Usage characterization crucial for company aircraft taxation

Implications

The characterization of flight usage has important implications for both the business and its employees, including the ability to deduct the usage and depreciation, and the need to impute employee income. There are special rules that may apply for purposes of applying the imputed income rules, the deduction disallowance provisions, and the depreciation recapture rules for “control employees,” “specified individuals,” and “5% owners.” Thus, each passenger on each flight who falls within one or more of these statuses (or is related to one) must be identified as such.

Deduction disallowances

The Tax Cuts and Jobs Act barred any deduction for expenses to operate an aircraft incurred in connection with entertainment activities and commuting between an employee’s residence and place of employment. Thus, the costs incurred to provide and operate an employer-provided aircraft, such as depreciation, fuel, flight crew salaries, hangar fees, and interest, are generally not deductible under Section 274 to the extent they are attributable to entertainment activities or commuting.

The amount of the deduction disallowance under Section 274 is the aggregate amount determined under the allocation method selected for the taxable year (discussed further below) for each passenger flight that is characterized as either entertainment or commuting, generally reduced by the following amounts (to the extent applicable):

1. Any amount a passenger reimburses the employer for such a flight.
2. In the case of a passenger who is characterized as a specified individual (as defined below), the amount treated as taxable compensation or income under the Section 61 income inclusion rules for personal entertainment (but not commuting) flights on the employer-provided aircraft.
3. In the case of a passenger who is not characterized as a specified individual (as defined below), the amount of expenses allocated to the passenger for personal entertainment (but not commuting) flights on the employer-provided aircraft, if the employer properly treats the value of such flights as taxable compensation or income in accordance with the Section 61 income inclusion rules.

Specified individual definition

A “specified individual” generally is defined as any individual who is subject to Section 16(a) of the Securities Exchange Act of 1934 with respect to the employer, or any individual who would be subject to it if the employer were an issuer of equity securities subject to the Securities Act, which would generally include officers, directors, and 10% owners.

A flight provided to a nonemployee guest or family member of a specified individual is treated as provided to the specified individual for purposes of the Section 274 deduction disallowance rules because of that person’s relationship to the specified individual.

Allocating deductions

To properly apply the deduction disallowance rules, the expenses incurred to provide an employer-provided aircraft generally must be allocated to each entertainment or commuting passenger flight. There are two general methods for allocating the employer-provided aircraft expenses to entertainment and commuting passenger flights ꟷ occupied seat method or flight-by-flight method. Each can be computed based on either hours or miles, resulting in four possible allocations.

The occupied seat method allocates expenses based on the total occupied seat hours or miles for an aircraft for the entire taxable year. The flight-by-flight method allocates expenses to individual flights and then to each passenger traveling for entertainment or commuting purposes on that flight. Both methods require data to be gathered for each passenger on a flight and for all flights taken during a particular taxable year. The regulations outline specific steps to compute each method.

Each of the four allocation methods generally must take into account all flights on an employer-provided aircraft during the employer’s taxable year and are applied separately with respect to each employer-provided aircraft. An employer may be able to elect to aggregate the expenses of aircraft with similar cost profiles and apply the allocation methods on an aggregate basis. For this purpose, aircraft generally have similar cost profiles if their operating costs per mile or per hour of flight are comparable, and they have the same engine type (jet or propeller) and the same number of engines. Other relevant factors for determining whether aircraft have similar cost profiles include, but are not limited to, maximum take-off weight, payload, passenger capacity, fuel consumption rate, age, maintenance costs, and depreciable basis. 

Disallowed expenses

The expenses subject to the Section 274 deduction disallowance rules generally include all of the expenses of operating the aircraft, including all fixed and variable expenses the employer would deduct in the taxable year, which include, but are not limited to:

• Salaries for pilots, maintenance personnel, and other personnel assigned to the aircraft
• Meal and lodging expenses of flight personnel
• Take-off and landing fees
• Management fees
• Costs of fuel, tires, maintenance, insurance, registration, certificate of title, and inspection
• Depreciation
• Interest on debt secured by or properly allocated to an aircraft
• All costs paid or incurred for aircraft leased or chartered to the employer

Expenses allocable to a lease or charter of an employer’s aircraft to an unrelated third-party (as determined under Sections 267(b) or 707(b)) in a bona-fide business transaction for adequate and full consideration generally can be excluded from the expenses subject to the Section 274 deduction disallowance rules.

