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Tax Law Changes for Personal Use
Taking flight: Tax Aspects of Aircraft Ownership

by Victor C. Anvick, MST, EA, Atis Group LLC, copyright March 2007

This section provides basic guidance in an extremely complex area resulting from the American Jobs Creation Act of 2004 and IRS Notice 2005-45. Any CPA who gives advice in this area should be thoroughly familiar with the client or employer's facts and circumstances as well as these two pronouncements.

Notice 2005-45 mandates the tax treatment for flights on or after July 1, 2005. All expenses, including depreciation, for maintaining and operating the aircraft allocable to "recreation, entertainment or amusement" flights by "specified individuals" are disallowed unless the specified individuals include the imputed value of those expenses as income on their W-2s if they are employees or as a guaranteed payment if they are partners or LLC members. Expenses include, but are not limited to, fuel, pilot salaries, personnel assigned to the aircraft, flight crew meals and lodging, take-off and landing fees, maintenance and maintenance flights, onboard refreshments, amenities, gifts, hangar and parking costs, management fees, depreciation and special expensing amounts under IRC section 179. (Note: If you charter an airplane, all charter costs, as well as payments on leased aircraft, are subject to the same disallowance provisions.)

"Specified individuals" include:

• Individuals subject to section 16(a) of the Securities Exchange Act of 1934.
• Direct or indirect owners of more than 10% of any class of any registered equity security issued by the taxpayer.
• Officers, directors or other individuals who are more than 10% owners of C or S corporations.
• Partners who hold more than 10% equity interest in the partnership, general partners, officers or managing members of a partnership.
• Directors or officers of tax-exempt entities.
• Spouses of specified individuals, as well as other related business entities, also may be specified individuals.

Disallowed aggregate expenses. Notice 2005-45 provides two ways to calculate the disallowed expenses — the occupied-seat-miles or the occupied-seat-hours method. Taxpayers can use whichever method produces the more favorable result.

• Under the occupied-seat-miles method, total aircraft costs and depreciation are divided by total occupied seat miles to arrive at per-seat-mile cost for the year. In this case, one passenger occupying a seat for one mile is an occupied seat mile.
• Under the occupied-seat-hours method, total costs are divided by total occupied seat-hours to arrive at a seat-hour cost factor. One passenger occupying a seat for one hour results in one occupied seat-hour. To arrive at disallowed expenses, multiply the occupied recreation, entertainment or amusement miles or hours used by specified individuals over the course of the year by the per-mile or per-hour cost factors.

Example 1. An aircraft owner elects to use the per-hour method. The company incurs $10 million in aircraft costs and depreciation for the year. Total occupied passenger seat-hours are 5,000 hours; the cost per occupied seat-hour is $2,000. If specified individuals used 1,000 occupied seat-hours, then $2 million of depreciation and other deductions would be disallowed if none of the specified individuals reimbursed the company or had any portion of the $2 million added to their W-2s.

Example 2. A company flies 20 business trips and eight entertainment trips during the year. All passengers are specified individuals. Each business round-trip has three passengers and is four hours long for a total of 240 occupied-business-seat-hours for the year. Each of the eight entertainment round-trips is also four hours long; eight passengers a trip total 256 entertainment occupied-seat-hours. The total occupied-seat-hours for the year is 496. However, since 256 hours are allocated to entertainment use, 51.6% of all deductions, including depreciation, will be disallowed unless the executives reimburse the company or have the $2 million of entertainment seat value added to their W-2s as additional income. If the executives impute $500,000 of additional income, the company will lose only $1.5 million in aircraft deductions provided those executives are not also classified as "covered employees" subject to section 162(m). (Covered employees generally are the four highest-paid employees of public companies, with salaries in excess of $1 million.)

While example 2 may be an extreme case with lower-than-average total annual hours for a business aircraft, it illustrates that a few fully loaded entertainment flights can deplete the tax deductions for many bona fide business trips with relatively few passengers. Trips with children, nannies and other family members could be particularly expensive and troublesome for a business that needs maximum tax benefits from aircraft expenditures.

Planning tip. Instruct clients or employers not to accept any reimbursement in the form of a personal check or other compensation for entertainment, recreation or amusement use by specified or non-specified individuals. If a company accepts such payments, it must pay a 7.5% federal excise tax and segment fees. But that's the least of its problems--the FAA will consider the employer as having furnished commercial air transportation services and may impose fines and sanctions if the flight was not conducted under FAR part 135. In addition, the pilots who flew the aircraft could have their licenses revoked.

This is one instance where the FARs supersede any creative tax planning. The IRS doesn't care whether the employee reimburses the employer for transportation. It just wants its federal excise taxes on the value of air transportation services.

Planning tip. Since notice 2005-45 does not define the terms recreation, entertainment or amusement, CPAs should help employers and clients develop definitions based on their own facts and circumstances. For example, a bereavement flight to attend a funeral hardly falls into one of the three tainted categories, but is "other personal use." Thus it is eligible for much more favorable treatment, using the standard industry fare level (SIFL) rates published by the IRS semiannually in combination with Treasury regulations section 1.61-21(g) to assign the imputed income values. Narrowing the definition of tainted categories makes it possible to mitigate the severe impact of this IRS notice.