IRS announces increased audit activity for personal usage of corporate planes

ARTICLE | March 07, 2024

Authored by RSM US LLP

Executive summary:

The IRS announced that it will begin audit activity relating to business aircraft that are also used for personal purposes.  The personal use of aircraft tax laws are complex and based on the taxpayer’s specific facts and circumstances. An IRS examination of this issue can be time intensive and arduous if the business does not take the necessary proactive steps to ensure all required documents are in order to defend the company’s position in front of the IRS.

IRS continues to increase scrutiny on high-income taxpayers and announces the beginning of audits focused on the personal use of business aircraft. Careful considerations and detailed documentation should be evaluated now to prepare for the increased audit activity surrounding this complex area of tax law.

The IRS announced it will begin auditing dozens of taxpayers who own business aircrafts that are also used personally by executives, partners, shareholders, and employees. This campaign is a result of funding from the Inflation Reduction Act (IRA). The number of aircraft audits could increase significantly depending on the results of these initial examinations, especially as the IRS continues hiring additional agents and subject matter experts. The IRS has historically been interested in examining aircraft compliance, but this is the first time the IRS has formally announced a campaign into the issue. The Business Aircraft Campaign is part of the IRS Large Business and International division’s “campaign” program to help address areas that they believe have a high risk of non-compliance.  In the announcement, the IRS states that it will be taking swift and aggressive action to increase scrutiny on certain high-income taxpayers and some of the income positions they, and their companies have taken.

The IRS will focus on aircraft usage by large corporations, large partnerships and high-income earners to ensure that a) income tax deductions related to personal entertainment use are disallowed; and b) a taxable fringe benefit is properly being imputed into compensation of those individuals flying for personal purposes.

Background

Congress allows a business deduction for expenses for maintaining and operating noncommercial aircraft, to the extent the aircrafts are being used for business purposes and the expenses are both ordinary and necessary for the business. Personal usage includes allowing an employee, owner, partner to use the aircraft for personal purposes, but personal use can also include allowing spouses, children or other guests to ride along on the plane, even if the trip is otherwise for a business purpose.

When there is personal use of the company aircraft there are two main tax implications the IRS is scrutinizing: 1) imputed compensation income for personal use and 2) disallowance of business deductions, such as the aircraft expenses, based on personal entertainment use.

Imputed income for personal flights can be calculated using two different methods: 1) based on the fair market value (FMV) of the transportation provided (i.e. using a charter rate) or 2) use of the Standard Industry Fare Level (SIFL rate). The SIFL rate methodology generally results in a smaller income inclusion (akin to the cost of a first- class commercial ticket). The fringe benefit imputed income is reported either on the W-2 for an employee, as a guaranteed payment for a partner or Form 1099 for non-employee contractor or board member. SIFL compensation reported on an employee’s W-2 is subject to applicable payroll taxes and related payroll tax reporting requirements.

If the aircraft is owned in a sole proprietorship (or disregarded entity 100% owned by an individual), imputed income is not required to be computed to that individual because sole proprietors do not receive W-2s or other compensation reporting. In this case, if the primary purpose of the flight is not for business, the deduction will be fully disallowed.

There are different rules for purposes of disallowance of business deductions and thus, flights (other than for business) must be categorized further into four separate categories to determine proper treatment:

1. business entertainment,
2. personal entertainment,
3. personal non-entertainment or
4. personal non-entertainment commuting flights.

For employer-provided aircraft, the classification of flights is made on a per passenger basis.

In addition to the imputed income and disallowance of deductions, there are also other tax implications that must be considered when using an aircraft for a business including but not limited to ordinary and necessary expenses hurdle, hobby loss rules, passive activity loss rules, excise tax, property tax and sales tax.

Business deduction rules - section 162

Under section 162 a trade or business is generally allowed a deduction for all the ordinary and necessary expenses paid or incurred. A business usually should develop an aircraft business use and analysis plan before the plane is purchased (or before the business signed up for lease or frequent use of corporate aircraft). This documented analysis should include items such as an analysis of the cost, expected benefits to the business, estimated business usage, and authorized use of the aircraft. We generally recommend that companies develop aircraft business-use and personal use policies to be able to respond to any IRS inquiries.

Hobby Loss rules –  section 183

Sometimes individual owners decide to purchase noncommercial aircraft, expecting to use the plane, and allowing their businesses to use the plane.  Businesses and business owners need to consider the “Hobby Loss” rules, under section 183. Airplane activities can result in ongoing net losses due to the extensive costs of operating an aircraft, especially relating to the depreciation deduction. Section183 precludes deductions from activities that are not engaged for profit. The hobby loss rules may allow for multiple business activities to be grouped as one activity.

In addition, there is a set of nine relevant factors that should be taken into account when determining whether an activity is engaged in “for profit”. The relevant factors, as explained by the Tax Court in Elliott v. Commissioner, 84 T.C. 227 (1985), citing Reg. section. 1.183-2(b) are as follows:

• the manner in which the taxpayer carries on the activity,
• the expertise of the taxpayer or his advisors,
• the time and effort expended by the taxpayer in carrying on the activity,
• expectation that assets used in the activity may appreciate in value,
• the success of the taxpayer in carrying on other similar or dissimilar activities,
• taxpayer’s history of income or losses with respect to the activity,
• amount of occasional profits earned,
• financial status of the taxpayer,
• elements of personal pleasure and recreation.

