Eighth Circuit Affirms Expanded Corporate Aircraft Deductions
July 2001
Maintaining corporate aircraft is becoming more common due to the convenience, comfort and privacy offered by corporate jets and helicopters to a company’s executives. Although used primarily for business purposes, almost all corporations make the corporate aircraft available to their top executives for limited personal trips and, in the case of helicopters, for commuting. Many executives even receive continued personal use as part of their retirement packages.
A significant number of practical corporate issues must be addressed to maintain corporate aircraft, including matters under the jurisdiction of the U.S. Federal Aviation Administration, the U.S. Federal Election Commission (if federal politicians use the aircraft) and, of course, the Internal Revenue Service. For federal tax purposes, corporations must consider several issues under the Internal Revenue Code, including transportation and fuel excise taxes, executive reimbursements, corporate deduction limitations and reporting and withholding obligations for any related executive compensation. Regarding the latter two areas, corporate America can breathe a little easier as a result of last week’s per curiam opinion by the U.S. Court of Appeals for the Eighth Circuit affirming the U.S. Tax Court in Sutherland Lumber-Southwest, Inc. v. Commissioner, No. 00-2827 (July 3, 2001).
Competing Theories for Aircraft Use Deductions
Whenever a corporate jet or helicopter is used solely for business purposes, it is clear under the code that the executive can exclude the value of the trip as a working condition fringe benefit and the corporation can deduct the operating expenses of the aircraft, assuming they are ordinary and necessary, as business expenses. These expenses include jet fuel, excise taxes, pilot salaries, a depreciation allowance, airport user fees, maintenance and more. Obviously, the cost associated with each personal use of the aircraft can be quite significant.
The proper tax treatment becomes muddied whenever an aircraft is flown solely for personal reasons or for mixed business and personal reasons such as where an executive is required to fly on the aircraft for security reasons. A full discussion of the applicable rules, especially in the mixed-use context, are beyond the scope of this On the Subject…. Most corporations have implemented corporate aircraft policies that address many, but typically not all, of the competing tax considerations. Nevertheless, some corporations are unaware of one of the key rules related to the personal use of the corporate aircraft by an executive, a family member or a friend, i.e., the executive does not have to include the entire fair market value of the trip as gross income. Instead, corporations may value the personal use at a substantially reduced safe harbor valuation for gross income tax purposes known as the Standard Industry Fare Level (SIFL) formula. The SIFL formula takes into account the weight of the aircraft, the miles flown, the applicable terminal charges and the employee’s status as a control or noncontrol employee. The SIFL formula is generally intended to approximate the cost of a first-class ticket on a commercial aircraft.
When including the SIFL value in an executive’s gross income, the question naturally arises as to what amount the corporation may deduct for the cost attributable to the personal use of the aircraft. Two prominent theories have been the focus of the recent litigation. The first theory is that the corporation can only deduct the amount that the executive includes in gross income.
The second theory, which we refer to as SIFL arbitrage, maintains that, notwithstanding the limited gross income inclusion based upon the SIFL safe-harbor valuation rule under the fringe benefit regulations, the corporation may deduct as ordinary and necessary business expenses the cost of providing this fringe benefit to its executives. Obviously, a significant mismatch occurs between the generally reduced income inclusion and the correlating large deduction for the cost of providing the fringe benefit, especially when the corporate aircraft is relatively empty or on a "dead-head" flight. As a general rule, we have advised our clients to take advantage of SIFL arbitrage by deducting the actual cost attributable to the flights, rather than deducting only the SIFL amount included in the executive’s compensation. As one would expect, the IRS advances the first theory, arguing that the deduction should be limited to the SIFL amount.
High-Flying Taxpayer Grounds the IRS
Beginning in the early 1990s, the IRS began to challenge the use of SIFL arbitrage by corporations operating corporate aircraft. The IRS challenged the full deduction under the code provision that generally disallows deductions for entertainment and for facilities used for entertainment. Although the IRS acknowledged that corporations are entitled to some deduction for an executive’s personal entertainment use of the aircraft, the IRS adamantly insisted that the applicable exception to the disallowance rule was partial in nature. This provision relied upon by the IRS and interpreted by the Tax Court and the 8th Circuit essentially transforms certain nondeductible entertainment or entertainment facility use expenses into deductible compensation expenses.
More specifically, the Tax Code allows a deduction for expenses for goods, services and facilities, to the extent that the expenses are treated by the taxpayer, with respect to the recipient of the entertainment, as compensation to an employee on the taxpayer’s return and as wages to the employee for income tax withholding purposes. The IRS argued that the "to the extent" language necessarily tied the amount of the deduction to the amount included in compensation. Thus, since the applicable SIFL valuation rule resulted in substantially less income to the employee than would result under the general valuation rule for charter flights, the employer’s allowable deduction was substantially less than its cost.
Sutherland Lumber, as well as most other corporations that are aware of the issue, maintained that the exception is just that—an exception, not a limitation. If the employer appropriately includes the SIFL amount in income, the employer satisfies the exception, avoids the Tax Code’s additional limitations on entertainment deductions and may fully deduct its cost attributable to the aircraft use as ordinary and necessary expenses of running its business.
Looking at legislative history and the U.S. Congress’ demonstrable ability to express limitations when it desires to do so, the Tax Court opinion concluded that Congress intended that a proper inclusion in compensation would satisfy the exception to the disallowance rule and result in a full deduction. The fact that the SIFL amount may be substantially less than the offsetting deduction is irrelevant and taxpayers may take as a deduction the full cost of allowing their executives to use corporate aircraft for personal purposes.
The 8th Circuit affirmed the Tax Court in a per curiam decision. Due to the legal soundness of the Tax Court’s decision, it is unclear whether this ruling will be challenged or whether other federal circuit courts will also defer like the 8th Circuit to the Tax Court’s analysis when it said, "Because we have nothing of substance to add to the Tax Court’s thorough analysis, further discussion is superfluous." Barring successful IRS litigation in a different federal circuit, these broad corporate aircraft deductions for personal flights now appear safe.
Refund Opportunities and Future Planning Opportunities
It is not clear whether the IRS will choose to litigate this issue in other federal circuits, but that is possible given the hundreds of millions of dollars at stake annually on this issue. However, in the meantime, employers taking the full deduction for personal use of corporate aircraft when the SIFL amount is included in income are vindicated. For those employers who have not taken the full deduction, notwithstanding the appropriate corresponding SIFL income inclusion to the employee, significant refunds should be available. Likewise, there may be opportunities for tax savings in prior years where business entertainment use was neither deducted by the employer nor included in the employee’s compensation. There are also potential significant opportunities to expand the SIFL arbitrage principles to other types of commonly provided fringe benefits, most notably corporate-provided vehicles.
