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.

FMI: JohnAlanCohan@aol.com, www.irs.gov