Alvaro Pascotto

NBAA Fractional Ownership & Part 135 Seminar

Operational Control of Business Aircraft in the New Environment
January 20, 2004 • Van Nuys, CA

Seminar Description

The FAA has changed the landscape of business aviation ownership and operations. Changes affect charter operators, fractional aircraft owners and program operators. How will these changes affect you? Are you ready?

In addition to answering these questions, this one-day NBAA Fractional Ownership & Part 135 Seminar will allow ample opportunities for you to interact with the country's leading experts on fractional and charter operations – the individuals who wrote the new fractional rule. Through this Seminar, you will understand your increased responsibility and the impacts to your operations in light of the recently published changes to the Federal Aviation Regulations (FARs), including the new Part 91, Subpart K – Fractional Ownership Operations and revisions to Part 135.

This Seminar will review in detail the new rule and revisions to the FARs, ownership and operator roles and responsibilities, tax implications and finance options, international operations, and aircraft registration considerations.

Presenters

This seminar will be presented by the industry’s leading aviation regulatory experts, most of whom served on the Fractional Ownership Aviation Rulemaking Committee (FOARC). Speakers will include:

Gary Arber, Esq., Arber, Lannik & Badolato, LLP, Brookline, MA

Douglas Carr, Director, Government Affairs, NBAA, Washington, DC

Mark A. Dombroff, Esq., Dombroff & Gilmore, New York, NY

Gary Garofalo, Esq., Garofalo Goerlich Hainbach, PC, Washington, DC

Eileen Gleimer, Esq., Crowell & Mooring, Washington, DC

Aaron Goehrlich, Esq., Garofalo Goerlich Hainbach, PC, Washington, DC

Kent Jackson, Esq., Jackson & Wade, Overland Park, KS

Dayton Lehman, Jr., Esq., Deputy Assistant General Counsel, US Department of Transportation, Washington, DC

Alvaro Pascotto, Esq., Morrison & Foerster, Los Angeles, CA

Katherine Perfetti, National Resource Specialist, Federal Aviation Administration, Washington, DC

Brint Smith, ARM, Senior Vice President and Global Aviation Practice Leader, Marsh Private Client Services, Seattle, WA

Aircraft Leasing and Passive Activity Rules

by Alvaro Pascotto, Irell & Manella, LLP

If you own and/or operate an aircraft, a broad understanding of complex income tax rules is important to the timing of any losses from the aircraft activities. If the principal business in which you are personally involved for more than 500 hours per year is not aircraft rental operations, you may stop reading now. However, if you are considering setting up your aircraft into an aircraft rental company, this article may be of interest to your income tax planning since it provides a very basic overview of complex “passive activity losses” (PAL) rules relating to aircraft rental.

The brevity of this article does not permit an in-depth discussion of the PAL rules. A survey of the detailed rules may be found in the IRS Market Segment Specialization paper entitled Passive Activity Losses (MSSP), prepared as training materials by the IRS, effective February 1996. At 152 pages, it explains the rules in a thorough, albeit lengthy, way.

Overview

How the PAL rules generally operate could be explained simply by using the example of three buckets. The first bucket stores interest and dividends for the year. The second accumulates salaries, income and losses from business activities in which the taxpayer is directly involved on an ongoing basis. The third bucket accumulates passive income and losses arising from businesses in which the taxpayer does not materially participate (such as limited partnership investments and most rentals). This third bucket is treated in a special manner, since any net losses in a given year generally may not be applied against the income in the other two buckets. In fact, any net PAL must be carried over to years in which there is (1) net income from all passive activities, and/or (2) the complete disposition of the activity that generated the passive loss. When there is net income from passive activities, it may be offset by available passive loss carryovers. In a year when there is a complete disposition of a passive activity, related PAL may be applied without limitation to reduce the income from the first two buckets.

Definitions and Analysis

Basically stated, there are two kinds of passive activities:

(1) activities that involve the conduct of a trade or business in which a taxpayer does not materially participate on a regular, continuous and substantial basis;

(2) rental activities, regardless of the level of participation, including both equipment and rental real estate, subject however, to certain exceptions. Long term equipment rentals (generally over seven days), such as aircraft leases, also are passive.

The PAL rules apply to individuals as well as partnerships, limited liability companies, S corporations, trusts, estates, personal service corporations and closely held corporations. In the case of these entities, the categories of income (or buckets) are accounted for at the entity level and then as appropriate are passed through to individual owners for application for the PAL rules.

As the ownership and/or operations of an aircraft usually create losses for income tax purposes, it is important to determine whether such losses would be characterized as PAL. This would generally occur when the aircraft is leased or rented to lessees/customers for an average of more than seven days, or when the use of the aircraft is in a trade or business in which the taxpayer does not materially participate.

Material participation requires the taxpayer to participate in the operations of an activity on a regular, continuous and substantial basis. Complex and technical regulations interpret this standard by providing seven different tests to determine material participation (mostly quantitative time tests).

Often it may be difficult to satisfy the material participation tests when an aircraft is involved, un-less the taxpayer can group various closely related endeavors into a single activity before applying the material participation definitions. The regulations state that one or more business activities should be grouped into a single activity if the activity constitutes an appropriate economic unit for the measurement of gain or loss. The taxpayer may use any reasonable method of applying the relevant facts and circumstances in grouping activities, with five factors given significant weight. The result can be favorable categorization in the second bucket, rather than the third one. The IRS, however, closely scrutinizes such groupings. Additionally, the regulations prohibit the grouping of a rental activity with a trade or business activity unless the activities being grouped together constitute an appropriate economic unit and either the rental activity is insubstantial or each owner has the same proportionate ownership percentage.

Summary

If you are planning to acquire or operate an aircraft, you may wish to determine how the PAL rules will apply to your income tax returns. Assuming substantiated business usage, PAL rules may delay the tax benefits of any losses from the aircraft’s ownership and/or operation. Such delays in tax benefits can be overcome by (1) generating net passive income in the year from all your passive activities, or (2) meeting the material participation tests, perhaps by the artful grouping in defining your activities. Otherwise the tax benefits from the aircraft losses will be delayed and factored in at its disposition. In any case, care is suggested as the IRS closely monitors both aircraft activities and passive activity losses.