Why Most Private Aircraft Operators Violate the FAA's Operating Rules

Narrow Exemptions to Part 135 Certification and Operations

Beginning in the 1970s, the FAA acknowledged that certain Part 91 operators should, in limited circumstances, have the flexibility to conduct cost-reimbursed operations otherwise prohibited under Part 91. Accordingly, the FAA promulgated a number of narrow exemptions to the general rule that no “commercial” operations can be conducted solely under Part 91 (i.e., operations involving the flow of money or other value from one person to another with respect to a flight). These exemptions primarily appear in 14 C.F.R. ' 91.501.

Specifically, the FAA created a number of exemptions for reimbursed flight so long as the operator is not otherwise required to comply with Part 135, generally meaning that the operator is not holding out to the public to act as a common carrier of passengers. For example, companies (but not individuals) can legally engage in time sharing under 14 C.F.R. ' 91.501(c)(1), interchange arrangements under 14 C.F.R. ' 91.501(c)(2) and joint ownership under 14 C.F.R. ' 91.501(c)(2). Each option addresses different operational needs or circumstances of the respective parties. In essence, these provisions allow some limited cost sharing to occur when the operator conducts flights for a limited amount of compensation, without triggering the requirement to comply with Part 135.

It is very likely that 14 C.F.R. ' 91.501(b)(5) provides the most widely used exception to the general “no-compensation” rule. This regulation allows for fully allocated cost-sharing. It states that a Part 91 company can conduct aircraft operations, and receive some reimbursement for those flights, so long as the flights are “within the scope of and incidental to the [non-air transportation] business of the company.”

Stated differently, this exception only applies to a company whose primary business is not commercial air transportation. And this distinction is at the core of the breaches of the FARs we addressed in Part One of this article ' the very common strategy of placing ownership of an aircraft in a special purpose entity (“SPE”), such as a limited liability company, and then using that SPE to operate that aircraft in its own right and as its sole business activity.

By definition, an SPE cannot, does not, and will not fit into this ' 91.501(b)(5) exemption because it exists primarily or solely to conduct flight operations as its major enterprise or primary business purpose. It does so in many instances for the benefit of its owners, affiliates or third parties. Accordingly, the FAA regards each such SPE as a “flight department company,” meaning they are per se commercial operators as far as the FAA is concerned.' And in fact, it is this very specific exclusion found in ' 91.501(b)(5) to the use of an SPE to serve as the non-commercial operator of the aircraft that most likely negates the ability of an SPE to use any of the ' 91.501 exemptions. In other words, the SPE cannot function this way unless it obtains its own air carrier certification to fly under Part 135.

In practical terms, improperly structuring aircraft ownership and operations is probably the single-most common error clients make in this arena. Clients simply assume that their operations are private and confidential. In their minds, because the company does not offer travel services to the public, it does not “hold out” or market commercial transportation by air. Rather, it simply shares costs or funding with or through affiliates, and as such should be viewed as a non-commercial operator.'

Moreover, these companies quite often do not study or choose simply to ignore these regulations, on the one hand, or erroneously believe that their flight department companies meet the 14 C.F.R. 91.501(b)(5) exceptions, on the other hand. But when they make these errors, they misunderstand one of the fundamental concepts applied in this area. In the view of the FAA, you cannot “have your cake and eat it too.” You cannot, before the crash, take the position that the SPE is merely a pass-through entity that should be treated as such (i.e., it can be treated as if it doesn't even exist with respect to the flow of funds from its members and affiliates), but after the crash direct any civil liability to an empty shell of a company that then holds nothing but a claim for the lost aircraft from the insurance carrier.' In sum, one point cannot be overstated: An SPE cannot by itself operate aircraft legally solely under Part 91.

FAA Enforcement: The Real Story

The discussion above may imply that the FAA will not pounce on abuses or will allow operators to skate past any negative consequences of their actions. Customers and financiers know the FAA has not typically enforced this particular infraction, in part, to allocate resources to higher safety-based priorities. While exceptions may occur, operators often believe that using an SPE as a liability shield does not in itself threaten passenger safety.' Customers and financiers, therefore, express little, if any, concern about noncompliance or even a desire to understand the prohibitions in the regulations.

