisses attempts to restrict the disallowance to variable costs (in part on the dubious rationale that industry use of "operating costs" includes tax depreciation). And it brushes aside attempts to clarify how executives might avoid the disallowance by paying fair market value for flights by referring to existing authority.
Why should you pay attention to regulations that are merely proposed? Aviation professionals don't generally follow proposed FAA regulations until the FAA actually adopts them. But IRS regulations have a different import. Tax professionals often rely on them-and are entitled to do so-even before they are adopted. If you have "entertainment" passengers on your airplane, you should consult your aviation tax advisor about what these regulations mean to you.