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New Federal Excise Tax Liabilities for Whole Aircraft
Operations Under FAR Part 91 and for Fractional Ownership
By: Keith G.
Swirsky -
Galland, Kharasch, Greenberg, Fellman & Swirsky, P.C.
There is a common perception
among industry professionals and aircraft owners that
Federal Excise Taxes (FET) are not applicable to FAR Part 91
operations for whole aircraft owners and that the fractional
aircraft programs collect all applicable FET. Effective
January 1, 2008, for many fractional owners and whole
aircraft owners operating under the rules of FAR Part 91,
these perceptions will be, in many cases, wrong. Even prior
to January 1, 2008, as will be discussed below, owners have
inadvertently created ownership and operating structures
that result in liability for FET.
New Law
The IRS issued final
regulations (T.D. 9356) under the Self-Employment
Contributions Act that treat qualified subchapter S
subsidiaries (QSubs) and single member limited liability
companies (SMLLC’s), currently considered disregarded
entities, as separate entities for purposes of FET. These
regulations were effective August 16, 2007, and apply to FET
liabilities for periods beginning on or after January 1,
2008. Under these regulations, an entity that is disregarded
for federal income tax purposes is nonetheless required to
pay and report excise taxes, required and allowed to
register with the IRS, and allowed to claim fuel tax credits
and refunds. Since a disregarded entity does not file an
income tax return, the fuel tax credit may be claimed on the
owner’s personal income tax return. The regulations provide
few examples of their applicability; there exists a real
possibility that the IRS will interpret the regulations to
treat an SMLLC or QSub as an entity that provides
“transportation services” to its member or shareholder,
thereby subjecting the contributions and payments to the
SMLLC or QSub to the FET imposed under IRC Section 4261, for
periods commencing on or after January 1, 2008.
Overview and Prior Law
Application to Fractional Aircraft Owners
It is very common for fractional
aircraft owners to set up a new legal entity to acquire
ownership of their fractional share. In many cases this entity
is set up as an SMLLC, or as a QSub, which is treated as a
disregarded entity for federal income tax purposes (or possibly
an S corporation, discussed later in this article). In many
cases this SMLLC or QSub will enter into all of the fractional
program governing documents. The fractional program will invoice
the SMLLC or QSub for the monthly management fee and the
periodic occupied hourly rate charges and other incidental fees.
In order to pay the invoices, the owner of the SMLLC, or the
parent corporation of the QSub, will generally make capital
contributions or provide other funding to the SMLLC or QSub to
pay such monthly charges.
If this fact pattern fits your
current operating structure, the new law effective January
1, 2008, may directly impact you. Specifically, under a
conservative reading of the regulations, your SMLLC or QSub
will be deemed to have provided a transportation service to
you as the SMLLC’s single member, or to the QSub’s parent
corporation, and you will need to perform an analysis to
determine the “amounts paid” subject to FET. This result is
inconsistent with the current fractional industry paradigm
whereby the program collects and remits to the IRS federal
excise taxes on the occupied hourly rates.
Possible Solutions
It may be possible to restructure
the fractional ownership and operating structure to avoid FET,
other than FET collected by the fractional program on the
occupied hourly rate. The key to avoiding application of these
regulations for SMLLCs and QSubs, relates to bifurcating
ownership from operations. In particular, the approach to
bifurcation would require separation of the ownership from the
management into two separate entities and/or persons. The
fractional program documents will need to be revised slightly,
and an additional “Dry Lease” will need to be entered into
between the “Owner” and the “Operator”.
In addition, an anlysis should be
performed to determine if the “affiliated group” exemption
contained in IRC Section 4282 applies. This section provides
that amounts paid for transportation services between and among
entities, eligibile for filing their federal income tax returns
on a consolidated basis, are exempt from the FET imposed under
IRC Section 4261. For these purposes, the exclusion of certain
entities, under the affiliated group rules such as S
corporations, does not apply. Therefore, it is likely that a
QSub will be eligible for the affiliated group exemption, but,
more often than not, an SMLLC will not be eligible.
Application to Whole Aircraft Ownership Operated Under FAR
Part 91
Many owners of whole aircraft have
also set up SMLLCs or QSubs to acquire ownership of their
aircraft and to fund all aircraft operations. As of January 1,
2008, the new regulations described above may apply to these
structures, and these entities may no longer be treated as
disregarded entities for purposes of FET. Accordingly, under IRC
Section 4261, all capital contributions and other funds provided
to these SMLLCs and QSubs to cover aircraft operations will be
deemed “amounts paid” for taxable transportation and may be
subject to FET. Simply put, if your P & L shows a payment to an
SMLLC or QSub of pilot salaries, fuel, landing fees, catering
and other direct and fixed operating costs associated with
aircraft operations, then it is likely that an aircraft
transportation service has been provided by the SMLLC or QSub to
another person or legal entity, creating the FET liability
dilemma.
Professional Management
Many whole aircraft are managed by
professional management companies. In the event you utilize a
professional management company and, assuming the facts above,
the contract for management services has been entered into by
this SMLLC or QSub, it is likely that there is an inadvertent
FET liability applicable to the cost of the “owners” flights.
Application to New York Residents.
Of particular interest, many
owners of aircraft based in the State of New York will have
created ownership and operating structures to comply with the
New York “interstate” commerce exemption, in order to avoid
sales and use tax in the State of New York. The New York
interstate commerce exemption applies to operations conducted
under FAR Part 91, and, with properly structured aircraft
operations, the purchase and use of an aircraft hangared in the
State of New York may be exempt from sales and use tax. The
problem, however, is that such structures will in most cases
result in FET being imposed on the amounts charged by the
aircraft owning entity to the affiliated entity or entities.
