Tax course addresses needs of commercial operators

Aviation International News » September 2007
August 30, 2007, 6:46 AM

If you are thinking of starting a business aviation charter or management company, consider sending as many of your company’s managers as possible to Conklin & de Decker’s Commercial Operators & Management Tax Course. The two-day seminar goes into great depth about the myriad subjects that any charter/management company will eventually encounter. And by attending courses such as this, your company will be way ahead of competitors run by the typical aviation-loving non-businessperson.

While the seminar covered the issue of taxes, there were plenty of other subjects to whet the interest of potential and existing charter/management operators. Operating costs, financial options, insurance, FAA/DOT charter issues and the upcoming Part 135 rewrite, FARs, charter/management agreements, independent contractors, international fees and taxes were among the other subjects under discussion during the seminar.

Operating Costs

Brandon Battles, one of the owners of Conklin & de Decker (the company is employee-owned), has a long history of studying operating costs. Before joining the company in 1995, Battles spent eight years as manager of direct operating cost programs for Bell Helicopter. At Conklin & de Decker, he helped develop the MxManager maintenance-tracking, inventory and work order software package and the AMAS service that helps managers understand maintenance costs.

“I’ve been wrestling with [costs] for 20 years,” he said. One of the universal reactions that Battles often sees is a new owner shocked to learn how much it actually costs to operate an aircraft.

“Costs are a significant piece of the puzzle,” he said. Over a five-year period for a jet flying 400 hours a year, operating costs range from more than half of the purchase price of a small jet to just slightly less than half the purchase price of a large jet. “Little do [new owners] realize how large a piece of the pie is operating costs,” he said. “They’re infrequently prepared for what’s about to hit them.”

Battles explained the importance of understanding not only what variable and fixed costs are but also how they behave and affect a company’s profitability. Variable costs rise as activity increases. Fuel, for example, is a variable cost; the more the airplane flies, the more fuel it burns, but the cost per hour remains the same (depending, of course, on the volatility of fuel prices). Fixed costs–such as insurance or office rent–are constant and don’t vary with the level of activity.

How fixed and variable costs behave directly affects profitability and the accuracy of budgets, Battles explained. “All industries wrestle with this. It’s messing with your profitability if you don’t understand this.”

Battles used insurance costs to illustrate how an incorrect estimation of a fixed cost or level of activity can blow a budget. If insurance costs double from $24,000 to $48,000 from one year to the next, for example, the hourly cost for a 500-hour-per-year airplane increases by $48.

If activity decreases, say from 500 hours per year to 450, and other costs remain the same, the cost per hour also climbs. If the department has an annual budget of $200,000, the increase in cost per hour for flying 50 hours fewer adds up to $44 per hour, almost the same amount as the cost-per-hour increase that would result from a doubling of insurance costs. “I see a lot of people get tripped up on this subject,” he noted.

The different kinds of cost, Battle said, generate a good deal of confusion. He said operators are confusing fixed/variable costs with direct/indirect costs. Fixed/variable costs address the behavior of costs; direct and indirect costs are associated with the traceability of costs. Direct costs are traceable to an activity or product. For example, maintenance labor costs can be assigned to a specific aircraft instead of spread over the entire flight department. Managers need to understand what costs are direct or indirect when comparing one operation to another. “Those costs are not necessarily applied in the same manner from organization to organization,” he explained.

Battles used a flight department he did some work for to illustrate how understanding cost traceability can help a department make decisions about its investment. The department’s managers thought they could save money by doing a major inspection in-house. The inspection ended up taking a year-and-a-half because the flight department didn’t have the capacity to perform the job efficiently. “This gives you information to manage your organization more wisely,” he said.

Finding this information can be challenging, and Battles recommends using software to convert maintenance data to actionable information. Commercial operators especially have to control costs because they often have no control over the prices they charge (the market sets prices). A good example of useful information is looking at maintenance labor hours versus flight hours. Battles showed a chart for an operator where labor hours spiked at 600-hour intervals. It’s better to know ahead of time that there is a need for additional labor or to outsource maintenance work during those intervals than to be surprised by the added labor cost every 600 hours.

Battles wrapped up his presentation by noting, “If you do these types of things, you will have a better allocation of resources.” This helps an operator make more objective decisions, take care of minor issues before they become major expenses and positively affect profitability because “one dollar saved is one dollar in profit.”

Predict Costs Accurately
David Wyndham, also a Conklin & de Decker owner, has been with the company since 1993 and manages and updates aircraft cost and performance databases and focuses on cost and performance analyses, fleet planning and life-cycle costing.

