““CEOs go to their vacation homes just after companies report favorable news, and CEOs return to headquarters right before subsequent news is released. More good news is released when CEOs are back at work, and CEOs appear not to leave headquarters at all if a firm has adverse news to disclose. When CEOs are away from the office, stock prices behave quietly with sharply lower volatility. Volatility increases immediately when CEOs return to work.” —David Yermack, a New York University finance professor, whose recently released study shows a correlation between when CEOs take their private jets on vacation and movements in their companies’ stock price ”
The Flight Department Company Trap
If I owned a business jet, my worst nightmare would go something like this: my airplane is involved in an accident and I get sued for zillions of dollars in damages. I call an aviation attorney and she says the limited liability company (LLC) I formed solely to own and operate my aircraft (known as a “flight department company”) won’t limit liability after all because it was operating the jet illegally. Then I call my insurance broker and he says my insurer is denying coverage because the damage occurred on a flight that was operated illegally. The dream ends with me prospecting for gold in the Yukon under an assumed name.
Unfortunately, this nightmare rarely seems to visit the aircraft owners who should be having it regularly. Notwithstanding all of the publicity the flight department company “trap” has received in the last 20 years, it continues to snare unwary business jet owners. Here’s why.
Entities like corporations and LLCs were created so investors could own and finance a business without assuming responsibility for its liabilities. Thus, in the absence of legal no-nos like fraudulent conveyances and failure to observe corporate formalities, the classic way to protect business owners from liabilities is to isolate those risks in a separate liability-shielding entity. So, when a business lawyer gets a call from his client about purchasing an expensive, dangerous-sounding asset like a business jet, his first thought will probably be: we have to create a new entity to own and operate it.
Unfortunately, few business lawyers are well versed in arcane FAA rules and regulations, especially ones as counterintuitive as the flight department company trap. Suppose I buy a business jet and own and operate it in my own name. Since I’m flying myself around in my own aircraft, the FAA says I can follow the non-commercial Part 91 Federal Aviation Regulations. Now suppose I create a wholly owned LLC to own and operate my jet, the company’s only business. I may regard the LLC as a kind of alter ego; after all, I’m the sole owner, and it’s doing only what I could do myself—operating the aircraft. But the FAA doesn’t look at it that way. It considers my LLC a completely separate legal entity. Now I’m not flying myself around anymore; the LLC is flying me around. Put differently, my LLC is providing air transportation to a different person—me. And providing air transportation to others for compensation or hire requires, according to the FAA, a commercial certificate, which the LLC doesn’t have.
You might say: “Ah, but the flights aren’t for compensation or hire and aren’t commercial because there are no payments.” Unfortunately, the way the FAA looks at it, there will be plenty of payments: I will have to fund the LLC to cover all of its expenses, including fuel, pilots, hangar and insurance. Since the LLC is not engaged in any other business, where else will it get the money? Again, the FAA views the LLC and me as distinct legal persons for purposes of air transportation, so my capital contributions to cover expenses constitute compensation.
Next, you might say: “Why not just get a commercial certificate?” An easy answer would be that the FAA recently called a moratorium on issuing new certificates. But even without a moratorium, it could take me a year or two to obtain a brand new air-carrier certificate—a time-consuming and expensive process—while my jet sits idle in a hangar. It would be easier to contract with an existing certificate holder to operate the aircraft for me.
Now we come to the question every frustrated client will ask his aviation lawyer at this point: “What will happen to me if I ignore these rules and continue to operate the aircraft in the sole-purpose LLC?” The answer is, maybe nothing—which is why there are still so many flight department companies out there blissfully operating airplanes (including via fractional programs) in complete ignorance or dismissal of FAA requirements.
But remember my worst nightmare: the aircraft has an accident, the FAA investigates and revokes the licenses of my pilots and fines my LLC, people sue for damages, my insurance company denies coverage, my lender says loan covenants are violated and the IRS says I should have been paying transportation excise tax on those “commercial” flights. Granted, this nightmare hasn’t played out yet, but the FAA has raised the issue in some investigations and there’s no question the agency takes it seriously. Were your aircraft to have an accident, don’t count on that LLC to provide a liability shield from the consequences of the LLC’s aircraft operations in violation of federal law and without adequate capitalization and insurance to handle the consequences. There’s a case many plaintiffs’ lawyers would relish.
If you currently operate your jet via a sole-purpose LLC, what should you do? If you want to continue to operate under Part 91, have the LLC lease the aircraft to you and operate it yourself. (There’s no problem with the flight department company just owning the airplane.) You will be personally responsible for safe operation in that case, but you can purchase up to $500 million of liability insurance, which is more than enough to cover any business aviation damage award I’ve ever heard of.
Alternatively, move the aircraft operations to a company engaged in a trade or business. As long as the aircraft is used in a manner that’s incidental to and within the scope of that business, a commercial certificate is not required.
Finally, you could contract with a Part 135 certificate holder to operate the aircraft for you commercially. You will sacrifice some operational flexibility, and your costs and taxes will go up, but at least you’ll be able to say goodbye to flight department company nightmares.
8 reasons to avoid the flight department company trap
~ It’s illegal
~ Aircraft liability insurance may be voided
~ Possible default on contractual obligations requiring legal compliance
~ FAA fines
~ Loss of pilot licenses
~ Unfavorable tax consequences
~ Tort liability exposure
~ Potential bad publicity
What our readers had to say
Regarding Jeff Wieand’s “The Flight Department Company Trap” [Taxes, Laws and Finance, June/July 2013], how many people have actually had this “nightmare” happen to them? No insurance contract presently in use has a “FAR exclusion” in which the potential “illegal” operation you describe would not be covered. Furthermore, there are a number of legal remedies to the situation described here, including exclusive lease agreements.
This reads more like fear-mongering than a well-reasoned legal examination.
posted on bjtonline.com
Wieand replies: The FAA’s position is crystal clear in many interpretations and opinions. As for denial of coverage, the possibility is not merely theoretical. Avemco Insurance Company successfully denied coverage in a 2001 federal court case on the grounds that an aircraft operation was really “commercial.” I wouldn’t count on an insurer forking over millions of dollars if you are violating requirements of the policy when an accident occurs. Of course, the flight-department company may solve the problem by leasing the aircraft to another entity, but to do that, it has to recognize the problem first.
“The Flight Department Company Trap” [June/July 2013] was a fantastic article and those who ignore it deserve to get hammered. Owners have options, so pick the one that works best for you and is legal. It may not be a 100 percent solution, but what in life is? At least you (or your client) will sleep well. To think that in the event of a mishap all interested parties won’t immediately scrutinize everything about an operation in order to affix liability is completely illogical.