If the lease rate is too low, a state may impute its own rate or perhaps disregard the lease and charge use tax on the full purchase price. (Illustration: John T. Lewis)
If the lease rate is too low, a state may impute its own rate or perhaps disregard the lease and charge use tax on the full purchase price. (Illustration: John T. Lewis)

Setting a reasonable lease payment

Good news: rates are at record lows. Bad news: a rock-bottom rate can trigger trouble.

Leasing plays a big role in business aviation. A lease transfers possession of an aircraft from the lessor (usually, but not always, the owner) to the lessee. If you think of property as a bundle of sticks, as I was taught to do in law school, the lease gives some (but not all) of those sticks to the lessee, including the right to operate the aircraft when it’s in the lessee’s possession.
Aircraft leases are sometimes described as either wet or dry. According to Federal Aviation Administration regulations, a lease is wet if the lessor directly or indirectly provides at least one crewmember along with the aircraft, in which case the FAA requires that the lessor retain operational control of flights. Arguably, this means a “wet lease” isn’t really a lease at all, but rather an agreement by the lessor to provide a transportation service to the lessee. Dry leases, on the other hand, are usually “operating” leases where the lessee operates the aircraft (or subleases it to another party to operate it for him). The lessor remains the owner, enjoying the benefit of tax depreciation and facing the burden of market depreciation.
There are many reasons to lease business jets. Leasing is currently the customary way for an owner to provide an aircraft to a Part 135 certificate holder for charter flights. Leasing is also a classic way of separating in different entities the liabilities associated with owning and operating an airplane. Many leases are designed to make aircraft available to affiliates of the owner or to avoid payment of sales or use tax on an airplane purchase. Financial institutions offer operating leases (usually between five and 10 years) to customers as an alternative to debt financing.
What’s a fair lease rate for an aircraft? It depends. Financial institutions consider a host of factors in setting the rate, including the term, interest rates, the lessee’s credit position, the availability of options for the lessee to purchase the aircraft and its estimated fair market value on termination. Lease rates to charter operators for purposes of revenue charter reflect the assumed hourly cost of operating the aircraft and the anticipated hourly revenue. As a rule, the charter operator will pocket approximately 15 percent of the gross revenue (excluding the fuel surcharge) and give the balance to the owner as a lease payment. Lease rates between aircraft owners and operators usually involve informed, arm’s-length negotiations based on the value of the aircraft.
But suppose there is no arm’s-length negotiation. In a typical business-jet ownership structure, a subsidiary company acquires the aircraft and immediately leases it to its parent company or another affiliate to operate. The purpose of this arrangement is often to minimize sales/use taxes by switching the target of the tax from the purchase price to the lease payments. Essentially, the initial transaction is regarded as a purchase for resale, so the ultimate “sale” subject to tax is the monthly (or hourly) lease.
In situations like this, there is an irresistible temptation to make the lease payment as small as possible. Assuming the applicable sales tax is 6 percent, if the aircraft is leased for $200,000 per month, the monthly tax is $12,000, and if it is leased for $20,000 per month, the monthly tax is a vastly preferable $1,200. But as aviation attorney Cliff Maine is fond of saying, pigs get fat and hogs get slaughtered. A state is unlikely to recognize an agreement as a bona fide lease if the rate is too low. When the state revenue department figures out that you low-balled the lease rate, it may impute its own rate or perhaps disregard the lease altogether and charge use tax on the full purchase price. Interest and penalties will follow as night follows day.
So how do you set a realistic lease rate? For a long time, the rule of thumb was 1 percent of the aircraft’s value per month. Applying this rule, a $200,000 monthly rate would be perfect for an aircraft you just bought for $20 million. But the cost of funds today is so low that the 1 percent per month rule has lost much of its relevance. Most monthly operating lease rates are well below 1 percent per month, especially for long-term leases of new or near-new aircraft, and sometimes as low as 0.4 percent.
Note that in setting the rate, the aircraft is valued as of the beginning of the lease, so if you’re paying $140,000 per month in the first year on a $20 million aircraft (0.7 percent), the percentage of the aircraft’s actual value represented by that payment will be much greater 10 years later. This is one reason, no doubt, why rates tend to be significantly higher for short-term leases (up to three years) than for long-term ones. If this concerns you, you could try to “mark the lease rate to market,” as it were, on some regular basis, to take into account the aircraft’s depreciation in value.
But even an economically sensible lease rate may not work in every jurisdiction. Some states have lease rate expectations more suitable for when Nixon was president. To take advantage of the resale exemption in Texas, for example, a lease between related parties must be in the “normal course of business,” and Texas has decided that a monthly lease rate of less than 1 percent (and more recently less than 1.13 percent) doesn’t qualify. As a result, when entering into a lease between related parties, it’s wise to obtain a written rate appraisal from an established professional that you can retrieve from the file when the state revenue agent knocks on the door. 
Aircraft sales-tax expert Phil Crowther suggests that you might try to provide in your lease that if the state decides the rate is too low, it is automatically and retroactively revised to be the minimum rate the state deems reasonable. That’s an interesting idea, but one yet to be tested in practice. Meanwhile, remember that hogs get slaughtered. 

Jeff Wieand welcomes comments and suggestions at jwieand@bjtonline.com.

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This article does a great job of clearly articulating answers to many questions one might have on airplane leases.

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