Change in tax law: how it affects private jet users.

What possible connection could the resolution of a 33-year-old dispute between the United States and the European Union over U.S. export tax benefits have with the way in which business owners and executives use their companies' jet aircraft? The answer, as it turns out, is a very big connection--and one the business aviation community doesn't like at all.

The linkage was created when Congress passed the American Jobs Creation Act of 2004 ("AJCA") and President Bush signed it into law on October 22, 2004. Notwithstanding its "Jobs Creation" title, the AJCA was originally drafted as a bill to end export tax incentives. The law was designed to end an international controversy that had been simmering since 1971, but that had boiled over in March 2004 when the European Union began imposing tariffs on U.S. exports with the approval of the World Trade Organization. The EU tariffs began at 5% and were increasing by 1% a month, leaving the U.S. with no alternative but capitulation. Congressional sponsors had to gather support quickly for a tax law change in the middle of a U.S. electoral campaign--a sure prescription for pork barrel politics. By the time the House and Senate conferees were done, they had created election-year business tax breaks worth an estimated $137 billion over 10 years. At the same time, they had to figure out a way to pay for it. That's where the business jets come in--and Sutherland Lumber too.

What does Sutherland Lumber have to do with this, you ask? For builders and do-it-yourselfers in 15 Western states, the name "Sutherland Lumber Company" refers to a Kansas City-based lumber and home improvements chain. But in the cloistered world of CPAs and tax lawyers, "Sutherland Lumber" has an entirely different meaning and the words have been music to the ears of corporate aircraft owners and their accountants since 2000. That was the year a United States Tax Court ruled that Sutherland Lumber could deduct all the costs of operating and maintaining the company's aircraft, including costs incurred in providing vacation flights for corporate officers, even if the deduction was greater than the amount reportable by those officers as fringe benefits on their personal income tax returns.

Why did the Sutherland decision have such a big impact on federal tax policy? That requires a bit of explanation. Under long-established law, when a corporate officer uses a company jet for his own personal reasons, unrelated to the business of the company, the use of that company plane is considered a fringe benefit and the officer has to recognize the value of that fringe benefit as additional compensation on his personal income tax return. For many years, the Internal Revenue Service has allowed individual taxpayers to establish the value of such flights by applying a formula created by the Department of Transportation known as the Standard Industry Fare Level ("SIFL") rates. The imputed income an individual taxpayer recognizes under the SIFL formula is roughly comparable to the cost of first class airline tickets, but not surprisingly, the actual cost of operating a private jet often is substantially higher. The Tax Court's decision in Sutherland allowed corporations to deduct all of the costs of furnishing the executive with the corporate jet even though that same executive was only recognizing a taxable fringe benefit at the SIFL rate.

The Sutherland decision was affirmed by a federal Court of Appeals in 2001 and, after losing twice before judges, the IRS publicly conceded defeat and agreed to abide by the Sutherland holding. But even though it had lost the first two battles, the Service wasn't ready to surrender forever. The drafting of the AJCA afforded the IRS the chance it had been waiting for since 2001.

The AJCA is a potent potpourri of legislative legerdemain. The congressional enactment that ultimately landed on the President's desk for signature was 650 pages long and weighed nearly seven pounds, making it practically as large as a big city telephone book. The Act amended or repealed a total of 274 sections of the Tax Code and added 34 brand new sections. But the one provision that now has corporate aircraft owners up in arms is the amendment that limits a company's deduction to the actual amount of compensation reported by the employee when the aircraft is being used for entertainment, amusement, or recreational travel by "Specified Individuals."

Who constitutes a "Specified Individual?" The way in which Congress addressed this question was by reference to the Securities Exchange Act of 1934. This picks up officers, directors and owners of more than 10% of the stock of a company. Of course, privately owned companies aren't subject to the 1934 Act since their stock isn't publicly traded, but the AJCA resolves this issue by stating that "Specified Individuals" also include the same persons who would be affected if the private entity taxpayer was an issuer of securities. In this manner, the Act picks up partnerships, limited liability companies and S corporations as well as C corporations, both public and private. If an individual falls outside the definition of a "Specified Individual," the corporate taxpayer is still entitled to a full deduction of the flight expenses regardless of whether the flight is flown for a business or personal purpose.

The IRS has recently provided preliminary guidance on several aspects of this section of the AJCA in IRS Notice 2005-45. However, there are still lots of unanswered questions about what the new law means and how it will be interpreted and applied.