However, the FAA will in fact aggressively enforce such situations under the right circumstances. The FAA can impose monetary penalties on misguided operations of up to $25,000 per violation, which means that each separate flight under such a structure could constitute one individual $25,000 penalty. Additionally, SPE pilots can face license suspensions and other disciplinary actions if they fail to have the necessary license and meet other requirements.

Probably the most notable incident in this arena was the crash of a Challenger aircraft at Teterboro in 2005, which lead to an operator being assessed several million dollars in civil penalties, together with a number of the underlying persons spending time in federal prison.

Four More Risks of Violating Part 91

The FAA is not the only risk factor associated with the use of SPEs as the operator of aircraft. One small advance by a Part 91 operator into Part 135 operations, not squarely within Section 91.501, can produce negative circumstances in areas such as insurance, state and federal taxes, and reputational and economic risk.

1. Insurance in Doubt

Customers that believe they are legally operating under Part 91 typically obtain insurance only for those Part 91 operations. If, however, an aircraft operated in an SPE crashes, suffers another accident or incident, the insurance company may deny coverage because the operator breached “the purpose of use” clause or other provision in its insurance policy, which distinguishes between noncommercial use and lawful Part 91 private operations. An insurer may also treat the violation of Part 91 as a material breach of the representations or warranties in, or as application misstatements in connection with the purchase of, aircraft insurance policies. Either or both can arguably merit a denial of coverage.

It is possible to bind coverage that does not have exclusions for such actions, but these typically draw higher premiums, and, as noted above, operators do not always understand that they need such insurance. Therefore, it behooves customers to closely review their coverage with respect to commercial vs. private operations of their aircraft to maintain coverage, if possible, even if their insured operations fail to measure up to the requirements under the FARs.

2. State Tax Changes

The SPE is a taxpayer, and if it operates outside of Part 91 as a commercial carrier, it may inadvertently trigger different treatment under state property or sales tax rules. Customers and financiers both need to examine applicable state tax law for its economic impact as a commercial or private operator. Notably, operating as a commercial carrier may exempt the SPE from sales tax obligations and reduce property taxes, but leaves open the potential imposition of FET (described below). Tax and economic analysis intertwine here, the result of which could shift a decision to operating the aircraft under Parts 119 and 135 rather than under Part 91.

3. Federal Tax Assessment

The purposes for which a taxpayer uses an aircraft, whether personal or business, affect the federal tax treatment as well. For example, the Internal Revenue Service (“IRS”) has become more aggressive through its own 2012 Chief Counsel Advice (“CCA”), by imposing FET on Part 91 management agreement fees (even though the NBAA has successfully persuaded the IRS to ease back and re-study this CCA). This reprieve benefits operators and owners, but does not obviate the fundamental SPE issues discussed in this article.

Though the approach of the IRS in the CCA regarding “possession, command and control” of an aircraft (discussed above) differs from, and is not dependent on, the FAA regulations on “operational control” of any aircraft, any action that shifts operations from Part 91 to Part 135 is likely to require the Part 135-type operator to pay FET.'

Significant federal tax issues also arise out of personal use of aircraft where, for example, the personal use of a corporate aircraft triggers income to the users and a reduction in tax deductions for the taxpayer. This entire area remains fodder for new legislation as Congress engages in dialogue about the federal budget and other tax law changes.

4. Reputational and Economic Risk

Finally, if a crash or other accident occurs that destroys a financed aircraft while it is being operated in contravention of Part 91, customers and financiers both face reputational risk. The challenge would almost certainly arise out of any government investigation and/or imposition of penalties that highlight the intentional or unwitting breach of FARs. For institutional lenders and lessors, a negative article in a powerful national newspaper or magazine could cause intolerable and immeasurable harm, if, for example, it questions why the institution did not monitor regulatory compliance by an operator-customer implicated in a crash.