“The better you can predict, the better you can manage,” he said. But the real objective for a commercial operator, he added, “is basically survival.” This means avoiding negative cash flow and maximizing profits, goals that can be achieved only with proper data and analysis tools.

The tools that Wyndham discussed allow analysis of life-cycle cost, cash flow and time value of money.

Life-cycle cost is an important concept that looks at the total cost of buying and owning an expensive asset such as an aircraft over the entire life of the asset or at least the ownership period. The costs considered include acquisition, variable and fixed costs and overhead, plus residual value at the end of the ownership period.

Looking at life-cycle cost is useful when operators are deciding what kind
of airplane to buy (new or pre-owned) and what type of ownership to consider (charter/management, fractional, wholly owned). Wyndham used as an example a jet owner who was considering buying a Bombardier Global Express to be placed on a charter certificate so he would have an airplane as a backup when his was down for maintenance.

Taking into account all expenses and the potential charter revenue, the life-cycle cost analysis revealed that the new Global Express would have to fly 1,200 to 1,300 revenue hours per year just to break even. (Wyndham noted that this is why charter operators are better off using other people’s airplanes instead of buying their own. “If it was easier to make money owning a charter aircraft,” he said, “we wouldn’t be doing charter/management [arrangements].”)

There are many more factors to the calculation of how a particular aircraft and ownership structure will fare over time, including net present value analysis, tax effects, depreciation and cash flow.

Net present value takes all the revenues the aircraft generates and considers that the investment is repaid at the end of the period under consideration while taking into account the desired return on investment. If there is a positive net present value resulting from the ownership of the asset, the investment exceeded the target return on investment. A net present value of zero means the return was achieved, while a negative net present value indicates the return on investment fell short.

Factors that can affect net present value calculations include whether the aircraft is new or used and whether it was purchased outright or leased or financed. Taxes and depreciation are also factors in the calculation. Keep in mind, Wyndham warned, that today’s residual values are relatively high, but that doesn’t mean that will always be the case. The volume of new aircraft deliveries and entry into service of new aircraft types such as VLJs could have an effect on residual values, but not necessarily immediately.

Management Agreements
Attorney Eileen Gleimer’s seminar session on management and charter agreements offered a good deal of useful information that will help keep operators out of trouble. Gleimer is a partner at Washington, D.C.-based law firm Crowell & Moring.

One of the frequent questions she gets from parties needing a charter/management agreement is, “Can’t you just send me a form?” The answer is no, she explained. “One size does not fit all. [The agreement] is long because it’s a multimillion-dollar asset flying through the air.”

Each agreement has to address factors that are unique to individual owners and the charter/management companies they are working with. These factors include:

• the roles of the aircraft owner and operator;
• regulatory impact (especially in light of the FAA’s focus on operational control issues for charter operations);
• the length of the agreement and termination clauses;
• what services are provided and the fees
to be charged;
• crew issues (who hires and fires, who pays for workers compensation insurance, who the pilots actually work for);
• maintenance (maintaining Part 135 standards, which maintenance program to use, financial thresholds for expensive jobs);
• whether the owner pays excise taxes;
• confidentiality between all parties;
• financing/lender issues;
• insurance and indemnification;
• and charter hour guarantees (which are getting rare, Gleimer said).

Charter/management companies are taking on a lot of liability, Gleimer said, and need to be careful if their owners are making mistakes such as violating the regulations governing operational control. “Remember, the owner’s mistakes can be the manager’s liability,” she said.

Nel Stubbs, also an owner of Conklin & de Decker, joined the firm in 1999 after 12 years as a tax expert at NBAA. A key issue that always comes up in discussions of taxes and airplanes is why the FAA and Internal Revenue Service don’t agree on what a commercial operator is and when an operator needs to pay federal excise taxes. “That’s not necessarily a bad thing,” she said. “We can play them up against one another.”

The IRS might consider certain Part 91 operations as subject to commercial federal excise tax, Stubbs noted, and some Part 135 operations are not subject to the same tax. This is where IRS versus FAA attitudes confound operators. As far as the IRS is concerned, an aircraft owner might not be required to pay the federal excise tax if he is on a flight with his own crew, even if the airplane is on a Part 135 certificate.

Keep an Eye on Changes
However, the FAA’s recent tightening of its views on operational control might make it prudent not to let the owner use his airplane in that manner. Assuming the owner goes along with the charter/management company’s requirement to retain operational control to satisfy the FAA, the simple way to address the federal excise tax question is to charge the owner the tax, said Stubbs. She acknowledged that this is an aggressive technique but noted that it removes doubt and simplifies the paperwork.

