The corporate jet has fast become one of the key strategic business tools in this country, allowing, for example, a company with a single aircraft to visit multiple locations, customers and prospective customers on the same day, giving the user a decidedly competitive advantage in the market. Not surprisingly, demand for business jets tends to rise as corporate profits and markets grow and expand — assuming, of course, that aircraft financing remains available at reasonable rates and that aircraft operating costs (particularly the cost of fuel) remain at reasonable levels. The economies of the U.S. and other developed countries have provided strong platforms for the business-jet industry over the past several years, resulting in unprecedented levels of new and used jet sales in this country and elsewhere around the world. Until recently.

Over the past several months, companies and consumers throughout the United States have witnessed an economic implosion described as the harshest since the end of World War II, including a $700-billion government bailout of the U.S. financial system, a liquidity crisis, a recession, highly
volatile stock markets, rising unemployment, periods of high and unprecedented fuel and commodity prices and, most recently, pleas for bailout money by Wall Street and the Big Three automobile manufacturers (who recently received some corporate-jet attention of their own).

The reaction thus far to this new environment by those who own and operate business jets has been varied. For those owners whose businesses have been affected by the downturn, some have decided to sell or otherwise dispose of their jets (or at least attempt to do so), while other, less fortunate owners have had to deal with issues of repossession. Still others have decided to stay the course, at least in the near term, by limiting or restricting their aircraft usage and by allowing others
to begin using the equipment on an as-needed basis. Each new use of the aircraft has important FAA and tax implications. Our purpose here is to review some of the alternatives an owner might consider during an economic downturn to help generate some revenue until the economy recovers.

An aircraft owner wanting to bring in a new partner to share the use and cost of a corporate aircraft needs to be mindful of the tax implications.

Aircraft Leasing or Management

An owner may consider leasing the jet to a third party to generate revenue when the aircraft is not in use by the owner or its affiliates. Under the Federal Aviation Regulations (FARs), there are generally two types of leases: wet leases and dry leases. Under a wet lease, the owner/lessor provides the aircraft and at least one crewmember to the lessee; under a dry lease, the owner/lessor provides only the aircraft to the lessee. Wet leasing is the equivalent of operating a charter flight, which, under the FAR, generally requires that the lessor (i.e., the charter company) hold special safety authority issued by the Federal Aviation Administration (FAA) under FAR Part 119, allowing the charter company to operate an aircraft for compensation or hire under FAR Part 135. The FARs, however, contain an exception to this general rule, allowing the owner/lessor — which does not have safety authority from the FAA — to provide the aircraft and crew to a lessee under a time-sharing agreement. The critical catch in a time-sharing agreement is that the maximum amount of compensation
that may be charged by the lessor for each flight is limited to a list of 10 specific trip-related expenses. These permitted expenses include an amount equal to two times the actual cost of the fuel consumed on the flights operated by the lessor for the lessee, but exclude crew compensation and all fixed aircraft expenses, including maintenance and hull and liability insurance costs. Unless the lessor can lawfully charge and collect from the lessee more than the lessor’s cost of providing the transportation — which oftentimes is not the case — a timesharing agreement may not be a very attractive option.

An alternative to wet leasing may be to dry lease the aircraft to a third party. Unlike a wet lease, a lessor may charge and collect from the lessee market rent for the use of its aircraft. In addition to rent, the lessor also may require the lessee to cover all of the lessee’s operating costs associated with its use of the aircraft and participate in certain fixed costs associated with the aircraft based upon its relative use, including costs for scheduled maintenance, hangarage and perhaps insurance. Again, to have a dry lease under the FARs, the aircraft lessor cannot provide any crewmembers to the lessee.
Instead, the lessee must employ or engage the crew to operate the aircraft.

Dry leases can be structured in various ways. It is possible, for example, to create a dry lease or leases with one or more lessees, allowing each lessee to use the aircraft up to a specified number of days or flight hours, so long as the identity of the party then in operational control of the aircraft is clearly
delineated and all required hull and liability insurance is in place under each lease.

Dry leasing raises potential income tax issues. For example, for federal income tax purposes, leasing of aircraft and other assets generally is a passive activity — a result that may limit an owner’s right to immediately benefit from any tax losses attributable to its ownership or use of the aircraft. Depending
on the structure and extent of an owner’s leasing activities, the nature of the owner’s other income (whether passive or non-passive), and a number of other factors, an owner’s tax losses from its ownership or use of the aircraft may be suspended until the aircraft is sold. Dry leasing may also have state sales tax consequences. For example, an aircraft owner/lessor may be a dealer and, depending upon the circumstances, required to collect and remit state sales tax on the rents it receives under the lease.

If dry leasing is unworkable or impractical, an owner also might consider having its aircraft managed by a charter company (with safety authority from the FAA) to operate the aircraft on third-party charters for compensation or hire under FAR Part 135. In such arrangements, the owner generally receives a specified percentage of the charter revenue generated by the charter company when using the owner’s aircraft. An owner oftentimes benefits from lower fuel and insurance costs that may result from the charter company’s volume purchases. For many owners, an arrangement with a Part 135 charter company can reduce the cost of ownership. One practical issue with the charter alternative, of course, is whether the aircraft will see much third-party use in a slowing economy.

