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Checklist of Planning Considerations for New Aircraft Owners

copyright © 1998 Michael P. Fleming

Although their import varies by user, there are many factors to consider when determining the best structure in any particular case. In this section, I will identify the most common. Reviewing each should facilitate the planning process.

Usage Profile

The starting point for any user should be developing a thorough understanding of its own aircraft usage requirements. Often, this will narrow the range of planning options.

Operational Analysis

Each party involved should carefully review historical and forecast use, determining the flight hours used and their distribution, the city-pairs and airports visited, and typical passenger loads. Newcomers to business aviation should audit their historical commercial airline travel requirements to determine which flights could be replaced by business aviation. This will hasten a determination of the type of aircraft required as well as its likely use and availability for sharing.

Flexibility Requirements

Business aircraft users should also consider their requirements for operating flexibility. The FARs restrict the operational flexibility of Part 135 (air taxi) operators to a much greater degree than they do private, Part 91 operators. For example, Part 135 operators are subject to pilot flight and duty time restrictions, are prohibited from conducting "look see" approaches, have less flexibility in operating out of airports that lack weather reporting stations on the field, and must calculate minimum takeoff and landing distances using stricter rules.

Many of Part 135's constraints increase the margin of safety and should therefore be followed, but their impact on flexibility cannot be denied. For planning purposes, then, the best solution for private operators often is to create a structure that allows Part 91 operations, while complying with Part 135’s requirements on a voluntary basis. In any case, the user should determine the degree of operational flexibility required before implementing any shared-use structure.

Economic Considerations

Next, consider the financial aspects of sharing use. Operational needs impact the type of aircraft and number of flight hours required. The user then can calculate the expense of acquiring and operating the aircraft, usually with the help of industry experts. If the acquisition cost is too high, consider partners to share the purchase price, provided that usage requirements are complementary and that scheduling and liability concerns can be managed. Alternatively, a fractional share could be considered.

If operating costs exceed budget, examine shared usage options that allow for defraying some of these costs. The FARs limit this ability; certain structures allow only the recovery of actual, direct operating expenses (usually including twice the cost of fuel and oil), while others allow cost recovery on a fully-allocated basis (that is, direct costs plus an allocation for overhead and ownership). Chartering out allows charging third parties on an unlimited "cost-plus" (that is, profit-motivated) basis. Because the need for cost-recovery flexibility often drives the configuration chosen, the precise "charge-back" restrictions for each shared-use arrangement are discussed below.

Degree of Control over the Aircraft

Some users feel strongly about maintaining a high degree of control over the aircraft. For them, structures that cede significant activities to third parties are unacceptable, despite potential cost advantages. The issue often relates to scheduling; certain executives require that "their" aircraft is always waiting, no matter the cost. Consequently, they will have difficulty choosing a suitable sharing mechanism.

Ownership

The intangible benefits of ownership drive some structures. Fractional Programs have succeeded to some degree by offering Program Participants ownership, albeit of only a share. Other parties will go to great lengths to avoid ownership, desiring anonymity for their aircraft operations. Many companies wish to keep the aircraft "off-balance sheet," suggesting an operating lease arrangement. Ownership also entails a host of potential aircraft registration issues, particularly relating to foreign ownership.

Regulatory Status and Risk Profile

An extremely important (and rather complex) factor concerns the desired regulatory status of the operations and the level of related risk the user is willing to bear. As described above, Part 91 offers certain operational flexibility advantages as compared to Part 135, but decreased charging flexibility. Many operators wish to charge at will and enjoy Part 91’s flexibility at the same time, creating an insurmountable regulatory tension. Thus, it is worth examining the regulatory background in which business aviation operations take place.

Traditional Private Operations

From an FAA perspective, Part 91 operations are those private carriage flights where there is no transportation for hire, there is no "holding out" to the public that would constitute "common carriage," and the operation of the corporate aircraft is "incidental to the business of the company." The FAA clearly designed most of Part 91 based upon operations akin to "traditional" internal flight departments using the aircraft for company business.

Accordingly, unless otherwise expressly allowed, any sharing of the aircraft for which compensation of any kind is received could be considered using the aircraft "for hire," mandating a commercial certificate.

Regulatory Pigeonholes

In Subpart "F" of Part 91, though, the FAA has created some limited, specific structures for sharing use and cost recovery. These structures – such as Time Sharing, Interchange, Joint Ownership, demonstration flights, and corporate family flights -- are outlined in §91.501 and discussed in detail below. Many of the activities in question might otherwise be considered providing transportation for hire, requiring a commercial certificate, but for this special exception.

