NAFA member, Ryan Swirsky, Associate with GKG Law, discusses aircraft management arrangements and their consequences.
Aircraft owners frequently arrange for aircraft management companies to provide full-service management of their aircraft for aircraft operations under Federal Aviation Regulations (“FAR”) Part 91. However, when the aircraft management company contracts with the aircraft owner, there is the so-called “Flight Department Company Trap” that can result in serious negative consequences.
Some background will be helpful. It is common for a special purpose entity (“SPE”), typically wholly owned by an individual or his or her operating company, to take title to the aircraft. The aircraft management company usually prepares its management agreement for the SPE to sign. This commonly occurs because the management company rarely has any information related to ownership structuring issues.
FAR 91.501(b)(5) allows aircraft operations to be conducted under FAR Part 91 when the carriage of officials, employees, guests, and property of a company on an airplane operated by that company is within the scope of, and incidental to, the business of the company (other than transportation by air) and no charge, assessment, or fee is made for the carriage in excess of the cost of owning, operating, and maintaining the airplane. This generally means that flights must be in furtherance of a primary business activity of the company. For example, flying executives of a company that sells widgets to a manufacturing facility where the widgets are made to oversee production would be within the scope of, and incidental to, the primary business of the company.
Essentially, the Flight Department Company Trap is a situation where the SPE operates its aircraft illegally because stricter FAR are applicable to the SPE’s aircraft operations, but those stricter rules are not followed because the SPE operates the flights solely under FAR Part 91. The primary activity of an SPE would be transportation by air, as there is no other primary business activity being conducted by the SPE (hence leading to the “Flight Department Company” description). Therefore, the SPE will be unable to meet the requirements of FAR 91.501(b)(5). Further, under FAR Part 91, the aircraft operator is not permitted to receive compensation of any kind, except under certain limited exceptions. Capital contributions by an individual or by his or her operating company to the SPE (which would typically be the only way to fund aircraft operations, as the SPE’s only asset is the aircraft) are deemed to be compensation.
With the structure where the SPE enters into the management agreement, the Federal Aviation Administration (“FAA”) would likely view the SPE as providing air transportation services for compensation to the owner of the SPE. The fact that the SPE may be wholly owned by the recipient of such transportation services, or disregarded for federal income tax purposes, is irrelevant.
Fortunately, aircraft owners can still engage aircraft management companies for assistance operating flights under FAR Part 91 if structured correctly. Typically, the structure would entail the SPE “dry” leasing the aircraft (i.e. – lease the aircraft without crew) to an individual or his or her operating business, and the individual or business would enter into the aircraft management agreement. That individual or business would then pay the aircraft management company, and the individual or business would be deemed the operator of those flights by the FAA. Ideally, the SPE would not be involved in any cashflow with respect to the aircraft operating budget and would instead just have cashflow related income from the dry lease.
While, from a practical perspective, it may seem like there is not much difference between the two structures (after all, the same ultimate individual or business is flying on the aircraft, and paying the costs for the flights), use of the incorrect structure can result in serious negative consequences. Those consequences can include violation of insurance policies (and potential denial of coverage by the insurance company in the event of an accident), violation of loan covenants, civil fine exposure by the FAA to the SPE, penalties for the pilots of the aircraft (such as civil fines and license suspension), and federal excise tax liability. Further, liability protection planning may be potentially undermined due to a piercing of the entity veil argument (due to the principal activity of the SPE being to conduct unlawful aircraft operations). It is also more likely than not that this structure will undermine typical state sales and use tax planning.
Aircraft ownership and operation is a complex topic that requires consideration of multiple, often competing, factors. GKG Law’s business aviation attorneys have marshaled extensive knowledge of federal aviation, tax and regulatory issues, and we are one of the leading practices in the country primarily devoted to business aviation law. For more information on this topic or other business aviation related needs, please contact Ryan Swirsky (email@example.com or 202.342.5282).
This article was originally published by GKG Law on September 9, 2019.