“I’m not concerned with tax flight-log recordkeeping. If I get audited someday, my explanations of what I’ve been doing with the plane will be persuasive enough.” Tax advisors nationwide wring their hands over prospects who refuse to abandon this misguided, and long-disproven approach. A recent Tax Court case demonstrates, yet again, that no taxpayer can be convincing enough to sustain deductions, so long as specific substantiation requirements of the law are not met.
In Engstrom, Lipscomb & Lack v. Comm., TC Memo 2014-221 (Oct. 2014), the losing taxpayer was a renowned commercial litigation law firm with clients throughout the United States, which had claimed deductions on its tax return for its use of a Gulfstream GIV and a King Air 350. Upon IRS audit, and subsequent Tax Court litigation, many of the deductions were thrown out due to lack of adequate documentation of the nature of the aircraft use. The aircraft records were kept by the secretary of the law firm’s president. She prepared frequent schedules of aircraft usage and expenses, but, the court noted, these records “did not include details such as flight information, passengers, or purposes of the flights.” As is customary for aviators, the pilots also kept flight logs, but those “logs [did] not provide the business purpose of the flights or detailed passenger information.”
At trial, the taxpayer offered as evidence two “noncontemporaneous documents . . . introduced as reconstructions of [the taxpayer’s] trips.” These documents were prepared by the firm’s president and his secretary, and were based on flight logs, monthly calendars, and the recollection of law-firm staff, and “included each trip’s date, destination, file number [of associated litigation within the taxpayer/law firm’s business], and passengers.” The Tax Court, however, viewed the noncontemporaneous documentation skeptically, and allowed deductions only for flights that had an unambiguous connection to a clear and specific business activity of the law firm, such as a particular case the firm was litigating or a conference the firm’s lawyers were attending.
STRICT SUBSTANTIATION RULE
The Tax Court’s disallowance of flight deductions due to lack of business-purpose substantiation is hardly novel. Section 274(d) of the Internal Revenue Code sets out a particular, heightened level of proof that a taxpayer must set forth in order to claim deductions for either travel, or pieces of equipment used for transportation (such as aircraft). In other contexts, a court, faced with a lack of detailed proof, may apply a doctrine known as the Cohan Rule (after Cohan v. Comm., 39 F2d 540 (2d Cir. 1930)) to estimate the amount of expenses that the taxpayer would have expended to further its business purpose, and allow the taxpayer to deduct this estimated amount. In the cases of travel or equipment used for travel, the courts have repeatedly and consistently held that the strict substantiation rule of Section 274(d) overrules the more lenient cost-estimation approach of the Cohan Rule. When it comes to travel or travel equipment, a taxpayer who fails to produce the required proof gets zero deduction.
The amount of substantiation needed to satisfy Section 274(d), however, is not great. Taxpayers forewarned of these requirements can easily adopt recordkeeping habits and design policies that satisfy them. Section 274(d) requires that the taxpayer prove four things, on a trip-by-trip basis: (1) the amount of the expense, (2) the dates of departure and return and number of days away spent on business, (3) the destination or locality of travel, and (4) the business reason for the travel or the nature of the business benefit derived or expected. In the case of transportation equipment, such as aircraft, a special rule applies to the “amount of expense” requirement. Because it is impossible to associate fixed expenses with any particular trip, the rules establish an aggregation rule, wherein all expenses can be tracked and accumulated over the course of the tax year. Receipts and invoices should be retained to show the date and amount of each expense. The taxpayer may then prorate these aggregated expenses across all of the use of the property during the year. This creates a per-flight-hour, or per-flight-mile expense amount, which is used to calculate the expense associated with each particular flight.