• Scope of Subpart "F": Subpart "F" applies to "large [defined elsewhere as those over 12,500 pounds maximum takeoff weight] and of turbo-jet powered multiengine civil airplanes." Pistons, turboprops, single-engine (or very light) jets, and helicopters are not automatically covered, but their operators can seek an individual waiver or take advantage of the blanket exemption the FAA has granted if they are (or become) members of the NBAA. Be aware that Subpart "F" does not provide an exception to the licensing requirements where common carriage is involved or the use of the corporate aircraft is not incidental to the business of the company (more on this last point later).

• A Limited Exception: Business aircraft operators engaged in sharing should keep in mind the nature of this activity. Charging for use of the aircraft would simply not be allowed under Part 91 if Subpart "F" did not exist. Section 91.501 contains a relatively narrow range of exceptions to this rule. As a matter of legal interpretation, then, what is not expressly allowed is generally forbidden. Thus, any sharing activity where compensation is involved that does not fit expressly within the types of arrangements provided for in §91.501 carries some degree of FAA enforcement risk. What seems "logical and appropriate" might lead to an enforcement proceeding, a pilot threatened with license revocation, or even an argument by the insurance company to deny coverage under the policy. That said, I should note that the language and structure of this provision tend to be ambiguous and leave room for interpretation. In identifying the degree of risk undertaken, obtain competent advice from aviation regulatory experts familiar with Subpart "F" of Part 91.

Citizenship

Individuals or companies that do not qualify as U.S. citizens must be especially careful when sharing aircraft. The U.S. Department of Transportation (DOT) prohibits "remuneration for hire" of "foreign civil aircraft" absent receipt of DOT economic licensing authority. While it is not clear that business aircraft sharing arrangements lie within the scope of DOT’s authority (to my knowledge, DOT has never asserted its authority in any such case), problems could arise where the aircraft is "owned, controlled or operated" by individuals who are not U.S. citizens.

Further, owners that cannot register the aircraft directly as U.S. citizens under the registration rules normally employ a voting or ownership trust arrangement. These devices can cause complications in complying with Subpart "F" (Joint Ownership, for example, can be thorny) and can sometimes require attention to specific language in the insurance policy. Suffice to say, if non-U.S. citizens are involved, proceed carefully and with sound advice.

Tax Implications

Sharing simply should not be engaged in without examining potentially critical tax implications. These can be divided into three areas: the FET, state taxes, and other federal taxes.

FET

The Federal transportation Excise Tax (FET) applies to "commercial" transportation activities. Anyone providing transportation services that the IRS deems commercial must charge and remit the FET for domestic flights. Unfortunately for operators, the IRS and FAA have contributed to the complexities of business aircraft sharing by defining and applying differing standards for what is deemed to be "commercial," and by ignoring each other’s conclusions. Activities that the FAA deems non-commercial can be (and, in some cases, are) subject to the FET. The FET status of each sharing arrangement is set forth below, so that this factor may be considered in determining the best mechanism to use.

State Sales and Use Taxes

Most states impose a sales tax on the purchase and delivery of an aircraft within the state, and nearly all have a similar tax on use of the aircraft within the state. Many operators take delivery in a tax-beneficial state and wrongly assume that they have avoided state taxation. The state where the aircraft is based usually has sufficient nexus to assert taxation, as well as any state where the aircraft is used to a significant degree. Some states also include leasing activities within the use tax, creating implications for any structure that amounts to a lease of the aircraft. Many states provide exemptions for commercial operators (especially those states where airlines have headquarters or large hub operations), creating a tax benefit for "commercial" operations fitting within the state’s definition. Any sharing (or for that matter any operation) should involve careful state sales and use tax planning, considering all states that could assert a claim.

Federal Tax Issues

Federal tax matters often create the most significant financial structuring concerns. This section briefly addresses some of the more common issues.

Depreciation

Aircraft that are used in a trade or business or for the production of income, primarily operated domestically, and not used in common or contract carriage may be depreciated over a five-year MACRS (Modified Accelerated Cost Recovery System) schedule. Aircraft used in common or contract (such as Part 135) carriage are depreciable under seven-year MACRS. Using a charter arrangement can therefore substantially impact the depreciation allowance.

When property is used partially in a manner that would qualify it for depreciation and partially in a manner that would preclude the ability of the owner to take depreciation, the IRS generally allows depreciation to the extent used in the qualifying manner. For example, if an aircraft is used half of the time for personal use and half in a trade or business of the taxpayer, and the other requirements for depreciation are met, then the taxpayer should be allowed to depreciate 50% of the aircraft. Consider this when involved intensively in Personal Use.