Conclusion

Knowledgeable aviation lawyers should not be faint of heart if their clients “push back” when they present somewhat complicated documentation and structures designed to satisfy the FARs and, among others issues, insurance requirements and state and federal tax law. It is, therefore, incumbent on the lawyer to demonstrate the value and importance of strict compliance.

Neither the financier nor customer, whichever is your client, should take comfort in the unavailability of FAA agents to enforce these regulations or the use of the SPE to block federal action or liability. The FAA is highly likely to show up in a significant occurrence, and that matter may be the one in which a lax operator (borrower/lessee) takes a big hit from preventable violations and liabilities. At a minimum, neither financiers nor customers should overlook or remain in the dark on this issue on the chance that the FAA or other government entity will not shine'a bright light on their disobedience of the FARs.

David G. Mayer and David T. Norton are partners at Shackelford, Melton & McKinley, LLP. Mayer, a member of this newsletter's Board of Editors, is known for his work in domestic and international business aviation matters as well as for his extensive equipment financing/leasing transaction experience. Norton, an active pilot and Certified Flight Instructor, is known nationally for his regulatory and transactional work in the business aviation law arena, most recently completing service as the Co-Chair of the joint FAA/Industry RVSM LOA Process Enhancement Team of the FAA's Performance-Based Advisory Rule Making Committee. They can be contacted at mailto:[email protected]'and [email protected], respectively.

Last month, we noted that, according to a recent Equipment Leasing & Finance Foundation study on the business aircraft financing market, a high percentage of business aircraft operators do not comply with key provisions of Parts 91, 119 and 135 of the Federal Aviation Regulations (“FARs”), conducting their flight operations by and through illegal “flight department companies” in violation of these Parts of the FARs. Further, few, if any, of those involved in this situation intend to change their ways during the study period spanning from now through 2016.'

We first explained how operators can cross the line from Part 91 private operations into the forbidden zone of uncertificated Part 135 commercial operations. Building on this legal foundation, we then shared the relevant findings obtained from the 2013 study commissioned by the Equipment Leasing & Finance Foundation. David Mayer, a co-author of this article, wrote the study, titled: “From Recession to Recovery: Aircraft Transactions Build Momentum Despite Industry Challenges.”

In this Part Two herein, we describe certain limited and narrow exemptions that do allow specific “commercial” aircraft operations to be conducted solely under Part 91 rather than the operator also having to fully comply with Parts 119 and 135 as well. We end with a short description of four additional risks associated with an illegal flight department company that every lawyer (and client) should know before using an SPE in a structure created to operate business aircraft in the event an operator cannot ' or does not want to ' fit into the basic rules or their exemptions as noted above.'

Narrow Exemptions to Part 135 Certification and Operations

Beginning in the 1970s, the FAA acknowledged that certain Part 91 operators should, in limited circumstances, have the flexibility to conduct cost-reimbursed operations otherwise prohibited under Part 91. Accordingly, the FAA promulgated a number of narrow exemptions to the general rule that no “commercial” operations can be conducted solely under Part 91 (i.e., operations involving the flow of money or other value from one person to another with respect to a flight). These exemptions primarily appear in 14 C.F.R. ' 91.501.

Specifically, the FAA created a number of exemptions for reimbursed flight so long as the operator is not otherwise required to comply with Part 135, generally meaning that the operator is not holding out to the public to act as a common carrier of passengers. For example, companies (but not individuals) can legally engage in time sharing under 14 C.F.R. ' 91.501(c)(1), interchange arrangements under 14 C.F.R. ' 91.501(c)(2) and joint ownership under 14 C.F.R. ' 91.501(c)(2). Each option addresses different operational needs or circumstances of the respective parties. In essence, these provisions allow some limited cost sharing to occur when the operator conducts flights for a limited amount of compensation, without triggering the requirement to comply with Part 135.