Direct or Indirect Sale of Partial Interest in Aircraft

An owner also might consider selling a partial interest in its aircraft to generate revenue or reduce its costs. If the intended use of the aircraft by the co-owners is compatible, a partial sale may be an attractive alternative. The FARs allow multiple parties to own a single aircraft under a joint ownership arrangement. In a joint ownership arrangement, one of the co-owners provides the crew to operate the aircraft for all of the owners. It is also possible for multiple owners to enter into a co-ownership arrangement, under which each co-owner provides the crew when operating its flights. Instead of selling a part of the aircraft, an owner might consider selling a part of the company that owns the
aircraft; in that instance, the company will then lease the aircraft to each owner under separate lease agreements.

When the current member or shareholder of the target company (i.e., the company that owns the aircraft) intends to sell a part of the company to a third party, the transaction can be structured in one of two ways. First, the existing member or shareholder could sell a part of its equity interest in the target company to the third party; or, alternatively, the target company could sell a newly issued equity interest to the third party. In deciding which path to follow for income tax purposes, IRS Revenue Ruling 99-5 (the “Ruling”) explains the tax implications of each choice when the target company (the “LLC”) is owned by a single member (A), who wishes to bring in a business partner (B). The Ruling is particularly helpful since many business jets are owned by single-member limited liability companies.

In the first situation described in the Ruling, A sells 50 percent of his issued and outstanding membership interests in the LLC to B for $5,000. A keeps the entire $5,000 for his private account and does not contribute any portion of the purchase price to the new partnership. In this instance, A is treated as having sold to B, and B is treated as having purchased from A, an undivided 50-percent interest in each of the LLC’s assets. A and B are then each treated as having contributed their respective interests in those assets to the LLC in exchange for an undivided 50-percent interest in the new partnership.

The tax consequences of this transaction are as follows: A will recognize gain or loss on the deemed sale of 50 percent of the LLC’s assets by A to B. The deemed contribution of assets by A and B to the new partnership is tax free to A and B and to the partnership. A’s basis in his partnership interest is equal to his adjusted basis in the assets deemed to have been contributed by A to the new partnership. B’s basis in his partnership interest is equal to $5,000 (the amount he paid A for a deemed interest in the assets). The new partnership’s basis in the assets treated as having been contributed to it by A and B is equal to the basis of those assets in A’s and B’s hands immediately after
the deemed asset sale between A and B. A’s holding period for his partnership interest (for determining long-term capital gain treatment) will carry over from before the deemed asset transaction between A and B. B’s holding period for his partnership interest will begin from the date of the deemed asset sale between A and B.

In the second situation described in the Ruling, B purchases newly issued membership interests in the new partnership from the partnership (and not from A) in exchange for a cash payment of $10,000, which, after the transaction, gives B a 50-percent ownership stake in the new partnership with A. In the Ruling, all of the cash paid to the partnership by B is retained and used by the partnership for business purposes, and is not distributed or paid to A.

The tax implications of this transaction are as follows: B’s payment of $10,000 to the partnership is treated as a contribution to the partnership in exchange for an equity interest and, as such, is not taxable to the partnership or to the new partners. A is treated as having contributed all of the assets
of the LLC to the new partnership in exchange for an equity interest. That deemed contribution is also not taxable to the partnership or to the new partners. Because there is no deemed sale of assets by A, as there was in the situation described above, A correctly recognizes no tax. A’s basis in his partnership interest in the new partnership is the same as the LLC’s adjusted basis in its assets immediately before the assets were deemed to have been contributed by A to the partnership. B’s basis
in his partnership interest is equal to his cash contribution of $10,000. The partnership’s basis in the assets contributed to it by A is the same as A’s basis in the assets immediately before their deemed contribution to the partnership by A. Since B contributed cash to the LLC, the partnership’s basis in B’s contribution is equal to $10,000. A’s holding period for his partnership interest (for determining long-term capital gain treatment) will carry over from his holding period in the LLC’s assets before their deemed contribution to the partnership by A. B’s holding period in its equity interest in the partnership begins from the date of its cash contribution.

Therefore, as indicated in the Ruling, an aircraft owner wanting to bring in a new partner to share the use and cost of a corporate aircraft needs to be mindful of the tax implications of any proposed transaction. If the current owner receives payment from the new partner (either directly from the partner or indirectly from the partnership), he may have the benefit of the payment for his personal use. However, he will also have the burden of any resulting income tax, which could be significant if the aircraft (the asset that is deemed to have been sold by him) has been depreciated for income tax
purposes. On the other hand, if the owner is willing to forego immediate access to the funds, he may be able to defer tax recognition until the partnership either distributes funds to its partners or liquidates.

Conclusion

It is important that aircraft owners and operators avoid the urge to rush into a sale, lease, or management agreement involving their corporate aircraft without carefully considering the regulatory and tax implications of any proposed transaction to avoid costly surprises.