The specific section of the Tax Code that the AJCA amended pertains only to "entertainment, amusement or recreation." However, it is still unclear what is and is not "entertainment." The IRS Notice references existing Treasury Department regulations which are ambiguous and will require further clarification. It is relatively clear that usage of the company's aircraft by a Specified Individual for a non-entertainment purpose, even if it is personal is nature, should not trigger disallowance of deductions. Thus, it would seem that neither charitable trips nor flights flown in connection with a Specified Individual's other business endeavors would constitute "entertainment." Existing regulations also suggest that travel for "routine personal" use, even though such use satisfies "personal, living, or family needs of an individual" does not constitute entertainment. Such "routine personal use" might include a shopping trip, a doctor's visit, attending a funeral, taking a child to college or perhaps even visiting relatives. More guidance on this issue may be forthcoming as the IRS Notice contemplates that further regulations will be promulgated.

While the AJCA does place a significant restriction on the use of corporate aircraft for entertainment or recreational purposes, it does not prohibit it So, for example, if a company can demonstrate that a flight was directly related to or associated with the conduct of the company's trade or business, even if it did involve entertainment or recreation (say, taking clients on a trip to a resort in order to promote the company's business), the deduction of the expenses associated with that flight should still be allowed. Furthermore, if the full value of a flight is imputed to a "specified individual," the deduction will still be permissible. In certain instances, it might still make more sense, tax-wise, for the individual to absorb the full value of a flight on the company jet as imputed income rather than paying the same dollars to purchase the same flight from a commercial charter operator.

Another complication arises from the fact that the AJCA poses conflicts with the Federal Aviation Regulations ("FARs"). The FARs are the rules the Federal Aviation Administration has created to govern aircraft usage in the United States, including corporate jets. The FARs allow aircraft owners to enter into a number of different types of contracts affecting their airplanes, including leases, time-sharing and charter agreements. It is not yet clear exactly how the AJCA is going to affect these sorts of contracts. Part of the problem stems from the fact that the IRS administers the Tax Code and the FAA the FARs and the two agencies often adopt different views as to the permissibility and treatment of the very same arrangement So, for example, the FARs allow parties to enter into time-sharing agreements, but the maximum amount of reimbursement permitted is the cost of fuel multiplied by two. The Tax Code permits deduction of entertainment expenses which are "sold by the taxpayer in a bona fide transaction for an adequate and full consideration in money or money's worth," which is a legal way of saying "fair market value." Generally, however, the dollars generated by application of the fuel-times-two formula will not equate with the fair market value of the flight, which means that compliance with the FARs might bring a taxpayer into violation of the Tax Code and vice versa.

Attorneys for several of the major aviation industry trade groups, including the National Business Aviation Association, have already asked the Treasury Department for further clarification of the various ambiguities in the new law. Until the government provides a comprehensive response, however, business aircraft owners, their CPAs and attorneys, will be scratching their heads while trying to navigate the suddenly gloomy skies created by the passage of the American Jobs Creation Act. Unless Congress is pressured to restore the Sutherland Lumber doctrine, flying the company jet for entertainment is going to be more difficult, more expensive or both. To quote Bette Davis's classic warning in All About Eve, "Buckle your seatbelts. It's going to be a bumpy ride!"

RELATED ARTICLE: Business aviation and taxes.

All 50 states impose some tax on aviation, whether it is a fuel tax, aircraft registration fee, personal property tax or a sales and use tax. But each state differs in its assessment of the taxes.

In addition to the state taxes on aviation, operators also are required to pay Federal taxes. For noncommercial aviation, there is a 21.9 cents per gallon excise tax on jet fuel and a 19.4 cents per gallon excise tax on aviation gasoline. Operators considered commercial for tax purposes are entitled to a refund on a portion of the fuel tax: 17.5 cents per gallon for jet fuel and 15 cents per gallon for aviation gasoline. Commercial operators also are subject to a 7.5 percent passenger transportation tax and a 6.25 percent property transportation tax for domestic transportation. Additionally, there is a $3 segment fee charge for all commercial segments into nonrural airports (rural airports are exempt from the segment fee, but not from the transportation tax). Commercial transportation leaving the United States is subject to a $13.40 per person "head tax," but no transportation tax. Commercial transportation to Alaska and Hawaii is subject to a $6.70 "head tax" and the appropriate transportation tax and segment fees. For more information about business aviation taxes, visit www.nbaa.org/taxes.

Information provided by the National Business Aviation Association

Stephen R. Hofer is a partner with the law firm of Bailey & Partners in Santa Monica, California and chair of the firm's Corporate and Transactional Department.

This article originally appeared in the Los Angeles Daily Journal. (Copyright 2005, Daily Journal Corp.) Reprinted with permission. The Daily Journal's definition of reprint and posting permission does not include the downloading, copying by third parties or any other type of transmission of any posted articles.