Stubbs explained the intricacies of how the commercial federal excise tax is applied and who is responsible for paying, even if the operation isn’t commercial under FAA regulations. Fractional operators’ hourly rates, for example, are subject to commercial federal excise taxes, while their management fees are not. “Fractionals are going under audit,” Stubbs said, and she recommends itemizing these costs in case it becomes necessary to pay taxes on fees that were not thought taxable.

Ed Kammerer, partner at Providence, R.I. law firm Edwards Angell Palmer & Dodge, discussed expense and depreciation deductions for corporate aircraft, providing plenty of detail about how depreciation works. Among the topics he covered was how operating a corporate aircraft outside the U.S. affects depreciation. The depreciation schedule is less beneficial for a U.S.-registered aircraft operating outside the U.S., if the aircraft meets the test for being used “predominantly outside the U.S.”

In his discussion of passive-activity losses, Kammerer pointed out that the FAA’s focus on charter operational control via OpSpec A008 makes it difficult to claim such a loss in a typical charter/management arrangement. About the only way for an owner to meet the seven tests to establish material participation required for a passive-activity loss would be to fly charters in his airplane for the charter/management firm. “[OpSpec] A008 makes passive-activity losses even harder than before,” he said. “This is tax shelter legislation,” he concluded, after outlining many different scenarios where passive-activity losses might be claimed.

He then delivered a presentation on personal use of aircraft, explaining why the IRS is interested in this subject and how employers and employees can avoid having to pay taxes on income derived from nonbusiness use of corporate aircraft. Why did the IRS get interested in this subject? “There was abuse of corporate aircraft,” he said.

While the IRS says that it’s fine for an employee to reimburse the company for nonbusiness use of the company aircraft, the FAA does not agree because such travel is not “within the scope of and incidental to the business of the company.” The easiest way to handle this, Kammerer said, is for the employee to charter an airplane.

NATA manager of regulatory affairs Lindsey McFarren offered a summary of fees faced by operators flying outside the U.S., including U.S. customs, immigration and the new Animal and Plant Health Inspection Services fee.

Now that there are more U.S. operators flying outside the country, government agencies are paying more attention, she said. “They now know we exist.” Operators should not ignore these fees, she warned. They are not subject to a statute of limitations, and fines can be assessed for operators that have been ignoring the fees. “We had one operator that owed $250,000,” she said. If an operator is in the position of needing to admit not having paid fees, McFarren suggested approaching the government agencies and offering to pay, as they are more forgiving than if an operator continues to ignore the requirements.

Managing Insurance Costs Key for Small Firms

Bill Kingsley of Dallas brokerage AirSure outlined some moves that charter/management operators can make to keep insurance costs reasonable. While there is strong competition now among insurance underwriters, managing insurance costs is achievable and desirable. Kingsley advised operators:

• to develop personal relationships with their insurance underwriters and invite them to visit and see the operation and how it exceeds minimum safety and regulatory standards.

• to consider the size of the assets that need protection and the operational environment when selecting liability limits on an insurance policy. A rule of thumb is to plan for $3 million to $5 million per passenger seat. But some recent judgments are pushing the limits of that coverage, including, he said, $115 million for a charter Gulfstream crash in Aspen, Colo., and $38 million for one person killed in a Grand Canyon crash.

• not to sign a hold-harmless agreement without consulting with a lawyer and insurance broker. The language in such agreements can transfer risk to the operator but independent of the operator’s insurance coverage.

• to recognize that management contracts present some special insurance circumstances. The parties involved need the contract to specify who provides the insurance (owner or management company); which insurance underwriters are acceptable; minimum limits for liability, hull value, war risk insurance and European Union liability (if necessary); the type of insurance needed; and indemnification language covering issues such as loss of use, diminution of value in case of an accident/incident and compensation for other expenses involved in an insurance claim.

The insurance market today is soft, according to Kingsley, and premium reductions are normal, with average customers seeing 15- to 20-percent reductions and superior accounts drops of up to 35 percent. “There’s plenty of [underwriting] capacity,” he said. He added that the fact that airlines haven’t had huge insurance losses recently benefits the rest of the aviation industry. “If there’s an event,” he added, “things could change rapidly.” He expects this soft market to last for about two years, then operators considered “lesser” accounts will see the earliest tightening of insurance rates.

Kingsley’s advice for operators seeking to pay less for insurance is to show the underwriter how the company is different and better than others. “Ninety-nine percent of underwriters are wannabe pilots,” he said. “A good day is when they can get out of the office and see some airplanes. Ask your underwriter to join your pilot training class. You’ll get more mileage out of that. Underwriters really want to understand your business.”

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