It is very likely that 14 C.F.R. ' 91.501(b)(5) provides the most widely used exception to the general “no-compensation” rule. This regulation allows for fully allocated cost-sharing. It states that a Part 91 company can conduct aircraft operations, and receive some reimbursement for those flights, so long as the flights are “within the scope of and incidental to the [non-air transportation] business of the company.”

Stated differently, this exception only applies to a company whose primary business is not commercial air transportation. And this distinction is at the core of the breaches of the FARs we addressed in Part One of this article ' the very common strategy of placing ownership of an aircraft in a special purpose entity (“SPE”), such as a limited liability company, and then using that SPE to operate that aircraft in its own right and as its sole business activity.

By definition, an SPE cannot, does not, and will not fit into this ' 91.501(b)(5) exemption because it exists primarily or solely to conduct flight operations as its major enterprise or primary business purpose. It does so in many instances for the benefit of its owners, affiliates or third parties. Accordingly, the FAA regards each such SPE as a “flight department company,” meaning they are per se commercial operators as far as the FAA is concerned.' And in fact, it is this very specific exclusion found in ' 91.501(b)(5) to the use of an SPE to serve as the non-commercial operator of the aircraft that most likely negates the ability of an SPE to use any of the ' 91.501 exemptions. In other words, the SPE cannot function this way unless it obtains its own air carrier certification to fly under Part 135.

In practical terms, improperly structuring aircraft ownership and operations is probably the single-most common error clients make in this arena. Clients simply assume that their operations are private and confidential. In their minds, because the company does not offer travel services to the public, it does not “hold out” or market commercial transportation by air. Rather, it simply shares costs or funding with or through affiliates, and as such should be viewed as a non-commercial operator.'

Moreover, these companies quite often do not study or choose simply to ignore these regulations, on the one hand, or erroneously believe that their flight department companies meet the 14 C.F.R. 91.501(b)(5) exceptions, on the other hand. But when they make these errors, they misunderstand one of the fundamental concepts applied in this area. In the view of the FAA, you cannot “have your cake and eat it too.” You cannot, before the crash, take the position that the SPE is merely a pass-through entity that should be treated as such (i.e., it can be treated as if it doesn't even exist with respect to the flow of funds from its members and affiliates), but after the crash direct any civil liability to an empty shell of a company that then holds nothing but a claim for the lost aircraft from the insurance carrier.' In sum, one point cannot be overstated: An SPE cannot by itself operate aircraft legally solely under Part 91.

FAA Enforcement: The Real Story

The discussion above may imply that the FAA will not pounce on abuses or will allow operators to skate past any negative consequences of their actions. Customers and financiers know the FAA has not typically enforced this particular infraction, in part, to allocate resources to higher safety-based priorities. While exceptions may occur, operators often believe that using an SPE as a liability shield does not in itself threaten passenger safety.' Customers and financiers, therefore, express little, if any, concern about noncompliance or even a desire to understand the prohibitions in the regulations.

However, the FAA will in fact aggressively enforce such situations under the right circumstances. The FAA can impose monetary penalties on misguided operations of up to $25,000 per violation, which means that each separate flight under such a structure could constitute one individual $25,000 penalty. Additionally, SPE pilots can face license suspensions and other disciplinary actions if they fail to have the necessary license and meet other requirements.

Probably the most notable incident in this arena was the crash of a Challenger aircraft at Teterboro in 2005, which lead to an operator being assessed several million dollars in civil penalties, together with a number of the underlying persons spending time in federal prison.

Four More Risks of Violating Part 91

The FAA is not the only risk factor associated with the use of SPEs as the operator of aircraft. One small advance by a Part 91 operator into Part 135 operations, not squarely within Section 91.501, can produce negative circumstances in areas such as insurance, state and federal taxes, and reputational and economic risk.

1. Insurance in Doubt

Customers that believe they are legally operating under Part 91 typically obtain insurance only for those Part 91 operations. If, however, an aircraft operated in an SPE crashes, suffers another accident or incident, the insurance company may deny coverage because the operator breached “the purpose of use” clause or other provision in its insurance policy, which distinguishes between noncommercial use and lawful Part 91 private operations. An insurer may also treat the violation of Part 91 as a material breach of the representations or warranties in, or as application misstatements in connection with the purchase of, aircraft insurance policies. Either or both can arguably merit a denial of coverage.