Owners and companies generally need to consider these factors and have sufficient evidence showing the taxpayer is engaged in the activity continually and regularly with a potential for profit when looking at the factors in totality.

Passive activity loss rules – section 469

Another tax implication that needs to be carefully considered when operating a company aircraft is the passive activity loss rules under section469. Passive activity loss rules limit the deductibility of losses generated from activities that are passive in nature in which the taxpayer does not materially participate. Rental activity is also generally considered passive activity unless certain requirements are met. For various reasons, such as Federal Aviation Administration (FAA) or sales tax implications, companies may structure the aircraft operations so that the aircraft is leased to the operating company via a dry lease. Another scenario is that the company owning the plane dry leases (a lease without any crew member) the aircraft to a third-party charter operator (certified under the FAA Part 135).

These can have potential tax implications if the lease activity is viewed as being generally passive, absent specific planning around that hurdle. However, like the Hobby Loss rules, multiple activities may be grouped together under certain circumstances to allow the taxpayer to be a material participant. The grouping may be especially helpful when the operating business is the lessee and the business that owns and manages the aircraft is the lessor.

Other considerations

The other three tax implications that need to be carefully considered are excise taxes, property taxes and sales taxes. Generally, absent specific structuring, transportation of persons or property by air (i.e. flights operating under FAA Part 135) may be subject to federal excise taxes. Currently, the excise tax is a 7.5% tax on the ticket or charter price charged to use the aircraft. In addition to the 7.5% excise tax, there is also a domestic surcharge of $5 per flight segment or leg. For international flights, there is a flat per person tax. There are also special rules for Alaska and Hawaii, as well as flights within 225 miles of the United States. Excise tax is reported on Form 720, line 26, and is filed quarterly but depending on certain situations semi-monthly deposits of tax may be due.

Property tax may require careful thought to ensure the company is in compliance. Property tax is a local or state jurisdiction tax, so the rules can vary greatly based on the jurisdiction. Property tax may be based on the fair market value of the aircraft, which may result in a large tax obligation. Businesses need to review any property tax implications with their tax advisor based on their specific facts and circumstances.

Sales and use tax is imposed at the local or state level jurisdiction but is vital to consider when owning and operating an aircraft. Although this type of tax can vary greatly depending on the jurisdiction, generally speaking, sales tax may be due on the purchase price of the aircraft.  These rules may be different if there is a dry lease in place when the aircraft is being acquired. In a lease situation, the acquisition of the property may be exempt from sales tax but the lease payments may be subject to sales tax.

Yachts

While the IRS has not specifically announced a focus on company-owned yachts, these also involve significant risk of personal use, loss of tax deductions and other tax implications.

Some businesses own luxury ships and use these assets for client entertainment and employee recreation.  Uses of luxury craft raises many of the same issues discussed above. However, there are some significant differences in rules between aircraft and yacht implications. For example, it is more difficult to show business use, allowing avoidance of the deduction disallowance rules, given a yacht is more likely to be treated as an entertainment facility and not generally seen as a reasonable way to travel from one business location to another for business purposes. It is best practice to speak with your tax advisor before considering business ownership of yachts.

IRS examinations of mixed business and personal use

Taxpayers that own or use noncommercial aircraft need to review their policies, procedures, documentation, flight logs, tax positions and other implications now, so they are ready if they are selected for IRS examination. Proper planning and documentation will assist taxpayers in defending their tax positions in front of the IRS.

In the event of an IRS audit, it is critical that the various documents are readily available for inspection such as the closing documents related to the purchase of the aircraft, subsequent sale of the aircraft, lease or charter agreements, aircraft management agreements, detailed flight logs, etc. to facilitate the IRS examination.

Aircraft taxation is complex and the need for accurate record-keeping is essential, especially in the case of an IRS examination. Documentation will be key to substantiating business use. Typically, in IRS exams, the agent will assume everything is personal use unless the company can substantiate business use. It is essential that the business has records substantiating the purchase and operation of the aircraft, detailed flight records, number of passengers on each flight, purpose of each passenger and expenses of the aircraft.

Other non-tax rules

In addition to navigating the complex “use of noncommercial aircraft” tax laws, taxpayers considering significant use of noncommercial aircraft should consider FAA regulatory compliance, insurance considerations, and liability risks. Businesses generally work with experts to structure the acquisition and plan for the operation and use of the aircraft to mitigate various legal and tax risks.  These may include aviation experts such as consultants, brokers, aviation attorneys, aviation tax consultants and tax attorneys.   Businesses also need to work closely with insurance brokers.

At RSM US, we have aviation tax subject matter experts who can assist with various tax consulting services relating to the acquisition of the aircraft, structuring services, imputed income and disallowance calculations, ongoing operational assistance, etc. RSM also has a Tax Controversy team that can assist with audit defense relating to aviation examinations, among other industries.