In lieu of computing the Section 274 disallowance using tax depreciation, a taxpayer may make a straight-line election solely for Section 274 purposes. By doing this, the taxpayer is allowed to compute the depreciation straight-line over the class life of the property (rather than with accelerated depreciation, including bonus). This generally reduces the disallowance in the first year. However, once made, this “straight-line depreciation election” generally can be revoked only for compelling circumstances upon consent of the IRS by private letter ruling and applies to all aircraft.

Imputing income for personal use

If aircraft usage is characterized as personal for any passengers, the employer is generally required to impute income to these service providers, including employees, independent contractors, partners, and board members. (hereinafter collectively referred to as “employees”).

The amount includable in an employee’s income for the personal use of a non-commercial, employer-provided aircraft (e.g., employer-owned, chartered, or leased aircraft) is generally based on either (1) the fair market value of the transportation at fair market charter rates, or (2) the Standard Industry Fare Level (SIFL) rates. Commercial flights are valued under different rules not covered in this discussion. 

Charter rate method

Under the charter rate method, the value of a non-commercial flight is equal to the amount that an individual would have to pay in an arm’s-length transaction to charter the same or comparable flight (i.e., fair market value). A flight taken under these circumstances may not be valued by reference to the cost of commercial airfare for the same or a comparable flight. In general, fair market value is determined on the basis of all the facts and circumstances but cannot include any discount for the special relationship that may exist between the employer and the employee.

The value of a flight determined under the charter rate method generally must be allocated among all employees onboard the aircraft based on facts and circumstances. If one or more of the employees control the use of the aircraft, the value of the flight must be allocated solely among such controlling employees, unless a written agreement among all the employees on the flight otherwise allocates the value of such flight. For purposes of the charter rate method, “control” means the ability of the employee to determine the route, departure time and destination of the flight.

Standard industry fare level rate method

The SIFL rate method calculation includes the following three steps for valuing each passenger flight that generates imputed income:

1. Determine the statute miles and multiply them by the applicable rates published semi-annually by the IRS.
2. Determine the multiple in Treas. Reg. Sec. 1.61-21(g)(7)(i) based on the maximum certified takeoff weight of the aircraft and status of the employee as either a control employee or non-control employee, and then multiply the amount from (1) by the appropriate multiple in the regulations.
3. Add to the amount from (2) the terminal charge published semi-annually by the IRS.

Generally, for purposes of the SIFL rate method, a control employee is any employee (or potentially a former employee) of a non-governmental employer who is any of the following:

• A board or shareholder-appointed, confirmed, or elected officer of the employer, limited to the lesser of 1% (rounded up) of all employees, or 10 employees.
• Among the top 1% (rounded up) most highly paid employees of the employer and limited to a maximum of 50.
• Owns a 5% or greater equity, capital, or profits interest in the employer.
• A director of the employer.

A family member of a control employee automatically counts as a control employee, including siblings, spouses, ancestors, and lineal descendants.

If elected, the SIFL rate method must be used consistently for all employees on all flights during a calendar year that are characterized as personal flights, although there are a number of exceptions to this general consistency rule. The SIFL rate method is not allowed if it is incorrectly applied. In such a case, taxpayers must apply the general charter rate method valuation principles.

Employment taxes and fringe benefits

The application of either the charter or SIFL rate methods must be considered for employment taxes. Taxable noncash fringe benefits like employer-provided noncommercial flights are generally subject to federal income tax withholding as they are made available to an employee.

Employers may elect to treat taxable noncash fringe benefits as paid in a particular pay period, or, on a quarterly, semiannual, or annual basis, but no less frequently than annually. A special rule allows employers to treat noncash fringe benefits provided in the last two months or any shorter period of a calendar year as if they had been paid during the subsequent calendar year. This special accounting rule is an optional election that employers can make for determining the value of some or all fringe benefits (i.e., this election does not require that all fringe benefits be subject to the election). This election is not permanent once made, nor does it need to be reported to the IRS. Employers may choose to not make or change the period for the election in a subsequent calendar year.