PASSENGER FLIGHTS – NOT JUST AIRCRAFT FLIGHTS MATTER
Aviators are accustomed to keeping detailed logs of the movements of their aircraft, as well as aeronautical details of the flight for pilot training and proficiency. After all, an essential item in any student-pilot training kit is the flight log, which serves as the primary record of the pilot’s improving experience. These records, however, are plainly insufficient for tax purposes, and will not sustain tax deduction of trips. There is a crucial disconnect of intentions: the FAA is interested in recording the movements of the aircraft and the skill level of the pilot, whereas the IRS is concerned with the activities of the passengers in engaging in the travel. Thus, anyone seeking tax deduction of flights must maintain not only an aviator’s flight log, but also a tax flight log, tailored to satisfy the IRS’s various recordkeeping requirements.
The substantiation rule of Section 274(d) is only one of numerous rules that, collectively, drive the conclusion that a tax-purposes flight log is a necessity to anyone seeking deduction of aircraft expenses. IRS rules require documentation of where each passenger went, what his/her purpose was in making the flight, and what his/her role is vis-à-vis the taxpayer seeking deductions. Section 280F, for example, determines what depreciation schedule governs the taxpayer’s deduction of a acquisition price of an aircraft. (Taxpayers generally prefer the most rapid depreciation schedule available.) Under 280F, an aircraft must surpass a threshold in the amount of qualified business use in order to receive its most favorable schedule (5 years for non-commercial aircraft based in the United States, or 7 years for commercial aircraft based here). As interpreted by the IRS, 280F’s determination whether the qualified-business-use threshold has been met considers not only whether a particular flight of the aircraft was for business, but how many of the individual passengers were traveling for business and, yet further, what role each of those business passengers has with respect to the taxpayer. A passenger traveling for business who owns part of the company seeking deduction, or who holds a high position in it, may not have the same consequence as a passenger traveling for business who doesn’t own any of the company and is a rank-and-file employee.
Similarly, Section 61 requires that passengers traveling for a reason other than the business of the company (including if that reason is any other type of business) be taxed as receiving compensation income from the company. But the amount of that income will depend on whether the passenger is high-ranking or an owner of the company, or, if the passenger is a guest, will depend on who invited the passenger to be onboard the plane. Section 274(a) (not to be confused with 274(d), which is discussed above) establishes detrimental tax consequences of passengers traveling for personal entertainment or recreational reasons, and, here again, the consequence depends not only on the aircraft’s purpose for flying, nor only on the passenger’s purpose in flying, but also on the position in the company of the passenger, or, if the passenger is a guest, of the person who invited the passenger. A non-business, entertainment passenger who is (or who was invited by) a high-ranking employee of the company will result in loss of tax deduction of some fraction of the expenses of the flight. (Calculation of the expense-disallowance number is set out in exacting detail in IRS regulations and is quite involved). On the other hand, if the entertainment passenger had been a low-ranking employee, that same detrimental tax consequence may not result.
To handle any of these issues, a normal, aviator’s flight log is inadequate. The tax law governing aircraft has, in recent years, experienced significant bureaucratic creep: nothing ever gets simpler, new requirements continue to pile on top of each other. A point has been reached that anyone seeking tax deductions for a business aircraft must consider a tax-purposes flight log, tailored to meet IRS requirements, a necessity.
A common frustration in regulatory compliance is the many cases where multiple departments of government create rules for an area, but fail to coordinate their various requirements. The aviation field has always been highly regulated by the FAA, and aircraft recordkeeping, on that score alone, is voluminous. But satisfying the FAA is not enough to satisfy the IRS. Additional recordkeeping, using a different tool than an aviator’s flight log, is necessary to sustain deduction of a business aircraft. This article is a brief introduction to a complex area. Aircraft ownership should always be carefully evaluated with the aid of qualified advisers.
November 11, 2014
Jonathan Levy, Esq.
Jonathan Levy is a board-certified expert aviation law practitioner, and legal director of Advocate Consulting Legal Group, PLLC, a law firm whose practice is limited to serving the needs of aircraft owners and operators relating to issues of income tax, sales tax, federal aviation regulations, and other related organizational and operational issues.