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1 '!.':> T\VlN 8: TURB INE

2 1(!\:lil~il by Phil Crowther Whoever said, "words will never hurt me" had obviously never read IRS Notice In 2004, Congress hit employers with "sticks and stones" by enacting the "Anti-Sutherland" amendments to prevent employers from deducting aircraft costs attributable to entertainment of "specified individuals," particularly company officers, directors and owners. In 2005, the IRS issued Notice , which made things worse by requiring employers to use the "occupied seat hour/mile" rule to compute disallowed costs. This June, the IRS issued proposed regulations that supersede Notice The good news is that, while still painful, these rules are a marked improvement. A Brief History In the Good Old Days, a taxpayer engaged in a trade or business could deduct a wide range of costs associated with the business entertainment of customers and employees. In the early 1960s, Congress decided to eliminate perceived abuse by enacting the travel and entertainment (T&E) rules. The T&E rules "disallow" the business deduction of any item "of a type generally considered to constitute entertainment, amusement, or recreation" (i.e., an "entertainment activity") unless the taxpayer establishes that the item was directly related to the active conduct of the taxpayer's trade or business or directly preceded or followed a substantial and bona fide business discussion (i.e. the "directly related or associated" test). The rules also prevent a taxpayer from deducting any expenses, "with respect to a facility used in connection with an [entertainment] activity." The rules contained various exemptions. One provision allowed an employer to deduct the costs attributable to employee entertainment "to the extent that the expenses are treated by the taxpayer... as compensation to an employee." Another provision exempts "expenses for goods or services (including the use of facilities) which are sold by the taxpayer in a bona fide transaction for an adequate and full consideration in money or money's worth." continued on page 34 TWIN & TURBINE ~ ~~=----~

3 In Sutherland Lumber and other cases, the IRS argued that, under a literal interpretation of the statute, the employer deduction was limited to the amount of income taxed to the employee. Thus, where the costs attributable to an employee entertainment flight were $1,000 and where, under the fringe benefit rules, the employer treated only $800 as income to the employee, the employer could deduct only $800 of the aircraft expenses. The Court disagreed, concluding that the exemption applied whenever the employer properly computed the value of the flight to the employee in accordance with the fringe benefit rules. In 2004, Congress enacted the Anti-Sutherland rule to follow the IRS interpretation of the rule in certain cases. Specifically, in the case of a "specified individual," an employer can deduct the costs only "to the extent that the expenses do not exceed the amount of the expenses which are treated by the ta.'<payer... as compensation to an employee." In 2005, the IRS issued a notice providing additional information about the rules. However, instead of simply interpreting the rules, the IRS required employers to use the "occupied seat hour/mile rule" to compute the costs allocable to transportation of a "specified individual." This notice required an employer to implement a new system for computing the cost of all passenger flights, even where the entertainment use of the aircraft was minimal. Proposed Regulations On June 14, the IRS issued proposed regulations that effectively supersede the previous IRS notice. The preamble to the regulations describes statements made by various commentators regarding the Notice and explains the IRS response to those statements. l 3-! TWIN & T URJ31NE -- In general, the proposed regulations will apply to any taxable year beginning on or after the date the regulations become final regulations. Until that occurs, taxpayers

4 may either rely on the proposed regulations, on Notice , or both. The T&E rules only disallow the deduction of business expenses. They do not disallow the deduction of non-business expenses, such as interest, taxes and losses. The proposed regulations contain a definition of expenses that is consistent with this interpretation. Some commentators had noted that the legislative history refers to "aircraft operating costs" and "actual cost" and argued that this meant that Congress did not intend to disallow the deduction of fixed costs or depreciation. The preamble to the regulations confirms that the IRS does not agree with this interpretation. The preamble also confirms that the IRS interprets "entertainment" by reference to the general T&E rules. Thus, for example, "entertainment does not include travel for reasons such as attending to business other than that of the employer, medical purposes, attending funerals, and participating in charitable activities." Several commentators suggested that entertainment does not include transportation provided as part of a bona-fide security plan. However, according to the preamble, the IRS position is that using an aircraft for bona-fide security purposes "does not convert entertainment flights into business flights." Computing Deductions The most important change in the proposed regulations relates to the computation of deductions allocable to entertainment flights. Prior to Notice , the IRS computed disallowed deductions on a flight-by-flight basis. For example, in TAM , the IRS computed the costs associated with entertainment tlights by multiplying the entertainment tlight hours by the ratio of total aircraft continuecl on page 38

