Strategies to Share the Fixed Cost of
Your Twin Commander
By Louis M. Meiners, Jr. CPA
In financially troubled times, general aviation aircraft operators tend to fly less and therefore have excess capacity for their aircraft. This excess capacity, along with the current general economic conditions, has resulted in substantial deterioration of used aircraft market values. Aircraft operators can find themselves in a position of needing to shed excess costs, coupled with the inability to recover a fair price for their aircraft.
Several strategies are available as an alternative to either sale of the aircraft, or absorbing increased fixed costs. These strategies are available generally to both commercial and noncommercial operators alike. The purpose of this article is to outline operational issues, FAA issues, liability issues, and tax issues in some of the more commonly executed sharing arrangements.
SHORT-TERM LEASE
The first strategy is the use of a short-term lease agreement for a block number of hours. Operationally it is important that this type of agreement provides both accessibility to the aircraft and minimum daily usage re-quirements. The most significant operational limitation is the loss of flexibility among multiple users of the aircraft. The FAA does allow Part 91 use under block-hour lease agreements within certain limitations.
Their principal concern is that the lessee have operational control of the aircraft during their time of use, and clearly have the right to select their own pilots. Because the lessee has operational control, it is imperative that they be included as an additional insured under the owner’s insurance policy. It will also be important to clearly delineate responsibility in an attempt to isolate liability between the lessee and the lessor.
From an income tax standpoint, depreciation will naturally stay with the owner. It will also be important to consider whether or not such an agreement will result in a passive activity classification for income tax purposes. Finally, sales and use tax may be imposed on some, or perhaps all, of the lease payments depending on the tax jurisdiction of the operator.
LONG-TERM LEASE
A second alternative is a longer-term lease. The operational, liability, and FAA issues are similar to a short-term agreement, but the tax consequences can differ greatly. Depending on how this lease is structured, it may result in depreciation recapture for the lessor and new basis for the lessee. It is generally possible to draft agreements with the desired tax result as long as both parties are amenable.
Many states impose sales tax on lease agreements that constitute “conditional sale agreements.” This, too, generally can be designed to accomplish a desired tax result consistent with business goals.
CO-OWNERSHIP
The next option involves a shift to co-ownership. This can be accomplished in a number of ways including co-ownership designated as such on the FAA Registry, or ownership in a separate legal entity such as a partnership, limited liability company, or a corporation.
Regardless of the form of co-ownership, aircraft owners are strongly encouraged not to refer to co-owners as partners. The reliance by a third party on the designation of a co-owner as a partner may result in joint and several liability between those co-owners.
Co-ownership has the same potential conflicts of usage as short-term leases, but co-owners expect a greater level of access than a lessee. Co-owners also generally have the right to partition the property in the event of a dispute. It is therefore important that co-owners enter into an agreement that outlines rights and responsibility both as to usage and disposition.
It may be possible to contractually limit liability in certain cases between co-owners, but generally it will not be as effective as the use of a limited liability company. Therefore, co-owners should consider placing their respective ownership of the aircraft in an entity that has some asset protection capability where possible.
The FAA not only allows for co-registration on its registry, but also allows co-owners to share pilots. When a portion of the aircraft is sold to a co-owner, it will result in depreciation recapture of that pro rata share. The new co-owner will begin depreciating the asset as appropriate. Unless the co-owners are involved in the joint conduct of a trade or business, it generally will be possible for them to elect out of the partnership provisions of the Internal Revenue Code and treat each of their respective interests separately.
Generally, there will be sales and use tax imposed on an exchange of a partial interest of an aircraft unless an exemption provides for exclusion. Co-owners generally become named insureds on the insurance policy and may have differences in liability limits depending on the experience of their respective pilots.
LIMITED LIABILITY COMPANY
The second more common co-ownership arrangement involves the use of a limited liability company taxed as a partnership under the Internal Revenue Code. This differs from FAA “co-ownership,” where multiple people or entities are registered co-owners, in that a single LLC is the sole registered owner but the LLC is owned by multiple aircraft users.
We generally discourage clients from operating aircraft in partnerships due to the inability to escape liability for a partner’s negligence. We believe that a limited liability company offers all the benefits of a partnership without the liability. Of course, the same operational issues for other co-ownership arrangements apply to limited liability companies. Rights to partition the property often are statutory for limited liability companies and therefore should be clearly outlined in the operating agreement.
The FAA prohibits partnerships owned by corporations from registering an aircraft. Nonetheless, it does not prohibit corporate membership in a limited liability company.
Often there is some flexibility in the income tax treatment of either the admission of a partner or the sale of a partnership interest. The Internal Revenue Code often allows partners to dictate their own tax consequences when the adverse interests control and the agreements have substantial economic effect. Therefore, under certain circumstances the admission of a partner will not trigger depreciation recapture, nor provide the acquiring partner full depreciation on their investment.
On the other hand, if the parties seek to treat the transaction as resulting in depreciation recapture and a new basis of the acquiring partner, the agreement can be designed to do so. Regardless of how the transaction is treated at the time of acquisition, partnership basis and distribution rules often result in income allocations due to shift of ownership. This is an area of the law where adverse interest of the parties often dictates disclosure, negotiation, and agreement, by separate counsel.
THE CHARTER OPTION
Another common method of recovering a portion of fixed cost is the placing of an aircraft on a charter certificate. Although the owner generally has the ability to schedule ahead of charter use, there is nonetheless some loss of flexibility if the income flow is to be viable. The FAA and the DOT have specific rules governing charter operations of aircraft partially used for non-commercial use.
Although charter use generally will constitute business use for income tax purposes, special care must be given to control passive activity loss classification, and therefore loss of deductions. Sales tax varies significantly by jurisdiction and in certain instances may be due on the value received from the charter operator.
If the aircraft is used in charter, a commercial insurance policy will need to be adopted and premium rates often will increase significantly. Although many aircraft owners benefit from a contribution toward fixed costs from charter operation, it is necessary for the owner to generate significant charter revenue to offset incremental fixed costs in insurance and maintenance.
In summary, there are many viable alternatives to either the sale of an aircraft in this depressed market, or having increased fixed costs go unchecked while utilization falls.
In every instance, aircraft sharing will result in a loss of flexibility, but a well designed plan may maximize the effectiveness of this alternative.
Lou Meiners, Jr. is an Aviation Tax Consultant for 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. They can be reached at 888-325-1942 or www.advocatetax.com.
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