““The charter industry needs to become much more efficient…We need to take a page from the airlines’ code-sharing agreements…Part 135 charter [operators] could review each other’s schedules, use each other’s airplanes.” ”
What jet buyers must know about taxes, laws and finance
Taking delivery of a business jet is exciting, but maintaining that excitement can be tough, given the daunting work that awaits. Putting aside practical considerations-such as hiring a management company, finding a crew and hangar space and preparing the aircraft for operations-a host of legal, tax, risk-management and financial decisions require attention. Here's a look at the major issues.
Financing the Acquisition
You can't buy a business jet without paying for it, but if, like most jet buyers, you have excellent credit, the financing alternatives are attractive. Business aviation finance remains a buyer's market, with financial institutions in fierce competition for new aircraft loans and leases. Jets make excellent collateral, the loans are easy to administer and the credit of business jet buyers is unparalleled.
The biggest financing question you face is: loan or lease? Barring unusual circumstances, such as concerns about how an aircraft is reflected for accounting purposes, most buyers are better off borrowing. The after-tax cost of loan financing should trump lease financing every time, assuming you have taxable income that depreciation deductions can offset. Loans also offer the most flexibility, since you can repay them at any time, though a prepayment penalty may apply in early years.
On the other hand, if you can't use all the depreciation, you should consider leasing. In a lease, the financial institution buys the aircraft and leases it to you for a monthly payment. You're responsible for all fixed and variable operating costs. As the owner of the aircraft, the financial institution has the benefit of the tax depreciation, so the after-tax cost of lease financing to the financial institution is less than loan financing would be and, in theory, the lessor passes most (but probably not all) of this benefit to you.
You should solicit several proposals from financial institutions on an apples-to-apples basis. When evaluating proposals, it's worth keeping in mind the reputation and relative experience of the various financial institutions in the business of aircraft finance.
First Stop: FAA
When you pay the purchase price at closing, the seller will file a bill of sale that you will need in order to apply for registration with the FAA registry in Oklahoma City. Unless you file a request for expedited registration because of an upcoming international trip, the agency will take at least several weeks to approve the registration; meanwhile, the aircraft can fly within the U.S. on the "pink copy" of the application. You should follow the FAA filing with a filing on the new international aircraft registry based in Ireland.
Not everyone is eligible, however, to register an aircraft in the U.S. The FAA has stringent requirements about who can be the registered owner of an aircraft. Entities that are not eligible include a limited partnership with a corporate general partner, a corporation with a non-U.S. citizen as its president and a company owned directly or indirectly by a non-U.S. company. Make sure you qualify.
Armed with the pink copy, and assuming the aircraft complies with FAA airworthiness requirements, you can fly your new aircraft. The question is: how? The FAA heavily regulates aircraft operations. For most business jets, you must choose between "noncommercial" operations under Part 91 of the Federal Aviation Regulations (FARs) and "commercial" operations under FAR Part 135. This key distinction is often poorly understood. Part 135 lets you carry passengers and property for compensation or hire, so the operational requirements are substantially more onerous than for Part 91. For example, Part 135 contains restrictions regarding crew duty times, runway lengths, required equipment and similar matters that can be expensive and cumbersome for many operators. Moreover, the aircraft will have to be included on, and operated and maintained in accordance with, an FAA commercial certificate.
One benefit of being on a Part 135 certificate is that you can make the aircraft available for charter. That won't pay for your aircraft, but it will help defray fixed costs.
Although Part 91 permits charges for transportation by air in limited circumstances, it is generally designed for an operator providing its own transportation. Thus, a company that used an aircraft in its trade or business could operate under Part 91, but a company that wanted to charge someone else for transportation would, in general, have to operate under Part 135.
In sum, if you don't want to charge for transportation, you'll want to operate under Part 91, and if you do want to charge (especially if you want to charge fair market value), you'll want to operate under Part 135. You may want to do both: operate your own flights under Part 91 and charter the aircraft under Part 135.
No matter how you operate a business jet, you will be exposed to risks of property damage to the aircraft and liability for damage and injury to others. A common strategy to minimize such risks is to arrange for the aircraft to be held and operated by a corporation or other entity created for that purpose, often referred to as a "flight department company." This is a perilous technique, however. As long as the entity satisfies FAA citizenship requirements, the flight department company can own the aircraft, but unless the entity has other business, FAA rules prohibit it from operating the aircraft under Part 91.