To be eligible for deductions associated with an asset's use, such as the depreciation deduction, the property in question must be subject to wear, tear, exhaustion or obsolescence. Accordingly, the IRS does not allow depreciation for property (including aircraft) that it considers inventory or stock in trade, determined under a ?principal purpose" test. If the buyer’s principal purpose of purchasing the aircraft is to use it in its trade or business or for the production of income, then the plane is not inventory and the associated expenses and depreciation are currently taken into account. Conversely, aircraft principally held for sale to others, and not for use by the taxpayer in its trade or business or for the production of income, are considered non-depreciable inventory. This issue is particularly relevant in fractional programs and programs using brokers or sales entities.

Passive Loss Limitations

Even if depreciation otherwise is allowed to be taken, the current ability to recognize losses generated from certain activities might be restricted if the activity is deemed to be "passive." For entities that are "flow-throughs" for federal tax purposes, passive loss limitations are imposed at the level of the individual owners. Therefore, if using flow-throughs, review the following sections carefully.

Passive losses can be taken in a tax year only to the extent that they can be used to offset passive gains from other activities. These often do no exist. The tax benefits of these losses are likely to be lost, or at best deferred. Owners of flow-through entities engaged in significant sharing should determine whether they meet the passive loss tests. The issue often arises when the aircraft is placed in a separate leasing company in order to achieve regulatory or liability objectives.

Grouping of Activities

The easiest way to dispose of passive loss problems is to group activities, where allowed, so as to avoid having any passive losses altogether. The IRS gives taxpayers a good deal of discretion in determining which sets of income and deductions to group together as one activity.

The regulations allow for any groupings that constitute ?appropriate economic units for the measurement of gain or loss? in light of all the relevant facts and circumstances. But if the taxpayer’s groupings are determined to be unreasonable or abusive, the IRS may regroup them. Additionally, grouping must be consistent from year to year. Finally, rental and non-rental functions usually must be considered separate activities.

Rental Activities - the Per se Rule

If passive loss concerns cannot be avoided entirely by grouping to prevent losses, determine whether the group of unprofitable activities will be treated as passive." Rental activities are especially problematic because the IRS treats them as per se passive. There are six regulatory exceptions to this per se treatment, but they are often difficult to meet. Even if the taxpayer can apply an exception, the inquiry is not over. The individual owner of a flow-through entity must also pass the "material participation" test.

Material Participation

Whether non-rental activities will be considered passive or active depends upon whether the individual owner meets one of the seven material participation tests, applied on an activity-by-activity basis. If the taxpayer materially participates, he or she may treat the non-rental activity as active. The same is true for rental activities, provided that the per se test is passed. In short, if using flow-throughs, especially for leasing, consider passive loss issues carefully.

Capital Gains Treatment

In 1997 Congress passed the Taxpayer Relief Act, lowering the maximum rate of tax levied on long-term capital gains of individuals to 20-28%. The IRS continues to tax ordinary income at rates as high as 39.6%. The character of items of income and loss as either capital or ordinary in the hands of a flow-through entity generally passes through to the individual owners. Operators generally prefer to obtain long-term capital treatment upon the sale of their aircraft.

Gain from the sale of inventory, stock-in-trade or property held primarily for sale to customers is considered to be ordinary income and not capital gain. Conversely, an aircraft owner may obtain capital gain treatment on the sale of non-inventory aircraft. The IRS generally takes the position that where a taxpayer is engaged in both leasing and selling a certain type of property, gain recognized upon the disposition of all such property is ordinary in nature, including property that was previously leased for some period of time. If the sale is considered to be within the normal course of business of the taxpayer, then capital gain treatment will not be allowed.

Similar to the depreciation issue addressed above, the matter arises if a company in the business of buying and selling aircraft holds the plane for sharing purposes. Any company intending to share use should consider its impact on capital gains treatment, along with the other significant federal tax issues discussed above.

Income Tax Treatment

Personal Use of the company aircraft can give rise to income tax liability. See the discussion below.

Liability and Insurance Issues

Aircraft sharers should consider carefully the liability aspects of any arrangement, and ensure that insurance policies allow the activity in question. Similarly, the policy should cover all users (usually the owner is named insured and the others additional insureds). Parties using an aircraft owned by another entity should ensure that they are covered, given notice of termination of the policy, and that the policy contains appropriate clauses protecting their interests. If any complex sharing is planned, contact an expert in aviation insurance in the sharing context. Because many structures created to attempt to minimize liability run afoul of the FAA’s charging limitations (see the discussion below on "flight department companies"), companies generally should approach liability as an insurance, rather than structuring, matter. The greater the degree of sharing, the greater the liability coverage should be, and very extensive sharing might require the purchase of a policy designed, from a liability perspective, to cover charter companies, even though operating under Part 91.

Public Company Disclosure Requirements

Finally, public companies must consider S.E.C. disclosure requirements. For example, individual executives that use the corporate aircraft for personal transportation might have to disclose the arrangement (analogous to a constructive dividend for tax purposes) if they are paying less than fair market value (FMV). This will be discussed further in the section on Personal Use.