The Use of Business Aircraft: It's All in the Details
Author: Eileen M. Gleimer.
The increasing use of airplanes and helicopters by mine operators and other natural resource owners has helped minimize travel time, maximize efficiency, and increase flexibility. Although the aircraft themselves provide significant benefits, they come at a price. First, these aircraft can cost millions of dollars. In addition, owning and operating aircraft brings the potential for significant liability. To address the financial concern, companies may share the use and cost of the aircraft with other entities, whether affiliated or not. On the liability side, aircraft are frequently placed in affiliates or subsidiaries that are formed for the specific purpose of operating them in an effort to limit liability and insulate the company with the assets. By placing the aircraft in that entity, the liability and assets of the company will be insulated from liability. Or will they?
Although these attempts to minimize cost and liability make good sense in the business world, they are often at odds with the applicable legal requirements. That does not necessarily mean that the business objectives cannot be met; it just means that meeting them may be a bit more complicated. The complications stem from the fact that aircraft operations are subject to a multitude of confusing and often conflicting regulations issued by the Federal Aviation Administration ("FAA"), Department of Transportation ("DOT") and Internal Revenue Service ("IRS"). As a result, an understanding of these rules should be the starting point for a company to determine whether the aircraft it intends to acquire can be used as intended and whether existing aircraft operations are in compliance with law.
Many corporate aircraft are operated under Part 91 of the Federal Aviation Regulations ("FARs"), the general operating rules for U.S.-registered aircraft. Because Part 91 contemplates, in most instances, the operation of an aircraft by an owner (or lessee) for itself, it is less restrictive and generally does not require that the company have an operating certificate or license from the FAA. This is to be contrasted with the far more extensive and restrictive regulations applicable to air taxi operators (i.e., aircraft charter companies), which are in the business of providing air transportation for hire. Among other things, Part 91, unlike the regulations governing air taxi operators/charter companies, does not specify minimum rest periods or maximum hours of operation by crewmembers, and, for example, permits the use of shorter runways and airports without FAA-approved weather reporting services and the operation of aircraft with lower levels of visibility. These factors and others provide greater flexibility for the business operator than is available for air taxi operators/charter companies.
The Problem of Compensation. The tradeoff for not being licensed, however, is a general prohibition against operating for compensation or hire. Only in very narrow circumstances may a company operating under FAR Part 91 receive compensation for operating the aircraft. These exceptions to the "no compensation" rule, however, are available only for large aircraft (i.e., more than 12,500 pounds maximum certificated takeoff weight) or multi-engine turbojet aircraft. For the operator of a helicopter or other aircraft that does not meet the eligibility requirement to avail itself of these cost-sharing mechanisms, it would need an exemption from the FAA.
Assuming the aircraft meets the eligibility requirements (by definition or exemption), compensation will only be permitted if the operation of the aircraft is incidental to the primary business of the company (in other words, the company must engage primarily in a business other than operating the aircraft - mining, for example). Even if the carriage is incidental to another business, there are still strict limits on when compensation may be received and the amount of such compensation. For example, if the aircraft is operated "within the scope" of the operator's business (other than transportation by air), the operator may carry its officials, guests, and property as well as those of its parent, subsidiaries, or subsidiaries of its parent and may be reimbursed for the fully allocated cost of such operation(s). If the carriage is not within the scope of the business, other options may be available for more limited reimbursements which, in most cases, will not result in a fully allocated cost reimbursement. Determining what is and what is not "within the scope" is not always easy and requires an examination of the reason for each passenger's presence on the aircraft and the party benefited by such presence.
As opposed to the narrow interpretation placed on situations where compensation may be received by an unlicensed operator, the FAA broadly interprets the meaning of "compensation." Most significantly, compensation may be found to exist even though dollars do not change hands. For example, inter-company chargebacks or bookkeeping entries, quid pro quos, the expectation of future business, or the transfer to the operating party of anything of value would constitute compensation in the FAA's eyes.
The most common pitfall in the operation of corporate aircraft is the creation of a separate entity that serves no purpose other than operating as the flight department for the corporate family or its owners. Although this is typically done to limit liability, the receipt by that entity of compensation for the carriage of persons or property (in the form of chargebacks, reimbursement of expenses, and quite possibly capital contributions) requires it to hold an air taxi certificate. The fact that the company carries only its parent, affiliates, or owners does not change the end result. In the absence of an air taxi certificate, the company is operating in violation of the FARs. A significant concern for such a company is the impact such operations may have on the entity's liability. Specifically, if the owner is operating unlawfully, the insurer may seek to deny coverage if a claim is made - a position that has been upheld by courts in certain cases. Similarly, grounds may exist to pierce the corporate veil since the company was formed for an illegal purpose. In addition to the liability concerns, the pilots could be subject to FAA enforcement action (which could result in the loss of their licenses), or the company could be subject to substantial civil penalties. From an IRS perspective, the federal transportation excise tax (described in more detail below) would be due.
