Private Business Aviation as an Alternative to Commercial Airline Travel

An alternative to commercial airline travel (which is often expensive and cumbersome) is private business aviation. Options include charter flights, timeshares and leases or purchases of a business jet. For purchases, it may be preferable for a related leasing entity to buy the jet, such as a limited liability company (LLC). When purchasing, it is important to take into account the passive activity loss rules if the leasing activity will generate a net operating loss. Net present value (NPV) calculations (which include the new 50% bonus depreciation deduction enacted as part of the Jobs and Growth Tax Relief Reconciliation Act of 2003
(JGTRRA)) indicate a strong preference for purchasing a jet.

According to the National Business Aviation Association, companies invest in private aviation primarily to save time and improve employee productivity. With commercial airline service available at 500 national airports and private aviation at more than 5,000, convenience is also a factor. Before committing its resources, however, a company should analyze whether private business aviation meets its travel requirements. This depends on how many employees will be using the aircraft and the cost savings, as well as the transactions accounting method and the potential tax benefits. A company that wants to use private aviation, but is reluctant to own a plane directly, should consider forming a partnership comprised of employee-shareholders who would lease the plane to the company.

Charter Flight Service

Companies with less than 100 hours of business travel per year will find charter-flight service most economical when four or more employees travel to the same destination. Some charter-flight service companies have recently launched membership programs, permitting companies to purchase a set amount of flying time with few strings attached; see Carey, Fare Wars Hit the Jet Set: Sharing a Plane for Less, Wall Street Journal (10/23/02), p. D1.      

Fractional Ownership

Companies with as few as 100 flight hours per year should consider purchasing a one-eighth fractional-aircraft-ownership interest. Fractional ownership is a lien-free interest not affected or encumbered by other owners financial obligations, and it offers the benefits of private aviation without the burden of management responsibilities. A company selling fractional-ownership interests manages the owners interest for a monthly fee, which covers all fixed costs (e.g., pilot salaries and training, storage, regular refurbishment, administration and insurance).

Fractional owners are legally liable for passenger safety and should carry insurance sufficient to cover any admitted or legal liability. In addition to the initial fractional-share purchase price and annual fixed costs, there is an occupied hourly fee based on the number of flight hours per year, which covers fuel, maintenance, flight crew and catering, and Federal excise taxes. This fee is based on the actual time fractional owners spend on the plane flying to their destination (excluding time required to ferry the aircraft to the departure location). If the particular aircraft is not available for a desired flight time, the timeshare company will dispatch another aircraft from its fleet through exchange agreements with other fractional-interest owners.

Most timeshare agreements are for five years and permit carryover of unused hours to subsequent years, as long as the total hours used in any five-year period do not exceed 1,000. Some fractional-ownership programs require a mandatory repurchase agreement every five years, while others involve a simple renewal of the management agreement at prevailing monthly and hourly rates.

Commercial and charter airline expenditures are treated similarly for financial accounting and tax purposes. Charter aviation expenses are deductible as travel expenses under Sec. 162(a)(2) and Regs. Sec. 1.162-1(a) if they are adequately documented and substantiated as ordinary and necessary. The proper accounting treatment of a fractional-ownership interest is determined by whether the transaction is classified as a capital lease (purchase) or as an operating lease under Financial Accounting Standards Board (FASB) Financial Accounting Statement No. 13, Accounting for Leases.

Purchase of Aircraft

A company with more than 400 flight hours per year may want to purchase a business jet. With the wide range of aircraft to choose from, it can match its budget to its air travel needs. Unlike an automobile, an airplanes residual value declines only modestly, due to the high demand for used aircraft.

Example 1: C Corp. is considering whether to purchase a business jet to ease the travel demands made on its sales and marketing team, which in the past year booked over 400 flight hours. Flight delays, canceled flights and security issues plagued the team, resulting in the cancellation and/or rescheduling of key presentations. To avoid similar situations, C is considering buying a business jet. If so, it would hold the jet for 60 months, and plans on using an 8% discount rate, incurring a 3% sales tax and paying a 9% interest rate annually. Its marginal tax rate is 35%.