This issue is specifically targeted to structures utilizing
SMLLCs and QSubs for purposes of qualifying for the New York
State interstate commerce exemption. Those structures that
utilize C-corps eligible for filing on a federal consolidated
income tax return will not have such a problem as payments
between C-corporations eligible for filing on a federal
consolidated income tax return will remain exempt from FET.
Possible Solutions
As with fractional aircraft
owners, whole aircraft owners may restructure their operations
to avoid the impact of the regulations. Once again, the solution
to the problem rests with creating the bifurcated ownership and
operating structure. In other words, ownership of the aircraft
must be separated from operation of the aircraft into two
persons or legal entities and an additional “Dry Lease” will
need to be entered into between the “Owner” and “Operator”. In
addition, the affiliated group exemption should be reviewed, to
determine its applicability. For those owners in the State of
New York and utilizing a highly structured situation to avoid
state sales and use taxes, restructuring should be done only in
the context of an analysis of the impact thereof on liability
for state sales and use taxes.
Federal Excise Tax Liabilities for S Corporations
If your aircraft is owned by
an S corporation, that is owned by you or several
individuals, longstanding rules promulgated by the IRS
provide that amounts you contribute or pay to the S
corporation to cover the costs of operating the aircraft
(including fixed costs) are subject to FET. If you operate a
whole aircraft under FAR Part 91, this FET liability still
applies. If you are in a fractional program, and remit FET
on the occupied hourly rate charges, then you have shifted
the point of taxation to your S corporation, and an analysis
will be needed to determine the “amounts paid” by you to
your legal entity that are subject to FET. As with SMLCCs
and QSubs, the possible solutions to the FET problems are
identical.
FLIGHT DEPARTMENT COMPANY DILEMMA
It is also noteworthy that in the
event an SMLLC, QSub or Scorporation, with no other business
operations, owns and operates a whole aircraft, or enters into
all of the fractional program documents, there is the likelihood
of a violation of the Federal Aviation Administration’s (FAA) so
called “flight department company” rule. This “flight department
company” rule is violated because the primary activity of the
legal entity is to provide aircraft transportation services for
the entity’s owner(s). The FAA can impose civil fines and/or
undertake pilot enforcement actions in these circumstances. At
worst, if you own an insurance policy that requires all aircraft
operations to comply with the laws of the United States, such as
structure would potentially violate the terms of such a policy.
Overall Federal and State Tax Considerations
Any restructuring of aircraft
ownership and operations to account for the changes in the law
described above will also require a review of issues such as
eligibility for depreciation deductions, characterization of
depreciation as passive or active, and in general, deductibility
of operating expenses. Many aircraft ownership and operating
structures set up through S corporations, whose primary activity
is ownership (and operation) of an aircraft, have other problems
in the area of eligibility for depreciation, and deductibility
of operating expenses under IRC Sections 162 and 183 (Section
183 deals with hobby loss rules).
It is also likely that the
restructuring through a bifurcation of ownership and operations
will necessitate an examination of state sales and use tax
liabilities. The sales and use tax analysis will differ
significantly for fractional owners versus whole aircraft owners
because fractional ownership allows for additional theories of
exemptions from sales and use tax.
My Brain Hurts
It is clear that federal income
and excise tax planning, state sales and use tax planning and
FAA regulatory planning requires a “melting pot” approach. To
determine the best approach to depreciate an aircraft and deduct
operating expenses, to eliminate or substantially reduce sales
and use taxes, to avoid FET, to plan for FAA regulatory
compliance, and liability protection and economic/cash flow
considerations, requires significant aviation and tax expertise
and a large dose of business judgment. The FET liabilities
discussed in this article are only the tip of the iceberg for
those readers who have recognized that they have a problem with
their ownership and operating structure.
The aviation lawyers at
Galland, Kharasch, Greenberg, Fellman & Swirsky are adept at
analyzing these issues and providing tax, FAA and business
oriented guidance on creating an ownership and operating
structure to produce the most advantageous results with the
least amount of risk. The National Business Aircraft
Association (NBAA), is also alert to these FET concerns, and
together with members of the NBAA Tax Committee and its
lobbyists, will be working with the IRS to achieve a
positive result for its members.
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Keith G. Swirsky
is a tax specialist concentrating in the areas of corporate
aircraft transactions and aviation taxation. The firms business
aircraft practice group, chaired by Mr. Swirsky, provides
full-service tax and regulatory planning and counseling services
to corporate aircraft owners, operators and managers. The
group’s services include Section 1031 tax-free exchanges,
federal tax and regulatory planning, state sales and use tax
planning, and negotiation and preparation of all manner of
transactional documents commonly used in the business aviation
industry, including aircraft purchase agreement, leases,
joint-ownership and joint-use agreements, management and charter
agreements, and fractional program documents.
Mr. Swirsky can be
reached at the firm’s Washington, DC office, 1054 31st Street
NW, Suite 200, Washington, DC 20007, telephone (202-342-5251,
facsimile (202)-965-5725, e-mail kswirsky@gkglaw.com .
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IRS Circular
230 Disclosure: To ensure compliance with requirements by the
IRS in Circular 230, we inform you that, unless we expressly
state otherwise in this communication, any tax advice contained
in this communication is not intended or written to be used, and
cannot be used, for the purpose of (i) avoiding penalties under
the Internal Revenue Code or (ii) promoting, marketing or
recommending to another party any transaction or other matter
addressed herein.
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