Consequently, assuming you don't plan to operate exclusively under Part 135 (in which case the Part 135 certificate holder will be responsible for safe operations), your aircraft will have to be operated by a person or a genuine business. Either way, assets are at risk.
The simple way to address this risk is with insurance. You can buy up to $500 million of liability coverage-an amount that greatly exceeds any damage award to date in connection with a business aircraft accident. Historically, this insurance was relatively inexpensive, even though there were only a handful of providers. Prices shot up after 9/11 but recently improved, in part because new providers have entered the market.
Given the difficulties of organizing a flight department and business jet operations from scratch, many first-time jet buyers retain a management company to assist with operating the aircraft. In addition to providing flight crew, hangar and maintenance, many management companies offer fleet-wide insurance coverage that often represents an excellent value. Indeed, the management company may require you to purchase its insurance. Aircraft buyers should consult their insurance advisers about the advantages and disadvantages of purchasing insurance through a management company.
Another kind of insurance worth considering is title insurance. This coverage is overkill in many circumstances-the purchase of a factory-new airplane from the manufacturer, for example. But if an aircraft has a complicated past with many owners, especially some that are overseas, title insurance offers a relatively inexpensive way to help protect against unanticipated liens and title issues.
Federal Income Taxes
The deduction of the expenses of owning and operating a business jet to reduce income taxes is an important consideration for many buyers. At a 40-percent marginal tax rate, the ability to deduct aircraft expenses can reduce out-of-pocket costs to 60 percent of what they would otherwise be. That's a major advantage when your budget is, say, $2 million per annum.
Of course, to use tax deductions you must be entitled to them, and that's usually possible only if you use the aircraft in a trade or business. If the "business" is more of a hobby, the IRS may disallow deductions that exceed the hobby's income. Moreover, in structuring aircraft ownership and operation, you should pay attention to the IRS' "at risk" and "passive activity" rules, which can result in deductions that cannot be used by the taxpayer to offset income taxes or which are lost altogether.
You're entitled to deduct expenses associated with the use of an aircraft to the extent that the aircraft is employed in a trade or business and despite the fact that the aircraft is principally used in another activity. But the relative percentage of nonbusiness use may affect the timing of tax deductions.
Another major impact on the timing of deductions is whether the expense is capital or ordinary. The purchase price of an aircraft and any capital improvements to it must be capitalized and recognized over time (that is, "depreciated") for tax purposes. An aircraft that's employed more than 50 percent each year in qualified business use can be completely written off in only six years (eight years if the aircraft is primarily used in commercial operations, including charter flights) on a heavily front-loaded schedule. On the six-year schedule, you can write off 48 percent of the purchase price in most cases in the first two years.
But depreciation has an evil twin: depreciation recapture. When you sell the aircraft, you're taxed on the depreciation taken to the extent of the sale proceeds. If you're replacing the airplane with a new one, however, the IRS permits you to avoid the recapture by doing a tax-free exchange. Essentially, your basis for depreciation in the replacement aircraft will be reduced by the amount of taxable income that would have otherwise been recognized. To make a tax-free exchange, you have to follow specific rules, so you should consult tax professionals at the earliest opportunity.
Most other expenses of owning and operating the aircraft used in a trade or business, including fixed expenses such as crew salaries and insurance, and direct operating costs, such as fuel, landing fees and most maintenance, are deductible for income tax purposes in the year incurred.
The biggest income tax issue in business aviation in recent years concerns nonbusiness use of the aircraft. If the passenger is an employee, the IRS treats a free ride on the company aircraft as a taxable fringe benefit, and thus income to the employee. As we've seen, Part 91 generally prohibits receipt of compensation for air transportation, so it may be tough for the employee to avoid the income by paying fair market value for the flight. Fortunately, IRS regulations permit the executive to receive imputed income for the flight using the Standard Industry Fare Level (SIFL), an attractive valuation formula based on first-class airfare. Income imputed under SIFL is usually far less than the actual cost of the flight or a fair market value charter rate.
