Jul 14, 2010

Beware The “Flight Department Company”

The majority of U.S. corporations flying their own aircraft operate under Part 91 of the Federal Aviation Regulations, the catch-all part of the FAR that authorizes private flying – or they believe they are operating under Part 91.

But it is probably safe to say there are many corporate operators violating the FARs by their operating structure without being aware of the fact. The rule in question is this: Part 91 operators are prohibited from accepting anything of value as compensation for flying passengers or cargo. Although Part 91 contains exceptions to this rule, the criteria for these are quite limited. The Federal Aviation Administration (“FAA”) has long taken a very restrictive view of what constitutes private aviation, as opposed to aviation “for compensation or hire” that requires an FAA operating certificate. This official view is tighter than many aircraft operators may expect.

For example, let us suppose that Company X operates a commercial business and decides to acquire an aircraft to support that business. To protect against the risk of third-party liabilities, Company X creates a wholly-owned LLC. It arranges for the LLC to purchase an aircraft, employ pilots and fly Company X’s employees and cargo. The sole reason for the LLC to exist is to own the aircraft and operate it for Company X. Company X reimburses the LLC its fixed and variable costs of owning and operating the aircraft. This LLC structure would appear to provide the benefit of limiting Company X’s liability in the event of an accident with the aircraft.

But instead Company X has created a violation of the FARs because the LLC is providing flight services for compensation without a required charter operator certificate. Why is Part 91 not sufficient authority for the LLC’s activity? The reason is that Part 91 authorizes companies to fly their own or affiliates’ people or cargo only to the extent each flight is “within the scope of, and incidental to, the business of the company” doing the flying. Here, Company X is not flying its own people or cargo. The LLC is doing the flying, the LLC is separate from Company X and the LLC has no business of its own apart from flight services. Funds from Company X in compensation are paid to the LLC or for its benefit – either by straight fees, by capital contributions or by payment to providers. In this manner, the LLC is receiving “compensation or hire” for flight services without authorization. You may observe that Company X controls the LLC 100%, and as a wholly-owned entity the LLC would be disregarded for federal income tax purposes. It is true that the IRS does not regard the two entities as separate. But to the FAA, they are completely separate. The FAA’s view of the separateness of entities such as the LLC above, often called “flight department companies,” is that strict. Such flight activity is treated by the FAA as an illicit charter operation.

What are the consequences of this type of violation? First, if discovered by the FAA, each instance of violation could bring a fine of up to $11,000. Worse consequences, however, are possible if an accident should occur with the aircraft. In applying to purchase aircraft liability insurance for the LLC, Company X informed the underwriters the aircraft would be operated only under Part 91. The insurance was issued based on this representation. Accordingly, the policy covers only private flying for corporate purposes (called “industrial aid” in the insurance world). It does not cover any type of “for-hire” operation other than the strictly limited exceptions built into Part 91. If on investigating an accident, the insurer should discover the “for-hire” operation in violation of the FAR, it may be presumed the insurer would be at least tempted to deny coverage — just when the insurer’s duty to defend and indemnify the operator may be most needed. Further, if a court should find that the LLC was significantly undercapitalized for the flying endeavors it was undertaking, the liability veil of the LLC could be pierced, leaving Company X with a substantial uninsured liability.

There are a number of potential solutions to the problem. One solution is for the entity that has the operating business in it – Company X in the example above – to own the aircraft, employ the pilots and operate all flights. That company may operate the aircraft for itself or for other companies in its corporate group for compensation up to the full costs of ownership, operation and maintenance of the aircraft, as long as flights are within the scope of and incidental to its business. Under this structure, a strong policy of aircraft liability insurance is key to the protection of company assets. A second possibility is for the wholly-owned, single-asset entity to own the aircraft and lease it to the parent corporation on a “dry” basis – that is, without crew. The crew would be employed directly by the parent corporation. Because the parent is the aircraft operator, the same insurance considerations will apply as in the first suggested solution. A variant of this second solution is to create an LLC which is owned by principals in Company X and dry-leases the aircraft to Company X, with the additional caveat that federal tax deductions associated with the aircraft may be passive, in which case they will offset only passive income, dry leasing being generally a passive activity for IRS purposes. A third solution would be to identify a company in the overall corporate group that has a substantial business of its own (other than air transportation). That company may own the aircraft and operate it for itself, the parent and any subsidiaries of the parent as long as the business of the operator has sufficient relationship to the purpose of the flight.

The solutions to the “flight department company” problem are practical and well known to aviation advisers. But oftentimes, the existence of the problem may not be known to those who have it. Are you operating a flight department company?

Share via
Copy link
Powered by Social Snap