Business Entities and Aircraft Transactions
Business Entities and Aircraft Transactions
Flying might not be all plain sailing, but the fun of it is worth the price.
Amelia Earhart, 1897–1937
After reading this chapter, you should:
1. know the four primary business entities;
2. understand the tradeoffs of each entity as an aircraft owner;
3. be familiar with basic aircraft transactions;
4. know the elements of aircraft valuation;
5. be able to explain the FAA’s aircraft registration process.
For the average American unfamiliar with aviation, aircraft ownership may seem to be a privilege reserved for the wealthy minority. Those involved in the aviation community, however, understand aircraft ownership as a viable means of transport, business, and enjoyment. Though it may seem to be a far-fetched idea for some general aviation pilots, if someone is spending well over $100 per hour to rent an aircraft, there is a point where a pilot who flies regularly may find an economic advantage in owning his or her own aircraft.
Many people shy away from “luxury” purchases, like cars and boats, in time of economic turmoil. A high-ticket item like a sports car or boat typically depreciates in value steadily over time, especially in economic recession, where the resale demand is low. The interesting thing about the general aviation market (namely single- or twin-piston engine airplanes) is that aircraft used to be stable investments. The average potential buyer looks primarily at used aircraft, which historically appreciated in value if they were properly maintained. In strong economies, the demand for good used aircraft often skyrockets, depleting the supply quickly and driving up prices. In slower economies, the supply is greater, but tax incentives and flexible financing options often offset the decrease in prices.
Regardless of whether a person is looking to buy a Piper Cub or a Piaggio Avanti, purchasing an aircraft is a big commitment. Even the most economically priced aircraft will require some type of financing for acquisition costs, as well as considerable operational costs such as maintenance, fuel, annual inspections, and tie-down or hangar fees. Taxes, though outside the scope of this text, are another large factor that affects the immediate and long-term costs of ownership. The average aircraft owner will deal with a wide variety of federal and state taxes for the duration of ownership.
Insurance and liability are also of concern to a potential aircraft owner. Though insurance coverage for the airplane itself (namely hull insurance) is important, the biggest risk in aircraft ownership lies in liability coverage. If another person suffers an injury or property damages resulting from the operation of the aircraft, he or she may be able to sue the owner personally for damages beyond what the insurance policy covers.
Because of concerns like these, many owners feel uncomfortable owning an aircraft under their own name. A more appealing option may be to create a business entity to own and operate the aircraft, whether as an individual or corporation. Deciding which legal form the ownership will take is referred to as the choice of entity. The circumstances of every owner are unique and therefore there is no one “right way” for buyers to pursue. Each option offers tradeoffs in terms of taxes, liability, and operational flexibility. The choice of ownership is often very complicated and it is advisable to seek the professional guidance of an attorney in making a final decision.
Perhaps the simplest entity to set up and operate, a sole proprietorship is a one-person business that, unlike a corporation or limited liability company (LLC), is not registered with the state. Sole proprietorships do not require any paperwork to start, other than obtaining the required licenses and permits that all new businesses must complete. The business can be run under the operating individual’s name, such as “John Smith,” or under a fictitious name, such as “Smith Flight Instruction.” A fictitious name is also referred to as a “DBA” or “doing business as,” which indicates that the individual is operating a sole proprietorship (e.g. “John Smith d/b/a Smith Flight Instruction”). These names must be registered with the county or city in which the business is run.
A sole proprietorship does not offer many tax advantages compared to private ownership, as the Internal Revenue Service (IRS) does not differentiate between a sole proprietorship and the individual who owns the business. In fact, the owner of a sole proprietorship simply reports the business’ income or losses on his or her own individual income tax return, IRS Form 1040, on Schedule C, “Profit or Loss from a Business.” The benefit to this method is that any ordinary operational expenses from running the business may be deductible from a taxpayer’s income. If net income from the sole proprietorship is a loss, that too is deductible against any other income for up to three years of loss during five reportable years of income. After that point, the IRS may deem the proprietorship to be a hobby instead of a business and may reject further deductions.
Liability is the primary concern of aircraft ownership via a sole proprietorship. Just as the IRS sees no separation between a sole proprietorship and its owner, the same holds true for the law. If the business does not pay a debt, the owner’s personal assets – like a home, car, or other possessions – become vulnerable to debt collectors. The liability does not stop at debt either. If, throughout the course of business, someone becomes injured as a result of the owner, employees, or property, the owner is held personally liable for the victim’s injuries or damages. Even with liability insurance, protection is not guaranteed if damages exceed coverage – if they do, the owner (or proprietor) is held responsible for the remaining charges.