But though SIFL is a good deal for the employee, it can be a bad deal for the company. Recent tax legislation limited deductions for "entertainment" flights by certain top executives to the amount paid and/or imputed income recognized by the executive for the flight. This means that the company stands to lose not only the difference between the imputed income and the amount paid or imputed; it also stands to lose an allocable portion of the fixed costs associated with the aircraft, including tax depreciation. Dealing with the disallowance of deductions for "entertainment" flights has been a major challenge for tax practitioners, and aircraft buyers should have a plan for coping with this issue before purchasing the aircraft.
Business aviation is subject to two taxes that are often poorly understood even by tax professionals: the excise taxes on fuel and transportation. The fuel excise tax and certain other fuel taxes are payable by the aircraft operator when it buys jet fuel, while the transportation excise tax is payable by the person paying for the transportation.
The transportation excise tax is a tax on commercial aviation-that is, when a party with possession, command and control of the aircraft provides transportation for compensation or hire. The tax is due, for example, on flights conducted under FAR Part 135, such as charter flights, and on certain flights treated by the FAA as "noncommercial," such as a time-share or demonstration flight under FAR Part 91.501.
The rate of the transportation excise tax is currently 7.5 percent of the total amount paid for transportation, plus a modest "segment fee." Because the fuel excise tax is intended to be a tax on noncommercial aviation, the taxpayer is entitled to apply for a refund or credit for it if a flight is subject to transportation excise tax. Given that the transportation excise tax is usually substantially higher than the fuel tax, most tax planning in this area is devoted to avoiding it in favor of the fuel excise tax.
State taxes on aircraft include registration fees, property taxes and various forms of income tax, but the principal state taxes are the sales tax and the corresponding use tax. These taxes are imposed by most states on the purchase price of a business jet. Sales and use taxes can be as little as $300 (South Carolina) or, when combined with local taxes, more than 9 percent (Illinois).
Sales tax is relatively easy to avoid by closing your aircraft purchase with the aircraft physically present in a state that either has no sales tax or has a "fly-away" exemption that eliminates the tax as long as the aircraft leaves the state within a specified period. But if, after closing, you base the aircraft in, or in some cases even frequent, a state with use tax, you may have to plan carefully to avoid being taxed in that state. In many cases, the tax is unavoidable or can be minimized only through an aircraft lease.
This short summary can hardly do justice to the complexity of legal, tax, accounting and similar planning issues facing business jet buyers. However, with the help of aviation professionals, you can address these issues in a satisfactory, though rarely perfect, way. The reason there is rarely a perfect solution is that dealing with a problem in one area inevitably creates another problem somewhere else. The liability shield of a flight department company means operations must be conducted under Part 135. An aircraft lease created to minimize sales taxes causes passive activity losses for tax purposes. A joint-ownership arrangement that makes Part 91 operations possible results in transportation excise tax. And so it goes. But if you work hard and have qualified help, you should be able to fashion a reasonable compromise.
The New Rules of Registration
Since March 2006, when the so-called Cape Town Treaty took effect in the U.S., most American business jet purchasers have had to register their aircraft in two places: first, on the FAA registry in Oklahoma City, Okla.; and then, on the electronic International Registry of Mobile Assets, or simply the International Registry (IR), which is serviced in Ireland.
Ownership rights, security interests and liens in aircraft that were perfected with the FAA prior to March 1, 2006, are "grandfathered" and don't ordinarily have to be re-registered on the IR. Note that the IR also registers interests in aircraft engines as assets separate from the aircraft.
A properly registered interest on the IR will have priority over other interests that aren't registered or are filed later. This "first-in-time, first-in-right" concept represents a major departure from prior law. If an owner sells an aircraft twice, the second purchaser may prevail over the first under IR rules, even though he knew of the first buyer's claims, as long as he files first on the IR.
Accordingly, purchasers and lenders should always check the IR database to make sure the aircraft title is clear. (They should also search the FAA registry and/or relevant foreign registries to determine the status of title and to find out about any liens that existed before Cape Town took effect or that involve non-Cape Town jurisdictions.) And of course, when closing on a purchase or financing, you should make your IR title and lien registrations as quickly as possible. If all parties are willing, you may be able to pre-file to ensure that no one can get on the IR before you.
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