S Corp. can deduct cost of private jet use.

A recent Chief Counsel Advice (CCA), 200344008, provided a very favorable outcome for S corporations that own aircraft used personally by shareholders and employees. For years, the IRS argued that the personal use of a company-owned asset limited the employer's deduction to the amount included in the employee's income. Armed with case law and the recent CCA, employers should no longer suffer the penalty of limited deductions when offering certain benefits to their employees or shareholders.

Facts

In the CCA, an S corporation was engaged in the active conduct of a trade or business and owned fractional interests in two jet aircraft. The S shareholders were members of a single family. Flight logs documented that approximately 5% of the aircraft's use was for business purposes; the remaining 95% was for personal use by shareholders and two non-shareholder employees.

The S corporation properly determined the values of the personal flights under Regs. Sec. 1.61-21, using the Standard Industry Fair Level (SIFL) formulas, and reported those values in shareholders' and employees' compensation. (In general, the value of personal flights taxable to employees using SIFL does not correspond with the employer's actual costs of providing the flights.) In the CCA, the depreciation and operating expenses were more than 10 times the compensation reported to the shareholders and employees. The CCA determined that the S corporation could deduct all the expenses attributable to owning and operating the aircraft, not just the compensation reported to share holders and employees.

Deducting Compensation

Sec. 162 allows a deduction for ordinary and necessary business expenses, including compensation paid for personal services. However, Sec. 274(a)(1)(A) can disallow an expense solely for entertainment, amusement or recreational activities. A vacation or personal trip aboard a company aircraft constitutes entertainment under Regs. Sec. 1.2742(b)(1) and, thus, would fall under this disallowance provision.

Under Sec. 274(e)(2), however, entertainment expenses included in an employee's income are exempt from the Sec. 274(a)(1)(A) disallowance rules. Temp. Regs. Sec. 1.162-25T provides that when compensation is paid in the form of a noncash fringe benefit, an employer may deduct its cost in providing the benefit if the value is included in the employee's gross income. When the amount treated as compensation exceeds the corporation's actual cost, Temp. Regs. Sec. 1.162-25T limits the deductible expense to actual cost. The regulation is silent when the cost of providing the benefit exceeds the compensation reported.

Sutherland

A corporation's ability to deduct the actual cost of a fringe benefit that exceeded the amount included in an employee's income was tested in Sutherland Lumber-Southwest, Inc., 114 TC 197 (2000), aff'd, 255 F3d 495 (8th Cir. 2001). Sutherland, a C corporation, allowed its president and vice president to use the corporate jet for vacation travel. The company properly calculated and reported the value of personal-use flights as compensation. The IRS attempted to limit the company's deductions attributable to the nonbusiness flights to the income the employees reported as compensation.

The Tax Court ruled that the IRS position was incorrect, finding that there was no direct link between the amount of the employees' taxable income and the employer's deduction. It concluded that Sec. 274(e)(2) did not limit the deductions, but rather, operated as an exception to the deduction limits. The Eighth Circuit later affirmed.

CCA 200344008 is identical to Sutherland, except that the C corporation in Sutherland provided the aircraft for employee use, while the S corporation in the CCA provided the aircraft to shareholders and employees.

Additional Considerations

While the CCA only addresses aircraft use, the ruling may nevertheless apply to other assets typically limited in deductibility by Sec. 274(a)(1)(A), such as vacation homes or pleasure boats (possibly providing significant benefits for companies with the proper facts). However, the IRS could attempt to limit such deductions if it finds the rules are being abused, or may challenge the corporation's business purpose in owning these assets. For instance, the deduction could be disallowed if the expense is determined to be a dividend or unreasonable compensation. In addition, Sec. 280F could limit depreciation, because the personal use of a listed asset by a 5% shareholder affects the asset's business-use percentage.

There can also be a deleterious effect if the increased compensation endangers the corporation's qualified plans. Further, the increased compensation will be subject to FICA and Medicare withholding. The IRS has stated that it will closely scrutinize transactions involving the personal use of airplanes; clients should be made aware of the potential for increased audit exposure. While the IRS has acquiesced in Sutherland, it may challenge deductions for assets with minimal business use. If taxpayers decide to place assets (such as aircraft or vacation homes) in an S corporation, they should be prepared to defend them as ordinary and necessary business expenses.

Conclusion

The IRS concluded in the CCA that Congress intended for the Sec. 274(c)(9) exception to apply to entertainment provided to nonemployees (such as S shareholders), just as the Sec. 274(e)(2) exception applies to entertainment provided to employees. An S corporation's ability to pass through deductions that exceed the income reported to shareholders for personal-use flights provides an opportunity to effectively deduct expenses for assets that would normally be limited under Sec. 274(a)(1)(A). With proper planning, businesses can offer benefits to employees and executives cost effectively, rather than by paying cash bonuses. S shareholders also have an opportunity to transfer expensive-to-operate assets to their corporations, thus passing the cost burden from their after-tax personal dollars to pre-tax corporate dollars.

FROM EMER MCNAMARA, CPA, AND PHILIP SEGUIN, CPA, CLEVELAND, OH