 

A jet is depreciated for tax purposes using seven-year modified accelerated cost recovery system depreciation and would be eligible for the 50% bonus depreciation deduction if it is original use equipment purchased on or after May 5, 2003 and before 2005; see Regs. Sec. 1.48-2(6)(7) and JGTRRA Section 201(a). As shown in Exhibit 1, purchasing is preferable to leasing and results in a NPV savings of over $9.8 million without bonus depreciation, and over $10.6 million with it. The NPV of the cash outflows is reduced by 5.7% with a bonus depreciation election. Management fees and occupied hourly fees also affect the cash outflows NPV, but they are not considered, because they are the same whether or not the transaction is treated as a purchase or as an operating lease.

Alternate Ownership Strategies

A publicly traded corporation may be reluctant to purchase a business jet, as this can have a negative effect on its balance sheet, earnings per share (EPS) or stock price. Alternately, it can create a separate entity to purchase the jet and lease it back to the corporation. To avoid financial statement consolidation with the new entity, the corporation cannot have a majority interest in the leasing entity; see FASB, Interpretation No. 46, Consolidation of Variable Interest Entities. An entity formed by shareholder-employees to conduct business with a related corporation will avoid the consolidated financial statement requirement, but must have a business purpose and be a valid tax entity; see Masoni, TC Memo 1968-129; Interior Securities Corp., 38 TC 330 (1962); and Grenada Indus., Inc., 17 TC 231 (1951). Care must be taken to negotiate a fair rental value lease between the entity and the corporation, to avoid Sec. 482, which gives the IRS the authority to reallocate income and deductions to reflect clearly the separate incomes of the entities involved.

An LLC is one possible entity choice. Under the Regs. Sec. 301.7701-1 check-the-box provisions, an LLC can be treated as a partnership, permitting losses from the rental activity to flow through to the members. Also, if the LLC were to become profitable, this structure would avoid double taxation.

LLC members may participate in management without losing their limited liability status, which is crucial in meeting the Sec. 469 material-participation requirements. In a recent district court case, Gregg, 186 FSupp2d 1123 (2000), the Service argued that LLC members should be treated as limited partners because of their limited liability. The court disagreed, calling the regulations dealing with limited partners (Temp. Regs. Sec. 1.469-5T(e)(3)(i)(B)) obsolete as applied to LLC members, because an LLC is materially distinguishable from a limited partnership. Thus, LLC members can meet these requirements without jeopardizing their limited liability status.

In addition to the standard purchase/lease input parameters used in Exhibit 2, the Sec. 469 passive-activity limits are incorporated into the NPV analysis and affect an LLC members after-tax cashflow. Each members share of flowthrough profit (or loss) is computed with and without bonus depreciation and with and without meeting the material-participation standard.

Example 2: The facts are the same as in Example 1, except that three C shareholder-employees form an LLC, purchase the jet and lease it to C for the jets fair rental value. Each member has a 35% Federal marginal tax rate.

Whether or not the material-participation standard is met, the LLC members are better off purchasing the aircraft rather than leasing it. Exhibit 3, shows that by electing the 50% bonus depreciation deduction on a new business jet acquired after May 5, 2003 and before 2005, each LLC member increases his or her cashflow by over $460,000, if he or she meets the material-participation requirement, and by over $31,000, if he or she does not.

Conclusion

Preferably, the LLC will purchase the business jet and lease it to the corporation, and the LLC members will meet the Sec. 469 material-participation rules. The LLC members receive an ordinary loss on their individual income tax returns; the corporation has a dedicated aircraft at its disposal, without having to book an additional liability on its balance sheet.

If the jets rental and operating costs approximate the companys current travel costs, there is no adverse effect on the corporations EPS. Private jet charter and fractional aircraft ownership can be an important cost-savings device for a company with substantial travel costs and can mitigate the problems employees encounter when taking commercial flights.

The spreadsheet used in the NPV analysis is available at www.biz.colostate.edu/faculty/cherieo.

From Cherie ONeil, Ph.D., CPA, Professor, College of Business, Donald Samelson, Ph.D., CPA, Associate Professor and Interim Chair, College of Business and Linda Wingate, MSBA, Colorado State University, Fort Collins, CO (None affiliated with Baker Tilly International)