Using a Management Company. Some aircraft owners hire a management company in lieu of having their own in-house flight department. This typically involves, among other things, the management company employing and providing crews, coordinating the operation of the aircraft, arranging or providing maintenance, and preparing and maintaining all necessary documentation relating to the aircraft. While most management companies are licensed air taxi operators, the owner's flights are usually operated under the less stringent requirements of Part 91. Under such circumstances, the management company is not the "operator" in the FAA's eyes despite the fact that it provides the crew and most, if not all, of the services required to operate the aircraft. Instead, the owner is the "operator" and therefore has the potential civil and regulatory liability for any violation of the FARs or any injury, death, or property damage arising while the owner is "operating" the aircraft. Although the owner may have a breach of contract claim against the management company, in the case of FAA violations, the FAA will look to the owner.
Fractional Ownership. Interests in aircraft are frequently acquired through fractional ownership programs that provide all of the support for the aircraft as well as alternate aircraft. Despite the broad role played by the program manager, the purchaser of the fractional interest is the operator of its aircraft and any other aircraft it uses in the program. Thus, the same rules and restrictions apply to these owners as apply to owners or lessees of whole aircraft. In other words, a single-purpose entity may not be the fractional owner, and any compensation received by the fractional owner must fit within one of the narrow exceptions to the certification requirements.
Is the Owner a U.S. Citizen? In addition to the restrictions on types of operations for which limited compensation may be received, an examination must be conducted to determine whether the owner of the aircraft is a "citizen of the United States" as defined by the federal aviation statute. For a corporation, citizenship requires that the corporation be organized under the laws of one of the states in the U.S., that the president and two-thirds of the other managing officers be citizens of the United States, and that at least 75% of the voting stock be owned or controlled by U.S. citizens. For a partnership, all of the partners must be individuals who are U.S. citizens. If any of the partners is other than an individual, the partnership is not a U.S. citizen for FAA registration purposes. Determining citizenship requires an examination of all entities in the chain of ownership. If at any point in the chain, the citizenship test is not met, all entities below that point will fail the citizenship test. For aircraft registration purposes, this means that the aircraft may only be registered at the FAA if it is owned by a company formed in the United States and is "based and primarily used" in the United States (i.e., 60% of its flights are between two points in the U.S.), through the use of an owner trust or, in some cases, a voting trust.
Although the failure to meet the definition of U.S. citizen can easily be remedied for purposes of registering the aircraft at the FAA, it raises significant issues for purposes of the economic regulations administered by the DOT. If the operator of the aircraft is not a U.S. citizen (regardless of whether the aircraft is U.S.-registered), the DOT will view the aircraft as a "foreign civil aircraft," which is defined as an aircraft "owned, operated or controlled" by a party that is not a U.S. citizen. If classified as such, the company will be required to obtain a foreign civil aircraft permit for flights between the U.S. and points abroad and will be prohibited from operating between two points in the U. S. whenever compensation is involved. As a result of the DOT regulations, the company may be unable to engage in the operations permitted by the FARs. At a minimum, it is likely that the operation will need to be restructured to enable the company to use the aircraft as desired.
In addition to the FAA concerns, the operation of corporate aircraft requires consideration of a variety of tax issues including, among other things, excise tax and imputed income.
Excise Taxes. Although the FAA may classify the operation of the aircraft as non-commercial, the IRS is not bound by such a determination. As a result, excise tax may apply to the cost-sharing mechanisms permitted by the FAA. The applicability of the excise tax also depends, in part, on the relationship between the operator of the aircraft and the passenger traveling. Specifically, if the company carries members of the affiliated group (as defined by § 1504 of the Internal Revenue Code), it is generally not required to collect the excise tax. However, if the aircraft on a particular flight is made available to persons outside of the affiliated group, the exemption is lost and the excise tax would apply to amounts paid by affiliated companies to the owner/operator whether such amounts are paid in cash, through chargebacks or otherwise.
If excise tax does apply, the 7.5% federal transportation excise tax and $3.00 fee per passenger per segment (i.e., the period from each takeoff to each landing) assessed by the IRS must be collected and remitted based on the amount paid for "taxable transportation" starting and ending within the U.S. or within 225 miles of the continental U.S. To the extent the excise tax is paid, a fuel tax credit or refund would be available.
