Employer's travel deduction not limited to amount reportable by employees.

Corporation T is in the retail lumber business, with outlets in eight Texas cities. T owns a Lear Jet, which is used for travel related to its lumber business and an air charter business. In addition, T's president and vice president use the plane for travel related to their positions as directors of other businesses, for business and charitable purposes and for vacation travel.

The use of the plane for all the non-T business flights was reported by T's president and vice president as compensation. T reported the amount of imputed income in accordance with Regs. Sec. 1.61-21(g). T deducted all its costs incurred in operating the plane, including the non-T business flights.

Citing Sec. 274(e)(2), the IRS limited T's deductions to the value of the

income imputed to T's president and vice president (i.e., the value of the benefit received); T challenged this assessment.

The Tax Court (opinion Gerber, J.) holds for T; Sec. 274(e)(2) excepts deductions of an employer's expenses in connection with an entertainment facility from the effects of Sec. 274, and does not limit the deduction to the amount reportable by employees.

Sec. 162(a) generally provides that a taxpayer is allowed a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business. An expenditure is "ordinary and necessary" if the taxpayer establishes that it is directly connected with (or proximately related to) his activities.

As an ordinary expense of carrying on a trade or business, an employer may deduct expenses paid as compensation for personal services. If the compensation is paid in the form of noncash fringe benefits, Temp. Regs. Sec. 1.162-25T provides that an employer may take a deduction for expenses incurred in providing the benefit if the value of the noncash fringe benefit is includible in the recipient employee's gross income. The employer may not deduct the amount included by the employee as compensation, but is required to deduct the employer's costs incurred in providing the benefit to the employee.

Some deductions previously allowable under Sec. 162 are disallowed by Sec. 274, which was enacted to eliminate or curb perceived abuses for business expense deductions for entertainment, travel and gifts. Sec. 274(a)(1)(A) generally provides for the disallowance of deductions otherwise allowable under chapter 1 of the Code, involving an entertainment, amusement or reaction activity; Sec. 274(a)(1)(B) disallows the deduction of otherwise allowable expenses incurred for a facility used in connection with such an activity.

Although Sec. 274(a) generally prohibits deductions for certain entertainment-related expenses, Sec. 274(e)(2) provides that the deduction disallowance provision of Sec. 274(a) will not apply to:

Expenses treated as compensation.--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, amusement, or recreation, as compensation to an employee on the taxpayer's return of tax under this chapter and as wages to such employee for purposes of chapter 24 (relating to withholding of income tax at source on wages). (Emphasis added.)

T argues that the "to the extent" language acts to except its deduction, as claimed, from the reach of Sec. 274. Conversely, the IRS argues that such language limits T's deduction to the amount includible as income by its employees.

The Sec. 274(e)(2) question is whether Congress intended the words "to the extent that" to except taxpayers from Sec. 274(a) or whether it limits a taxpayer's deduction to the income includible by the employee. Generally, for purposes of imputed employee fringe benefit income, the value of a benefit received from use of corporate property is the fair rental value of such property, less any reimbursement. Congress, however, has provided specific valuation rates for certain benefits (including employer-provided flights on noncommercial aircraft), for purposes of computing the employee's income inclusion. Such rates do not bear a correlation to the actual costs incurred by an aircraft's owner/operator. Instead, the rates are derived from use of a percentage of commercial flight fares. The use of this "bright-line" approach can result in uneven or different treatment. As a result, sometimes it is possible that an employee would be required to report a lower value as income while the employer would be allowed to deduct a higher cost amount. The opposite result could also occur; the value of an employee's use or benefit could be greater than the employer's cost of providing the benefit. In that setting, the employer would be limited to deducting cost, even though the employee would be required to report income in excess of the allowable deduction.

Sec. 274(e) is titled "Specific Exceptions to Application of Subsection (a)." (Emphasis added.) Likewise, the legislative history contains references to "exceptions" in describing Sec. 274(e). More particularly, for Sec. 274(e), the legislative history contains the following statement:

The bill contains nine exceptions to the general disallowance provision.... Where an expense falls within one of the enumerated exceptions, the item will continue to be deductible to the same extent as allowed by existing law.

Accordingly, Sec. 274(e) was intended to except certain categories of deduction from the effect of Sec. 274. Subsequent legislative history also references Sec. 274(e) as providing for exceptions.

Collaterally (and by way of comparison), Sec. 274(e)(9), concerning deductions for expenses for nonemployees, contains the "to the extent that" language. The legislative history of Sec. 274(e)(9) also contains an example of a manufacturer allowing a nonemployee dealer to use an entertainment facility. It provides that, as long as all reporting requirements are met, "the manufacturer will not be subject to these [deduction] limitations if the value of the entertainment facilities are includible in income of the dealer." In other words, Sec. 274 does not apply, and any restrictions are removed for otherwise allowable deductions by employers, as long as the value of the benefit is included in the nonemployee dealer's income.

The Service also seeks support in the legislative history. It contends that its interpretation of Sec. 274(e) is supported by Sec. 274. Sec. 274 was intended to curb the perceived abuses occurring with expense accounts and the resulting substantial tax-free benefits conferred on the recipients. The IRS argues that the difference between the value and cost here confers benefits not intended by Sec. 274.

The Service's argument misses the mark, for several reasons. First, irrespective of Sec. 274, the employees are being taxed in accordance with the Code for the benefits received, a fact with which the IRS agrees. Second, T, as employer, received no tax-free benefit. Third, although T has deducted its aircraft operating expenses, that is no more or no less than it was entitled to under Sec. 162. Finally, the application of the benefit provisions requiring the reporting of the value of the benefit to the employee may result in the employee's reporting more imputed income than the employer is entitled to deduct. With little support for the Service's position, T's interpretation of the "to the extent" language of Sec. 274(e)(2) is more appropriate and more likely the one intended.

Other portions of Sec. 274 have obvious caps or limits on the deduction amount available to taxpayers. For example, Sec. 274(b)(1) limits deductions for gifts "to the extent that such expense exceeds $25." Therefore, Sec. 274(e)(2) could have been phrased "expenses are deductible to the extent that they do not exceed the amount of expenses treated as compensation" or "to the extent of the amount includible in an employee's income." Congress, however, did not use language that limits the amount deductible to the amount includible.

There are numerous other examples in the Code in which Congress intended to place limits on particular items. Some are obvious and some more subtle. By means of slight yet significant modification to Sec. 274(e)(2), a limit (as opposed to an exception) could have been articulated. By changing "to the extent that" to "to the extent of," a limit could have more unambiguously been placed.

Sec. 274(e)(2) acts to except the controversial deductions from the effect of Sec. 274. Accordingly, T's deduction for operating the aircraft is not limited to the value reportable by its employees.

SUTHERLAND LUMBER-SOUTHWEST, INC., 114TC NO. 14