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Volume 12, Number 4 - March/April 2003
Your Client vs. the FAA
The flight department company trap
By Jeff Wieand
Your client, XYZ Corp., calls to tell you it is buying a corporate jet and it wants
your advice about how it should be owned. After counseling XYZ about the
potential liabilities of owning an aircraft, you suggest forming a new corporation or
limited liability company (Newco) to own and operate the jet.
Newco will employ the pilots, handle the maintenance and make the aircraft
available to XYZ Corp. and the other companies in the corporate family. You
explain how your proposal helps to isolate liabilities associated with the aircraft in
Newco, thereby shielding the rest of your client's companies.
Another brilliant legal move? Unfortunately, no. You have just fallen into the flight
department company trap.
Few business lawyers realize that the Federal Aviation Administration does not
permit a single-purpose or "flight department" company to operate an aircraft
without a commercial operating certificate. Most corporate jets are operated under
the general aviation provisions of Part 91 of the Federal Aviation Regulations, 14
C.F.R. Ch. 1, Parts 1.1 et. seq. (the FARs). Commercial operations require a
commercial license (called an air carrier or commercial operating certificate)
issued by the FAA under FAR Part 119.
Just as a taxi driver or limousine operator usually requires a commercial license
to carry passengers in an automobile, so an aircraft operator needs a FAA
commercial operating certificate to carry passengers for compensation or hire on a
CALENDAR
corporate jet. Corporate aircraft flying commercially generally operate under FAR
Part 135, the so-called air taxi or charter regulations.
What does this have to do with Newco? Section 1.1 of the Federal Aviation
Regulations defines a commercial operator as "a person who, for compensation or
hire, engages in the carriage by aircraft in air commerce of persons or property."
The definition concludes by explaining that "where it is doubtful that an operation
is for 'compensation or hire,' the test applied is whether the carriage by air is
merely incidental to the person's other business or is, in itself, a major enterprise
for profit" (my italics).
In numerous interpretations, the FAA has made clear that the last clause of this
definition (known as the "major enterprise test") prohibits a company like Newco
whose only business is air transportation from operating an aircraft without a
commercial operating certificate from the FAA.
Note that the major enterprise test concerns aircraft operations. There is no FAA
prohibition against a flight department company owning an aircraft and registering
it with the FAA in the company's name so long as the company satisfies the FAA
citizenship requirements.
How can you comply with the test? A standard response would be: The major
enterprise test does not apply to Newco because Newco does not intend to make
a profit. XYZ Corp. and other companies using the aircraft will simply reimburse
Newco for flight costs. In fact, Newco might not charge anything for specific
services it provides, but fund flight operations through periodic capital
contributions.
Although this response makes a certain amount of sense, it will not pass muster
with the FAA. According to FAA interpretations, a profit motive is not required for
an aircraft operation to be for "compensation or hire," and under the FAA's
extremely broad interpretation of compensation, capital contributions would
suffice. After all, because Newco has no other business besides air transportation,
how can it operate the aircraft without such contributions, and what are the
contributions for if not to fund the ownership and operation of the aircraft?
In effect, in the absence of any other business, the business of Newco must be air
transportation, and a company in the air transportation business needs a
commercial operating certificate from the FAA.
It follows that Newco cannot operate an aircraft as a flight department company
even if it is a wholly owned subsidiary of XYZ Corp. and provides all of its air
transportation to its parent. FAR Part 91 was amended in 1972 to permit, among
other things, one member of a corporate group to charge - under certain
circumstances - other members of the group for use of its airplane. But the
regulation requires that the air transportation be "within the scope of and
incidental to" the other business of the company (other than transportation by
air).
In the release adopting the amendments (37 Fed. Reg. 14758 (July 25, 1972)),
the FAA explained this requirement by saying that "if a corporation is established
solely for the purpose of providing transportation to the parent corporation, a
subsidiary, or other corporation the primary business of the corporation operating
the airplane is transportation and the carriage of persons or goods for any other
corporation, for a fee or charge of any kind would require the corporation
operating the airplane to hold a commercial operator certificate "
Three years later, the FAA confirmed this view in response to a request from
ELCO Service Co. Inc., a wholly owned subsidiary of Eli Lilly. Eli Lilly proposed to
vest operational control of an aircraft in ELCO, which had no other business than
owning and operating the aircraft. The FAA commented that ELCO could not
furnish air transportation to Eli Lily as its sole business without obtaining a
commercial operating certificate.
