Deducting Corporate Aircraft Entertainment Travel • Schedule M-3 Revisions • Partnership Liabilities • Estate Tax Inclusion of FLP Assets (Box)

Lesli S. Laffie, J.D., LL.M.

From the IRS

Deducting Corporate Aircraft Entertainment Travel

Notice 2005-45 clarifies the post-American Jobs Creation Act of 2004 (AJCA) tax treatment of the personal use of corporate aircraft for entertainment travel. For such use after Oct. 22, 2004, the employer’s deduction cannot exceed the amount the traveling employee includes in income.

Background: Prior to the AJCA, if an employee used a business aircraft for entertainment travel, the employer could deduct the cost of providing the flight if the employee properly reported the flight’s value as additional income. While the employer generally deducted many thousands of dollars for providing the flight, the employee would include in income only a relatively small amount, calculated under the Department of Transportation’s standard industry fare levels formula.

New law: Under the AJCA, the business’s deduction cannot exceed the amount the executive takes into income for entertainment use of the aircraft. The Sec. 274(e)(2) and (9) exceptions to Sec. 274(a)’s general disallowance rule apply in the case of a “specified individual” only “to the extent that the expenses do not exceed” those treated as compensation to the specified individual (e.g., officer, director or 10%-or-more owner of a public or private company).

Notice 2005-45: The notice defines “entertainment use” in the same way as does the statute—for amusement or recreational activity (e.g., traveling to a sporting event or vacation destination). If the trip’s purpose is business-related entertainment, the AJCA’s limit applies to the executive, too.

Schedule M-3 Revisions

The Service has issued a revised, draft version of Schedule M-3 of Form 1120, U.S. Corporation Income Tax Return, to allow taxpayers to take a manufacturing deduction and interest expenses into account.

According to Robert Adams, a senior industry adviser in the IRS’s Large and Mid-Size Business Division, the Service is also formulating versions of Schedule M-3 for partnership, S corporation, property and casualty insurance company, and life insurance company returns.

According to Adams, the revised draft Schedule M-3 includes provisions for taxpayers to calculate the new Sec. 199 deduction for domestic manufacturing and includes an interest expense line. The IRS has also expanded its list of Schedule M-3 frequently asked questions and answers.

Insurance companies: The Schedules M-3 planned for Form 1120PC, U.S. Property and Casualty Insurance Company Income Tax Return, and Form 1120L, U.S. Life Insurance Company Income Tax Return, will be effective Dec. 31, 2005.

Partnerships and S corporations: The Schedules M-3 for Form 1065, U.S. Partnership Return of Income, and Form 1120S, U.S. Income Tax Return for an S Corporation, are expected to have an effective date of Dec. 31, 2006.

Partnership Liabilities

Final regulations (TD 9207) define the term “liability” under Sec. 752 and prescribe rules to prevent taxpayers from manipulating the liability rules to create artificial losses when a partnership assumes a partner’s obligations.

New classes of liabilities: Regs. Sec. 1.752-1(a)(4)(i) describes two types of liabilities: “1.752-1 liabilities” and “1.752-7 liabilities.” An obligation is a “1.752-1 liability” to the extent it:

• Creates or increases the basis of any of the obligor’s assets, including cash;
• Gives rise to an immediate deduction to the obligor; or
• Gives rise to an expense that is not deductible in computing the obligor’s taxable income and is not properly chargeable to capital account.

All obligations that do not meet the definition of Regs. Sec. 1.752-1 obligations are Regs. Sec. 1.752-7 liabilities. An “obligation” can arise under a contract, debt, tort, pension, short sale or derivative financial instrument or be any other type of obligation, according to Regs. Sec. 1.752-1(a)(4)(ii).

A partner must immediately reduce his or her basis in the partnership when the partner transfers a Regs. Sec. 1.752-1 liability and the partnership assumes it. Regs. Sec. 1.752-7 liabilities do not result in an immediate basis reduction.

Regs. Sec. 1.752-7 liabilities: Traditional liabilities (such as mortgages) are described in Regs. Sec. 1.752-1. Regs. Sec. 1.752-7 describes liabilities that have not traditionally been treated as liabilities under the partnership rules, including those not included in the historic definition under Rev. Rul. 88-77. This category would include derivatives such as options and other contingent obligations.

Obligations that qualify as liabilities under Regs. Sec. 1.752-7 are treated significantly differently from Regs. Sec. 1.752-1 liabilities, because they do not result in an immediate basis reduction. Instead, basis reduction is delayed until a triggering or “separation” event occurs, such as:

1. A disposition or partial disposition of the partnership interest;

2. A liquidation of the partnership interest by the partnership; or

3. Another partner’s assumption of the liability.

Additionally, when the partnership satisfies the obligation or when the obligation otherwise becomes fixed (when economic performance occurs), the deduction related to the assumed liability is allocated to the contributing partner under Sec. 704(c) principles. In effect, the liability assumed by the partnership is treated as built-in loss (BIL) property; the BIL equals the amount of the liability at the time of contribution. This treatment is designed to prevent the acceleration of losses when the liability is assumed while, at the same time, allowing the partner to claim the deduction when it is passed through by the partnership.

The Regs. Sec. 1.752-7 liability rules include an exception for transactions in which a partner contributes to the partnership the trade or business with which the liability is associated (similar to the Sec. 358(h)(2)(A) exception for corporations). There is also a de minimis exception for situations in which the liabilities assumed (i.e., the remaining BIL attributable to Regs. Sec. 1.752-7 liabilities under Sec. 704(c)) are smaller than the lesser of $1 million or 10% of the gross value of partnership assets immediately before the triggering event. There is no exception for transactions in which the partner contributes substantially all of the assets associated with the liability.