These issues arise regardless of whether the aircraft is managed by an outside company, or, if managed, regardless of whether the aircraft is chartered to outside parties by the management company (although certain issues relate only to aircraft that are chartered to outsiders). If the aircraft is with a management company, the applicability of the tax is primarily determined by an evaluation of whether "possession, command and control" of the aircraft is vested in the company or in the management company. If vested in the company, the tax does not apply. Identifying the party with "possession, command and control" requires an examination of the management structure and agreement and the manner in which they are implemented.
In instances where an owner retains exclusive or substantial control over the aircraft, crew, and availability of the aircraft for the owner's use, and the operating costs effectively flow through the management company to the owner, the IRS has determined that no tax applies to the amount paid to a management company since the management company is acting merely as the aircraft owner's agent. The ability of the owner to use its aircraft whenever it desires and not be pre-empted by the management company's use of the aircraft for another party is strong (but not controlling) evidence that "possession, command and control" of the aircraft remains with the owner.
However, when the management company essentially controls the aircraft, its operations, and maintenance, and the owner does not have the right to pre-empt third party use of the aircraft (even if an alternate aircraft is provided for the owner), the service is essentially the same as a charter. Under such circumstances, the IRS has determined that the excise tax applies to amounts paid by the owner for the transportation service, including the value of owner-provided goods and services, because the owner has relinquished "possession, command and control" of the aircraft to the management company.
Personal Use of Company Aircraft. In many cases, the company aircraft is made available to select executives for their personal use. If the executive is not required to pay for such use, income must be imputed to reflect the value of the fringe benefit. This value is based either on the fair market value of a charter flight in an equivalent aircraft or the results of the mathematical calculation in which the Standard Industry Fare Level ("SIFL") in effect at the time of the flight is multiplied by the appropriate aircraft multiple. An applicable terminal charge is added to the product. The multiples are based on the maximum certified takeoff weight of the aircraft and vary for "control employees" and "non-control employees." Under the fair market value option, the number of passengers on board the aircraft is irrelevant. The SIFL option, however, results in income being imputed to the relevant employee for each passenger on personal travel. The amount to be imputed depends on the number of people on the aircraft on each flight segment, the relationship of the passengers on personal travel to the employee, and the reason the employee is using the company aircraft for personal travel, among other things. Not surprisingly, the IRS does not permit shifting between two options. When one is selected (most typically the SIFL formula) it must be applied consistently or the IRS will use the fair market value option for all personal flights on the company's aircraft.
Because of increasing public concern about executive compensation, some executives prefer to reimburse the company for such personal use rather than have it reflected in their salary. In some instances, the company will calculate the reimbursement based on the SIFL rate. SIFL, however, is intended to be used to calculate the amount of income that must be imputed to satisfy IRS requirements; it is not intended to be used to calculate the amount that may be paid to the company for personal travel. As noted above, the FAA will permit reimbursement only under certain limited circumstances. Since the aircraft is being used for personal travel, it is not "within the scope of the company's business" and, therefore, a fully allocated cost reimbursement is not permitted. The only practical option is the use of a time-sharing agreement where the executive will reimburse the company for twice the cost of fuel and some limited out-of-pocket expenses related to the specific flight. Although the amount calculated using the SIFL formula may be less than the maximum amount that may be collected under a time-sharing arrangement, additional steps would be required to comply with the FARs. Because a time-sharing arrangement is, by definition, a lease for FAA purposes, the executive would be required to have a written agreement with the company, the agreement would need to be filed with the FAA, the local FAA office would need to be notified in advance of the first flight under the agreement, and a copy of the agreement would need to be carried on the aircraft. Furthermore, the company would be required to collect and remit the federal transportation excise tax for the amounts paid under the time-sharing agreement.
In addition to excise taxes and imputed income, aircraft owners and operators are faced with a variety of other tax issues. For example, are all of the aircraft-related expenses deductible, what documentation is required to substantiate deductions, and how does personal use affect the deductible amount? These issues are only the tip of the iceberg. Almost every decision relating to the acquisition and operation of aircraft has tax implications.
There is little question that a company's aircraft is a valuable business tool. Maximizing that value while avoiding the perils and pitfalls relating to its ownership and operation requires a thorough understanding the applicable legal framework. While many pitfalls can be avoided through careful structuring, certain restrictions are unavoidable. A thorough cost-benefit analysis following an examination of the FAA and IRS restrictions is the best way to ensure that utilization of aircraft can be maximized in compliance with the applicable law.
[Editors' Note: The availability of corporate aircraft can greatly facilitate the management of far-flung mining operations and other natural resources properties. But, in this age of federal regulation, you may not be surprised to learn that, to take advantage of the benefits of corporate aircraft and helicopters, there are regulatory and tax shoals that must be carefully navigated. The following article by Crowell & Moring Aviation Group Partner Eileen Gleimer is a primer on some of the pitfalls to watch out for if your company is going that route.]