The simplicity of a sole proprietorship is often appealing to people looking for an easy way to do business. Because of the risky nature of aviation, however, the lack of personal liability protection that a sole proprietorship demands is hardly inviting. Though they are the least expensive operation to run, the long-term personal financial effects of a failed business or serious accident often compel aircraft buyers to seek alternative means of ownership.
General and Limited Partnerships
Very similar to a sole proprietorship, a partnership is a business owned by more than one person that is not registered with the state as a corporation or LLC. Very little paperwork (beyond the initial licensing and permits) is required – in fact, a partnership is considered valid as soon as two or people start a business. It is advisable, however, for a written partnership agreement to be drafted that details each partner’s contributions, authority, and duties.
Just like a sole proprietorship, the IRS does not consider a business run as a partnership separate from its proprietors. Partnerships file returns to report on income, losses, and deductions, but do not pay income taxes. Instead, any profits or losses are passed to each partner, who would then include the proportional share of the income or loss on his or her personal income tax return. This method is often advantageous to partners, who make quarterly federal and state payments on their distributive share, or the portion of profits that each partner receives as allocated in the partnership agreement.
The lack of personal liability protection in a general partnership is very similar to the sole proprietorship, with each partner assuming personal liability for any debts or damages of the business. The only form of partnership that offers any form of personal liability protection is the limited partnership. A limited partnership is comprised of both general partners and limited partners. General partners retain full personal liability and are responsible for the operation of the business. Limited partners typically invest in the company and have very little management or influence on how the business is run. In return, limited partners’ personal liability is limited to the money invested in the company, and his or her personal assets remain protected.
Something to be cautious about in the formation of a partnership is the purpose of the partnership. A partnership must have the intention to operate a business for profit. Too often, pilots simply want to split costs and purchase an aircraft together for non-business purposes. In this case, co-ownership is the proper term.
In general and limited partnerships, owners enjoy pass-through tax advantages and divided costs. The vulnerability of personal assets for general partners is still a deterrent for some, however, in the business of flying.
S Corporations and C Corporations
Though most individuals will not go to the lengths necessary to form a corporation, established businesses like flight schools or fixed-base operators (FBOs) may find an advantageous balance in the liability protection and taxation that a corporation offers. Corporations are very demanding to operate, however, and a business must first apply for corporation status with the IRS.
Though S corporations are becoming less popular as more businesses elect to form limited liability companies, they still remain advantageous for certain aircraft owners. S corporations offer the benefits of pass-through taxation similar to a partnership, with the added personal liability protection of a corporation. They are limited to 100 domestic (US citizen or resident aliens) shareholders, but a single-person S corporation is common. Rather than paying income tax as an entity, the S corporation’s income and losses are divided and passed on to shareholders, who then report the income or loss on their personal income tax return.
Shareholders of S corporations receive personal liability protection if the business is run according to corporation standards and formalities. If the corporation is a front for ownership of assets, the shareholders will accept personal liability for damages and injuries caused by the S corporation.
C corporations are what most people think of as a “regular corporation,” or a corporation that is taxed as a corporation, separate from its shareholders. C corporations have no limit on the number or type of shareholders (unlike S corporations, partnerships and companies can be shareholders of C corporations along with non-US residents), and all shareholders enjoy full personal liability protection from any debts or damages caused by the corporation. The primary drawback of a C corporation is double taxation, in which the corporation is taxed on its own income and its shareholders are taxed on dividends received.
For most businesses in general aviation, the complexity of running a corporation overshadows the benefits of personal liability protection. For the better part of the nineteenth century, the US lagged behind other countries in the ability to form a company with limited liability and the advantages of a partnership’s pass-through taxation. In 1977, Wyoming passed the Wyoming Limited Liability Company Act,1 which permitted the formation of LLCs for any legal business purpose, with the exception of insurance and banking businesses. Soon, each state followed suit with LLC statutes allowing the formation of these companies.
The pass-through taxation benefits enjoyed by LLCs mean that members or owners pay taxes on business profits on their own income tax returns. Should an owner want the LLC to be taxed as a corporation, however, he or she may choose to do so to retain earnings within the company.
Perhaps the most appealing aspect of the LLC is limited liability outside the confines of a corporation. Like a corporation, LLCs offer full personal liability protection to members; conversely, LLC members own an interest in the company, but retain the ability to determine how income and assets are divided.