Properly documenting the flights in your business aircraft has never been more important than it is now. The introduction of what is referred to in the aviation industry as the “occupied seat rule” in late 2012 added an extra layer of complexity and compliance for business aircraft owners looking to preserve aircraft related expenses and deductions. This rule (a treasury regulation), which became effective for some taxpayers in 2012 and for all in 2013, has caused a great deal of speculation and conjecture in the industry. While this rule may yet to be tested, it does not take much imagination if you know a thing or two about the tax code to realize that aircraft-owning taxpayers who fail to keep adequate flight logs and business records surrounding aircraft use will simply be exposing themselves to increased tax liability.
It should come as no surprise that the aviation industry puts a lot of emphasis on record keeping. After all, the motivation is a laudable goal: safety. Pilots log training time for certificates and ratings, insurance companies track time for insurability, and mechanics watch the calendar for engines and airframes for maintenance. Whether the aircraft is owner flown or flown by professionals, most aircraft owners are familiar with the concept of aircraft and pilot logbooks. However, flight logs and logbooks typically maintained by pilots and crew are simply inadequate for tax purposes.
Most small businesses do not have the luxury of a flight department. The pilots who crew the aircraft are tasked not only with flying the aircraft but also dispatching and recordkeeping duties. Pilots diligently record the date of the flight, flight time, destination, fuel burned and engine times and cycles (a fancy way to say takeoffs and landings in a turbine powered aircraft). Then this set of “logs” is typically handed off to another administrator for processing. Aircraft owners are often very busy managing their business so they delegate, as they should. However, this can result in what I call the “delegation disconnect” which oftentimes results in gaps in the records that must be kept in order to preserve the aircraft expenses and deductions under the tax code. This is exactly what took place in a recent tax court case that had a less than a favorable outcome for the taxpayer.
In Engstrom (TC Memo 2014-221) the members of a law firm owned a Gulfstream GIV and King Air 350 – quite substantial aircraft. The pilot of each aircraft prepared the aircraft “logs” as one would expect a pilot to typically do while the administrative secretary to the head of the firm scheduled the flights, aircraft maintenance, pilot time off and tracked invoices and receipts. However, neither the pilots nor the secretary had recorded the actual business purposes of the various flights. (In their defense, why would they? They were not likely privy to the nature of the trips.) The tax court put heavy emphasis on the “noncontemporaneous” nature of the documents and records used to “reconstruct” the taxpayer’s trips reminding us in their memo that “contemporaneous documentation is deemed more credible that after-the-fact reconstruction.” In other words, the fact that the missing business purpose information seemed to be filled in long after the flights were taken (i.e. once the audit was opened) made the evidence less persuasive to the point where the taxpayer could not meet their evidentiary burdens. While the business purpose of any trip may be obvious to the taxpayer, the fact that seasoned litigators were forced to give up substantial aircraft expenses and deductions on account of poor record keeping should get every business aircraft owner’s attention! If it can happen to them, it can happen to you.
To justify deductions and expenses related to travel in one’s business aircraft one must follow the enhanced substantiation rules of Internal Revenue Code Section 274 and related treasury regulations by keeping contemporaneous records of the following:
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The amount of the expense and when such expense was incurred;
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The locality of the travel, including departure and return dates and number of days spent away on business;
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The business purpose of the travel along with the expected business benefit derived or expected; and
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The purpose and relationship to the business principal of each and every passenger on each and every flight leg (the “occupied seat rule”).
The good news is that the first two requirements above are not that difficult to track and are typically successfully delegated to the pilot and other administrative staff. However, the aircraft owner and/or his/her high level employees are typically the only ones with enough knowledge of the business purpose of each flight to create a contemporaneous business record that substantiates the reason for the flight. In addition the business principals are likely the only ones who know the exact relationships and purposes of all the passengers on the aircraft. One thing Engstrom teaches is that contemporaneous recordation of each flight’s business purpose is essential.
It is easy to understand the motivation behind the third element above. Aircraft are “listed property” under Section 280F of the Code. As we all know aircraft can be used for both business and personal reasons or what accountants often refer to as “mixed use.” In enacting 280F lawmakers were attempting to curb abuse of depreciation deductions associated with excessive personal use of such property which is why documenting the business purpose is essential to preserving deductions. (It is worth noting that 280F is also a mixed bag itself in that is contains both favorable and unfavorable items for aircraft owning taxpayers but that is the subject of a future article.)
The fourth element above is the occupied seat rule. The potentially negative impact this rule can have on expenses and deductions suggests the only motivation behind it is of a punitive nature. Nevertheless it is now the law. The occupied seat rule is best illustrated with examples. But first we must revisit the old rule: the primary purpose test. Under the primary purpose, whether or not the flight was treated as a business flight depended on the primary reason the flight was being taken. Suppose one of the unfortunate lawyers above took a flight to go to Orlando for a deposition. Such a flight would have been treated 100% as a business flight as the primary reason was for the lawyer to attend a deposition. Now suppose the lawyer brings his wife and three children along with him to Orlando. The lawyer is still merely going to his deposition while the rest of the family is taking a diversion to Disney World. Under the primary purpose test, the flight is still treated 100% as a business flight (with the exception of some de minimis fringe benefit that is imputed to him by virtue of the family tagging along). Under the occupied seat rule, that flight has now become a 20% business flight and 80% a personal entertainment flight resulting in significant disallowance. While bringing such family members or guests along does not add to the actual costs of operating the aircraft, it now can have a potentially disastrous impact on an aircraft owner’s deductions. While the Engstrom case was based on pre-occupied seat rule law and facts, the opinion nevertheless also highlight the failure of the failure of the logs to include “detailed passenger information.” Now, as part of the flight logs, “seat-miles” or “seat-hours” must be calculated for the aircraft over the entire year so that expenses and deductions (and unfortunately disallowance) can be allocated among business, personal non-entertainment, and personal entertainment seat-miles or seat-hours.
Establishing a protocol for administering the aircraft business-related flight logs takes discipline and planning. Failure to maintain adequate logs can severely impact aircraft owner’s allowable expenses and deductions. The Service is likely to get a lot of ‘mileage’ out of the taxpayer’s lack of recorded seat-mileage unless aircraft owners condition themselves to follow both the existing and new rules.