Isn't the answer then just to get a commercial operating certificate for Newco?
Then Newco can charge whatever it wants for flights, and maybe even run a little
charter business on the side. Doesn't this solve the problem?
Well, yes it does, but you may merely have substituted one problem for another.
Obtaining your own commercial operating certificate can be an expensive and
time-consuming process. For example, for an aircraft to be included on a FAR Part
135 commercial operating certificate, the passenger seats must be "fire blocked"
using flame retardants and the aircraft may need equipment not required under
FAR Part 91, such as a flight data recorder and cockpit voice recorder.
In addition, you will have to set yourself up as a commercial operator with your
own operating procedures and manual. The requisite FAA approvals could take a
year.
To avoid the difficulties and delays of obtaining your own commercial operating
certificate, you could piggyback on someone else's certificate. For a fee, many
charter operators will agree to include your aircraft on their FAR Part 135
certificate, especially if your aircraft will be available to them for charter
operations when you aren't using it. The charter operator will then be the
operator of the aircraft for all FAR Part 135 flights.
But, because you have fallen into the flight department company trap, your own
flights will have to be FAR Part 135 commercial flights as well. This means that
you will have to comply with the more stringent operational requirements of FAR
Part 135 on matters such as runway lengths, permissible airports and crew duty
times. In addition, you may have to pay the 7.5 percent federal transportation
excise tax for your own flights.
No wonder everyone seeks to avoid complying with FAR Part 135 if possible.
But can't the charter company operate Newco's flights under FAR Part 91? The
same company that provides charter services will frequently offer aircraft
management services (such as pilots, maintenance, hangar and insurance). A
management company can operate some flights as commercial operations (such
as charter flights) while flights for the owner are conducted as noncommercial FAR
Part 91 flights.
But even though the management company provides pilots and other flight
services, if the flights are to be noncommercial, Newco (and not the management
company) must be the operator for FAA purposes and Newco is a flight
department company. Thus the management company can help solve the flight
department company problem only if all flights are FAR Part 135 charter flights.
In practice, the operation of aircraft under FAR Part 91 by flight department
companies is widespread, so your client may know other operators that use a
flight department company. Given your advice concerning the liability protection
afforded by Newco, why not just ignore the FAA requirement? The requirement
doesn't seem to make sense: XYZ Corp. can operate the aircraft itself under FAR
Part 91, but cannot create a wholly owned subsidiary like Newco to do so. That is
form over substance if it ever existed.
Unfortunately, the cost of pretending the flight department company is not a trap
can be significant. First, regardless of what may seem logical or fair, make no
mistake that the FAA's position is that operations by a flight department company
require a commercial operating certificate. On the analysis that a given flight
should have been conducted under FAR Part 135 instead of FAR Part 91, each
separate violation of FAR Part 135 carries with it a fine of $11,000. Thus, if the
FAA decides to enforce the flight department company prohibition on Newco, the
potential fines may add up quickly.
Although enforcing the flight department company prohibition has not been a FAA
priority, there has been at least one FAA enforcement action that proceeded on a
flight department company theory. And your pilots may face FAA sanctions for
engaging in operations without complying with FAR Part 135 requirements.
Another reason not to ignore the FAA requirement is that the flight department
company may violate contractual obligations. Many companies have financing or
other agreements containing covenants requiring the company to comply with
laws, have all necessary licenses, permits and approvals to conduct its operations,
and the like.
Failure to operate an aircraft with a required FAA commercial operating certificate
can constitute a violation of such covenants and place the company in default
under the relevant agreements. Such violations are especially significant in the
case of a lease or secured loan used to finance the aircraft itself, where the
company may run afoul of specific covenants governing the aircraft and its
operations (such as a prohibition on "commercial" operations or a requirement to
maintain the aircraft in compliance with applicable FAA requirements).
There may be federal and state tax consequences as well. Aircraft engaged in
commercial operations are treated differently in various ways by the Internal
Revenue Service from private or "corporate" aircraft. For example, for federal
income tax purposes, aircraft primarily engaged in commercial operations are
generally subject to a seven-year instead of a five-year MCARS depreciation
recovery period, and for federal excise tax purposes, commercial flights are
subject to the 7.5 percent transportation excise tax alluded to earlier.
