Legal Analysis By John Alan Cohan, Attorney at Law
Companies that own and
operate aircraft are generally entitled to deductions for ordinary
and necessary business expenses, among other things, in connection
with business use of the aircraft. A lesser known type of deduction
pertains to deductions for expenses in operating the company
aircraft for the benefit of employees for nonbusiness flights.
These fringe benefit flights are a form of compensation to the
employees who take advantage of the flights. But what amount is
appropriate for the company to deduct for these flights?
This issue was resolved in the Tax Court case, Sutherland
Lumber-Southwest, Inc. v. Commissioner of Internal Revenue, 114
T.C. 197. The company in that case owns retail lumber outlets in
Texas. The company’s 1976 Model 25 Lear Jet was used for
travel related to the lumber business and for its air charter
service business operated out of Kansas City. In addition, the
aircraft was used about 23 percent to 32 percent of the time for
nonbusiness flights for members of the board of the directors.
The directors reported these nonbusiness flights as compensation
in connection with their employment in accordance with the
valuation formula provided in the IRS Regulations on
employer-provided flights on noncommercial aircraft. The company,
for its part, took deductions for its total costs incurred in
operating the aircraft, including the nonbusiness flights.
The IRS contested these deductions and assessed substantial
deficiencies, claiming that adjustments were required with respect
to airplane expenses, net operating loss, environmental tax,
alternative minimum tax, and contributions. In essence, the IRS
argued that the company’s deductions for the fringe benefit
flights should be limited to the value of the benefits received by
the employees for the nonbusiness flights.
Essentially, the case
involved a consideration of employee fringe benefits and the
application of section 274 of the IRS Code, which provides special
rules for disallowance of certain deductions in connection with
entertainment, amusement or recreation activities. The issue was
whether the company may deduct its aircraft operating costs in full
or whether the deduction is limited to the amount reportable as
compensation by the employees.
Generally, an employer may deduct expenses incurred for noncash
fringe benefits as an ordinary and necessary business expense if
the value of the benefit is includable in the recipient’s
gross income. Section 274 was enacted to eliminate or curb
perceived abuses of business expense deductions for entertainment
and travel expenses, and for gifts. Section 274(e)(2) does,
however, allow the deduction of entertainment, amusement or
recreation expenses to the extent they are treated by the recipient
as compensation.
The rates provided in the IRS Regulations to compute the value
of income in connection with employer-provided flights on
noncommercial aircraft do not bear a correlation to the actual
costs incurred by the company. Instead, the rates are derived from
use of a percentage of commercial flight fares. The rates are
intended to approximate coach and first-class fares on commercial
airlines.
The Tax Court held that
the company is entitled to deduct the full cost of operating the
aircraft with respect to each of the employee-related nonbusiness
trips, even though this amount exceeds the value reported by the
employees on their tax returns. The opinion was affirmed by the
Eighth Circuit Court of Appeals.
Another case on this point was National Bancorp of Alaska v.
Commissioner of Internal Revenue, T.C. Memo 2001-202. The company
aircraft was used 28 percent of the time for the personal
entertainment use of employees for hunting, fishing, vacations and
other similar trips. The amount deducted by the company for the
fringe benefit trips was $734,096, whereas the amount declared as
income by the employees for the flights was $131,575. This case
reiterated the principle that an employer’s deduction for
fringe benefits, such as the use of aircraft for nonbusiness
flights, is not limited to the amount reportable by its
employees.