5 [ 38 T\\'IN & TURBIN E deductions to total aircraft flight hours. Furthermore, the costs allocable to passengers depended on the primary purpose of the flight. In the case of a business flight, the IRS would typically allocate only incremental costs to passengers traveling for entertainment. Con-versely, in the case of an entertainment flight, the IRS would typically allocate almost all of the costs to passengers traveling for entertainment. However, in Notice , the IRS decided to require taxpayers to compute disallowed deductions using the occupied seat hour/mile mle. This created several problems. First, this required taxpayers to keep track of all passenger flights for the year, even where entertainment use was minimal. Second, this created results that might be far different from the results under the general rule. For example, this would result in the disallowance of more deductions where the average number of passengers on personal flights was greater than the number of passengers on business flights. Third, this created definitional problems that taxpayers would have to consider on all t1ights. For example, the rules did not explain how to treat the transportation of children, who might accompany their parents on business or entertainment flights. The proposed regulations do not eliminate the occupied seat hour/mile rule. Instead, the regulations give taxpayers the option to allocate costs on a flightby-flight basis. In contrast with the old rules, the regulations require the taxpayer to allocate a pro-rata portion of the deductions to each passenger, regardless of whether the primary purpose of the flight is business or personal. Nevertheless, this is a vast improvement over the occupied seat hour/mile rule. First, taxpayers only have to make the computation for entertainment flights, not all flights. Second, this reduces the lil{elihood of distortion of deductions. Third, while this does not eliminate all definitional problems, it limits their application to entertainment flights. The Depreciation Deduction Commentators had pointed out that the rules unduly penalized aircraft owners in the first years when owners have relatively high depreciation deductions. The proposed regulations address this concern by allowing aircraft owners to compute disallowable deductions by computing the depreciation deduction using the straight-line depreciation method. At the same time, the owner can continue to depreciate the aircraft using the accelerated method for income tax purposes. This provision will prove especially helpful to aircraft owners who are purchasing new or upgraded aircraft. The regulations also address some other depreciationrelated concerns. The aircraft owner does not reduce the basis of property by the amount of disallowed

6 depreciation, and the aircraft deductions are subject to disallowance on a pro-rata basis. For example, if depreciation is SO percent of the costs subject to disallowance, then the aircraft owner will treat SO percent of the disallowed costs as depreciation. Some further clarification of these rules may be necessary. Rental Expenses Many aircraft owners rent their aircraft to charter companies or others. The proposed regulations provide that "expenses allocable to a lease or charter of a taxpayer's aircraft to an unrelated third-party in a bona-fide business transaction for adequate and full consideration are not taken into account" in computing costs subject to disallowance. This presumably means that, for.purpose of computing cost per hour, the owner should also exclude the aircraft hours associated with the rental or charter use. This interpretation could prove helpful because an aircraft owner who puts his aircraft on a charter certificate will often pay higher insurance, maintenance, pilot and training costs. This interpreta tion will probably not apply to the rental of an aircraft under a timeshare agreement, but could apply to the rental of an aircraft under an interchange agreement. Employee Rental The T&E rules generally apply only where an employet allows an employee to use a company aircraft for entertainment purposes. Th e rules exempt continued on page 40

7 "expenses for goods or services (including the use of facilities) which are sold by the taxpayer in a bona fide transaction for an adequate and full consideration in money or money's worth." This indicates that the disallowance does not apply if the employer rents or charters the aircraft to the employee for a fair value. Nevertheless, in the preamble, the IRS concludes that this exemption "applies only to ta.xpayers that are in the trade or business of providing entertainment to customers, and only to entertainment sold to customers." On the other hand, the regulations explicitly provide that any employee reimbursement will reduce the disallowed deductions. Other Issues In the case of trips that include both entertainment and non-entertainment flights, the regulations provide that "the entertainment cost of a multi-leg trip is the total cost of the flights... over the cost of the flights that would have been taken without the entertainment segment or segments." The regulations also contain complex rules for computing the deductions allocable to deadhead flights. While there is room for improvement in these rules, their impact is limited where the taxpayer uses the flight-by-flight method. In lieu of computing disallowed deductions by reference to actual costs, the preamble notes that the IRS is considering whether the regulations should allow taxpayers to compute disallowed deductions by reference to charter rates. Since this method would be optional, it should prove beneficial to taxpayers. However, coming up with acceptable charter rates may prove difficult. The proposed regulations are a vast improvement over Notice While the Anti-Sutherland rule will still prove painful to many taxpayers, the proposed regulations generally do not add to the pain. In the next article, we will consider how the regulations apply to specific examples. 40 TWIN & TURBINE