It is possible to bind coverage that does not have exclusions for such actions, but these typically draw higher premiums, and, as noted above, operators do not always understand that they need such insurance. Therefore, it behooves customers to closely review their coverage with respect to commercial vs. private operations of their aircraft to maintain coverage, if possible, even if their insured operations fail to measure up to the requirements under the FARs.

2. State Tax Changes

The SPE is a taxpayer, and if it operates outside of Part 91 as a commercial carrier, it may inadvertently trigger different treatment under state property or sales tax rules. Customers and financiers both need to examine applicable state tax law for its economic impact as a commercial or private operator. Notably, operating as a commercial carrier may exempt the SPE from sales tax obligations and reduce property taxes, but leaves open the potential imposition of FET (described below). Tax and economic analysis intertwine here, the result of which could shift a decision to operating the aircraft under Parts 119 and 135 rather than under Part 91.

3. Federal Tax Assessment

The purposes for which a taxpayer uses an aircraft, whether personal or business, affect the federal tax treatment as well. For example, the Internal Revenue Service (“IRS”) has become more aggressive through its own 2012 Chief Counsel Advice (“CCA”), by imposing FET on Part 91 management agreement fees (even though the NBAA has successfully persuaded the IRS to ease back and re-study this CCA). This reprieve benefits operators and owners, but does not obviate the fundamental SPE issues discussed in this article.

Though the approach of the IRS in the CCA regarding “possession, command and control” of an aircraft (discussed above) differs from, and is not dependent on, the FAA regulations on “operational control” of any aircraft, any action that shifts operations from Part 91 to Part 135 is likely to require the Part 135-type operator to pay FET.'

Significant federal tax issues also arise out of personal use of aircraft where, for example, the personal use of a corporate aircraft triggers income to the users and a reduction in tax deductions for the taxpayer. This entire area remains fodder for new legislation as Congress engages in dialogue about the federal budget and other tax law changes.

4. Reputational and Economic Risk

Finally, if a crash or other accident occurs that destroys a financed aircraft while it is being operated in contravention of Part 91, customers and financiers both face reputational risk. The challenge would almost certainly arise out of any government investigation and/or imposition of penalties that highlight the intentional or unwitting breach of FARs. For institutional lenders and lessors, a negative article in a powerful national newspaper or magazine could cause intolerable and immeasurable harm, if, for example, it questions why the institution did not monitor regulatory compliance by an operator-customer implicated in a crash.

Conclusion

Knowledgeable aviation lawyers should not be faint of heart if their clients “push back” when they present somewhat complicated documentation and structures designed to satisfy the FARs and, among others issues, insurance requirements and state and federal tax law. It is, therefore, incumbent on the lawyer to demonstrate the value and importance of strict compliance.

Neither the financier nor customer, whichever is your client, should take comfort in the unavailability of FAA agents to enforce these regulations or the use of the SPE to block federal action or liability. The FAA is highly likely to show up in a significant occurrence, and that matter may be the one in which a lax operator (borrower/lessee) takes a big hit from preventable violations and liabilities. At a minimum, neither financiers nor customers should overlook or remain in the dark on this issue on the chance that the FAA or other government entity will not shine'a bright light on their disobedience of the FARs.

David G. Mayer and David T. Norton are partners at Shackelford, Melton & McKinley, LLP. Mayer, a member of this newsletter's Board of Editors, is known for his work in domestic and international business aviation matters as well as for his extensive equipment financing/leasing transaction experience. Norton, an active pilot and Certified Flight Instructor, is known nationally for his regulatory and transactional work in the business aviation law arena, most recently completing service as the Co-Chair of the joint FAA/Industry RVSM LOA Process Enhancement Team of the FAA's Performance-Based Advisory Rule Making Committee. They can be contacted at mailto:[email protected]'and [email protected], respectively.