Aircraft Club Oct 2024: Year-end review

In brief

What happened? 

With increased likelihood of an IRS audit of business aircraft, companies should be aware of potential pitfalls regarding use of the aircraft for federal income tax purposes. 

Why is it relevant?

Failure to apply the federal income tax rules properly may adversely affect not only companies but also their employees.

Action to consider  

As year end approaches, companies should review their use of business aircraft during the tax year to manage potential exposures relating to (1) imputing income to employees for personal use of aircraft; (2) deduction disallowances for entertainment use of aircraft by specified individuals, employee commuting expenses, or inadequate substantiation of expenses; and (3) meeting the Section 280F qualified business use test for depreciation purposes, including bonus depreciation. 

Deduction disallowances

Entertainment use of business aircraft by specified individuals

Section 274(a) generally disallows deductions for entertainment expenses paid or incurred after 2017. Companies should evaluate whether an individual’s nonbusiness use of a company aircraft related to entertainment, because costs incurred by an employer for an employee’s personal nonentertainment flight generally would be fully deductible. A personal nonentertainment flight is a flight that is not for amusement or recreation, such as the use of company aircraft to attend a family member’s funeral, for medical purposes, or to participate in charitable activities.

If a flight is for personal entertainment, several exceptions to the general disallowance of the deduction for entertainment expenses may apply. For example, companies may deduct expenses relating to the personal entertainment use of a company aircraft by a specified individual (such as an executive or director) only up to the amount treated as income to the specified individual, increased by any reimbursement received from the specified individual.

A company may determine the amount of expenses of a particular aircraft or group of aircraft attributable to business entertainment use by specified individuals for the year using the occupied-seat method or the flight-by-flight method. Under either method, companies may use miles or hours flown, and the same method must be applied to all flights of all aircraft for the tax year. Companies should consider which method may provide the best result for the year.

Commuting expenses

Expenses relating to an employee’s travel (such as by aircraft) between any residence of the employee and regular place of employment (commuting) paid or incurred after 2017 are disallowed, even if the value of the use is reported as additional income to the employee, except as necessary for the employee’s safety as determined by a security study conducted by an independent company. Companies should review whether they paid or incurred these expenses in the current tax year and the adequacy of documentation supporting a determination of necessity.

Substantiation

Section 274(d) disallows deductions for business expenses for travel, gifts, or listed property (which includes aircraft) unless a taxpayer substantiates each element of the expenditure. To support these deductions, a taxpayer must maintain adequate records or other sufficient evidence substantiating the amount, place, date, and business purpose of the aircraft use, and the business relationship to the taxpayer of any persons using the aircraft. The records should be created contemporaneously with the use of the aircraft.

Unlike the disallowances for entertainment and 50% of meal expenses, there are no statutory exceptions to the substantiation rules, so companies are not permitted to estimate the amount of expenses subject to Section 274(d). Accordingly, taxpayers should review their documentation of aircraft expenses for compliance, as failure to meet these stringent substantiation requirements could result in disallowance of deductions.

Depreciation

Companies should determine whether more than 50% of the use of their owned or leased business aircraft for the year is qualified business use for purposes of Section 280F, which allows a taxpayer to depreciate an aircraft that meets this test under the MACRS general depreciation rules rather than the alternative depreciation system. An aircraft may fail this test due to excessive personal use by, or leasing of the aircraft to, 5% owners or related parties.

A failure to meet the qualified business use test also may prevent a taxpayer from qualifying for bonus depreciation, which the taxpayer otherwise may be eligible to claim for an aircraft acquired after September 27, 2017, and placed in service in the current tax year. Failure to meet this test in any subsequent year after the placed-in-service year will result in depreciation recapture, including recapture of bonus depreciation.

Observation: The bonus depreciation percentage has begun to decrease for property placed in service after 2022 (after 2023 for certain aircraft and longer production period property). In general, bonus depreciation is 60% for 2024 and 40% for 2025 under current law.