IRS Concedes Deductions for Company Aircraft

Earlier this year, the IRS acquiesced in the Eighth Circuit's decision in Sutherland Lumber-Southwest, 255 F3d 495 (2002):

Acquiescence relating to whether a taxpayer that provides vacation flights to employees and includes the value of the flights in the employees' income using the SIFL rates of Treas. Reg. Section 1.61-21(g) may then deduct the full (higher) cost of providing the flights, notwithstanding the deduction disallowance provisions of I.R.C. section 274(a).

Background

The Service first addressed this issue in Letter Ruling (TAM) 9715001. In that ruling, an employee and his spouse were provided use of taxpayer-owned aircraft for a personal vacation. On a Form W-2, the taxpayer properly reported the vacation flights' value ($26x) as compensation, pursuant to the Regs. Sec. 1.61-21(g) noncommercial-flight valuation rules.

The taxpayer's costs for operating the aircraft during the vacation flights were $340x. The IRS took the position that Sec. 274(a) precluded the taxpayer from deducting that amount, on the grounds that the exception in Sec. 274(e)(2) does not allow a deduction to exceed the amount included in the employee's income. The Service allowed the employer to deduct the amount actually reported in the employee's income ($26x), reasoning that to allow the full deduction would undermine Congress' intent in enacting Sec. 274, which was to prevent taxpayers from deducting personal ex-penses as business expenses.

Sutherland

Sutherland provided its president and vice-president with use of its company-owned aircraft for a variety of nonbusiness flights, including work for other businesses and charities and for vacation. Because the nonbusiness flights were "fringe benefits," Sutherland reported their value as compensation to its officers by using the Regs. Sec. 1.61-21(g) special-valuation rules.

On its 1992 and 1993 returns, Sutherland deducted all the expenses related to maintenance and operation of its aircraft that it incurred in providing the nonbusiness flights. In disallowing the full deduction, the IRS interpreted Sec. 274(e)(2) as relating to deductions for expenses incurred in providing employees with vacation flights on a corporate-owned aircraft, limited to the amount reported as employee compensation, as it had held in TAM 9715001.

The Tax Court held (114 TC 197 (2000)) that deductions for an employer's expenses incurred for use of an entertainment facility (although the court did not address whether the aircraft was an "entertainment facility") are not limited under Sec. 274(a) to the amount reportable by employees as compensation under Sec. 274(e)(2). Sutherland argued that the Sec. 274(e)(2) "to the extent" language acted to except the deduction in the full amount claimed from Sec. 274(a). The Service argued that the language acted to limit any deduction to the amount includible in income by the employees.

In ruling for the taxpayer, the Tax Court noted that Sec. 274(e) is titled "Specific Exceptions to Application of Subsection (a)." (Emphasis added.) Also, it reviewed the legislative history, which refers to "exceptions" in describing Sec. 274(e), rather than to "limitations." The court noted further that other portions of Sec. 274 and other Code sections have placed explicit limits on the deduction amount. According to the court, if Congress intended to limit the amount deductible under Sec. 274(e)(2), it would have used language that clearly limited the amount to that includible in the employees' income.

Finally, the Tax Court dismissed the IRS's argument that Sutherland's interpretation of Sec. 274(e)(2) resulted in mismatching income and expense. The court noted that under certain circumstances, the value of a fringe benefit included in an employee's income may be greater than the amount the employer is entitled to deduct; however, the Service did not comment on any potential mismatch in Sutherland. Consequently, the Tax Court held that as long as an employer reports the proper amount of income taxable to an employee, Sec. 274(e)(2) provides an exception to Sec. 274(a), rather than a limit.

The Eighth Circuit affirmed the Tax Court, stating:

After a complete review de novo, we agree with the Tax Court's well-reasoned opinion, and affirm on the basis of the analysis set forth therein. [Citations omitted.] Because we have nothing of substance to add to the Tax Court's thorough analysis, further discussion is superfluous.

Prior to the IRS acquiescence, the Tax Court solidified its position by reaching the same conclusion in National Bancorp of Alaska, TC Memo 2001-202, and Midland Financial Co., TC Memo 2001-203.

From David Michael Repass, J.D., LL.M., Washington, DC, and Richard C. Farley, Jr., J.D., LL.M., New York, NY