Although the Internal Revenue Service has declined to follow the FAA as to the
definition of "commercial" aviation (See Rev. Rul. 78-75, 1978-1 CB 340), the
need to operate with a FAA commercial operating certificate cannot be helpful to
the taxpayer if the IRS disputes the taxpayer's claim that aircraft operations are
noncommercial.
Moreover, failing to operate under FAR Part 135 does not incorporate the
additional safety measures the FAA believes are needed for a "commercial" flight.
If your aircraft is involved in an accident, this puts you in a very poor posture for
dealing with the FAA and third-party claimants. Under these circumstances, it is
worth considering whether Newco's corporate veil will provide the intended
protection from liabilities, losses and damages caused by an unlawful aircraft
operation. Reliance on your aircraft liability insurance in this case may be
misplaced, as the policy may in effect disclaim coverage to the extent you were
engaging in commercial operations without authorization from the FAA.
In sum, operating an aircraft out of a flight department company without a
commercial operating certificate is a big mistake.
Can you fashion a structure that will provide liability protection for your client
while preserving the ability to operate under FAR Part 91 without a commercial
license? The answer to this question will depend on a host of factors, but in many
cases you should be able to offer some alternatives.
One option is to try to avoid having a flight department company in the first
place. Under the FAA's major enterprise test, the air transportation must be
"incidental to" Newco's other business. No one knows exactly what that means,
but it is safe to say that if there is sufficient other business in Newco so that the
air operations can appropriately be described as "incidental," you have solved the
flight department company problem.
However, it is important to note that corporate jet operations by Newco for the
benefit of the XYZ Corp. (as opposed to the business of Newco itself) are generally
encompassed by FAR Part 91.501(b)(5), which (as noted earlier) contains the
additional requirement that the flights be "within the scope of" the business of
either Newco or XYZ Corp., depending on how you read the regulation.
And indeed to the extent that you try to avoid the flight department company trap
by adding businesses to Newco that do not require corporate air travel, you run
the risk that the FAA will take the position that the air operations are not
"incidental" to Newco's other business in any substantive sense.
Another option (assuming XYZ Corp. is engaged in other business besides air
transportation) is to lease the aircraft from Newco to XYZ Corp. so that XYZ can
operate the aircraft itself. After all, the major enterprise test does not prohibit
Newco from owning the aircraft, so long as it does not operate it. True, in this
case XYZ Corp. will furnish the pilots and assume the liabilities associated with
operating the aircraft. But XYZ Corp. will hopefully be shielded from any liabilities
that might accrue merely from owning the aircraft.
For example, if Newco engages a charter operator to make the aircraft available
for outside charter in order to raise additional revenue, Newco could be sued
(under various state statutes and case law) in its capacity as owner of the aircraft
in the event of an accident during charter operations even though the charter
operator, not Newco, was operating the aircraft at the time. You would doubtless
prefer in this case that Newco, not XYZ Corp., was the owner.
If you decide to pursue the leasing strategy, XYZ Corp. should carefully examine
the federal and state tax consequences of the lease. In many states, for example,
lease payments are subject to sales and use taxes. Unless lessor or lessee has a
FAA commercial operating certificate, FAA "truth in leasing" requirements will also
likely apply. FAR Part 91.23 requires that the lease be filed with the FAA and that
the local FAA Flight Standards district office be notified in advance of the first
flight under the lease. In addition, the regulations require that the lease contain
certifications concerning the maintenance and operational control of the aircraft.
But XYZ Corp. may want to reconsider forming Newco at all. It is possible to
purchase a significant amount of liability insurance, and the liabilities associated
with the aircraft, when properly insured, may be worse than the other risks of XYZ
Corp.'s business.
A final note. In lieu of purchasing an entire aircraft, XYZ Corp. might decide to
purchase one or more shares in a corporate aircraft fractional ownership program.
As the owner of a share of an aircraft, XYZ Corp. would pay a monthly
management fee and an hourly usage charge and would be entitled to use its
aircraft as well as other aircraft in the program.
But unless the program is operated under FAR Part 135 (which is rarely the case),
this will not avoid the flight department company trap. The FAA regards the share
owner, not the fractional program, as the operator of the aircraft, and if Newco
acquires the share on behalf of XYZ Corp., its aircraft operations must be
incidental to its other business.
Purchasing a new aircraft is an exciting endeavor. There are many ways it can be
done. But whatever strategy you choose, be sure to avoid the flight department
company trap.
Wieand is senior vice president and general counsel of Boston JetSearch Inc.
His e-mail is [email protected].
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