On August 1, 2012, the Department of Treasury published final regulations addressing the negative tax impact of entertainment use of business aircraft.  These new regulations solidify into law a legal framework first discussed by the IRS in a 2005 published notice, and later expanded upon in a 2007 set of proposed regulations.  Although these rules are complex and address a variety of topics, in this author’s view, the primary, noteworthy feature of the new regulation and its antecedents is a legal framework (referred to here as the “occupied seat rule”) which deals with how much aircraft expense is attributed to entertainment passengers onboard flights that are primarily flown for business purposes, with the effect that owners of business aircraft are now significantly deterred from bringing on business trips extra passengers whose primary purpose of travel is recreation, amusement, or entertainment.  The new regulations are effective for tax years that begin after August 1, 2012.

The Occupied seat Rule Contrasted to Related Law

When a person goes on a business trip, it is historically fairly common that another person might accompany him or her for non-business reasons.  Expenses attributable to the personal traveler have generally been viewed as non-deductible personal travel expenses (26 CFR 1.162-2(c)).  The critical variance of the occupied seat rule from other contexts is in how it determines the expenses associated with each traveler.  The attribution rule in other business-travel situations views the expenses of the non-business traveler as the “amount by which the total expense is increased because of” that person’s presence (Revenue Ruling 56-168), a category of test known in legal terminology as a “but-for” test; i.e., the “attributable” costs equal the amount of costs that would not have occurred “but for” the person’s presence.  This standard is illustrated in IRS Publication 463 (2011), explaining travel expenses, with the following example:

Jerry drives to Chicago on business and takes his wife, Linda, with him [for personal reasons].  . . .  Her expenses are not deductible.

Jerry pays $199 a day for a double room. A single room costs $149 a day. He can deduct the total cost of driving his car to and from Chicago, but only $149 a day for his hotel room.  If he uses public transportation, he can deduct only his fare.

Thus, the Publication illustrates, the expenses “attributable” to the personal companion are not deductible, and are measured by reference to the expenses that would have been necessary, even without her presence.  As discussed below, the occupied seat doctrine alters this analysis, overturning, within the rule’s scope, the but-for cost attribution rule, and replacing it with per-capita allocation, unconcerned with the events that actually caused expenses to be undertaken, and instead focusing on the specific make-up and intentions of the cohort being transported.

Scope of the Occupied seat Rule

The occupied seat rule applies when a “specified individual” (defined below) receives use of a business aircraft for entertainment, amusement, or recreation, generally in an employer-provided aircraft context.  The IRS ruling and regulation establishing the occupied seat rule do not target use of an aircraft for other purposes, such as business, or personal endeavors of a non- entertainment, amusement or recreational nature.  A specified individual, with respect to a company, is defined quite broadly to mean any individual who is subject to section 16(a) of the Securities Act of 1934 in relation to the taxpayer providing use of the aircraft, or an individual who would be subject to section 16(a) if the taxpayer were an issuer of equity securities referred to in that section.  Specified individuals generally include anyone who is, or is comparable to, an officer, director, or general or managing partner of a company, or is the direct or indirect owner of more than 10 percent of the company (on an equity basis, or in any class of its shares).  Specified individuals of one company are treated as specified individuals of all related companies.

Further, if any person receives an entertainment flight because of his or her relationship to a specified individual, then that specified individual is treated as the recipient of the flight if the specified individual is viewed having been permitted to authorize the presence of the non-specified individual as a fringe benefit.

Effect of the Occupied seat Rule

The cost of an employer providing personal flights of an entertainment, amusement, or recreational nature to a specified individual is not deductible.  The occupied seat rule establishes four methods for determining the amount of such costs, each based on the general idea of allocating the aircraft expenses evenly among the passengers.  These four methods may be viewed as allowing two different choices, along two different axes:

The full costs of owning, chartering/leasing, and/or operating the aircraft for the entire taxable year must be aggregated and apportioned across the use of the aircraft based, at the taxpayer’s election, on either miles flown or hours flown.  In addition, the taxpayer may elect whether to determine the disallowance portion on an annual basis, or per-flight basis.  These decisions have some interaction, as follows.  Under the calculation option (1) in the above table, the taxpayer divides the total aircraft cost by the total hours flown by the taxpayer during the year to determine a cost-per hour.  The taxpayer then must determine the cost attributed to each flight by multiplying the flight hours of that flight by the per-hour cost.  Finally, the taxpayer must determine the disallowed expense by allocating the expenses of the flight per-capita among the passengers and disallowing deductions for entertainment flights of, or attributed to, specified individuals.  Calculation option 2 differs only in that the miles flown, rather than the hours, is used to determine the expenses attributable to each flight.  Calculation option 3 requires the taxpayer to determine the total number of seat hours of the aircraft for the year by multiplying the number of passengers on each flight by the hours of the flights, and aggregating across all flights.  Once this number is known, it is divided into the total aircraft cost for the year to reach a cost per seat mile.  The portion of seat miles attributable to entertainment flights by specified individuals then becomes the portion of the total expenses that are rendered non-deductible.  Calculation option 4 is similar to 3, but looks to seat miles flown, rather than seat hours.  The most significant distinction among these choices is the per-flight versus annual option.  The annual option will place greater weight on more heavily occupied flights, while the per-flight option will not.  Special exceptions apply in a number of cases, including bona fide sales of aircraft use to unrelated third parties, and scheduled airline flights where at least 90 percent of the seats are available for sale to the public.  Further, entertainment cost disallowance can be reduced by recognition of income to the deemed flight recipient (under the aircraft fringe-benefit rules) and/or payment by the deemed recipient for the flight (subject to FAA limitations on compensated carriage).

Conclusion

The occupied seat rule significantly increases the negative tax effect of allowing onto trips otherwise flown for business specified individuals who are traveling for entertainment purposes.  It should lead companies to curtail such “tag-along” passengers, and to inquire as to the nature of their personal purpose, and, in the case of non-entertainment, non-business passengers, to retain documentation to support the passengers’ non-entertainment characterization.  This article is intended as a brief introduction to a complex area; it is not comprehensive, and may not address other related issues that have a bearing on taxpayers.

August 2, 2012

Jonathan Levy, Esq.

Legal Director

Advocate Consulting Legal Group, PLLC

Advocate Consulting Legal Group, PLLC is a law firm whose practice is limited to serving the needs of aircraft owners and operators relating to issues of income tax, sales tax, federal aviation regulations, and other related organizational and operational issues.

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