POLARIS AIRCRAFT INCOME FUND III, 10-K405, 1999-03-29

POLARIS AIRCRAFT INCOME FUND III
10-K405, 1999-03-29
EQUIPMENT RENTAL & LEASING, NEC

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

--------------------

FORM 10-K

--------------------

_X_ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998

___ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ___ to ___

Commission File No.33-10122

POLARIS AIRCRAFT INCOME FUND III,
A California Limited Partnership
--------------------------------
(Exact name of registrant as specified in its charter)

California 94-3023671
------------------------------- -----------------------
(State or other jurisdiction of (IRS Employer I.D. No.)
incorporation or organization)

201 High Ridge Road, Stamford, Connecticut 06927
------------------------------------------ ----------
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (203) 357-3776

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:
Depository Units Representing Assignments of Limited Partnership Interests

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes _X_ No___

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. _X_

No formal market exists for the units of limited partnership interest and
therefore there exists no aggregate market value at December 31, 1998.

Documents incorporated by reference: None

This document consists of 42 pages.
<PAGE>

PART I

Item 1. Business

Polaris Aircraft Income Fund III, A California Limited Partnership (PAIF-III or
the Partnership), was formed primarily to purchase and lease used commercial jet
aircraft in order to provide quarterly distributions of cash from operations, to
maximize the residual values of aircraft upon sale and to protect Partnership
capital through experienced management and diversification. PAIF-III was
organized as a California Limited Partnership on June 27, 1984 and will
terminate no later than December 2020.

PAIF-III has many competitors in the aircraft leasing market, including
airlines, aircraft leasing companies, other Limited Partnerships, banks and
several other types of financial institutions. This market is highly competitive
and there is no single competitor who has a significant influence on the
industry. In addition to other competitors, the General Partner, Polaris
Investment Management Corporation (PIMC), and its affiliates, including GE
Capital Aviation Services, Inc. (GECAS), Polaris Aircraft Leasing Corporation
(PALC), Polaris Holding Company (PHC) and General Electric Capital Corporation
(GE Capital), acquire, lease, finance, sell and remarket aircraft for their own
accounts and for existing aircraft and aircraft leasing programs managed by
them. Further, GECAS provides a significant range of aircraft management
services to third parties, including without limitation, AerFi Group plc
(formerly GPA Group plc), a public limited company organized in Ireland,
together with its consolidated subsidiaries (AerFi), and Airplanes Group,
together with its subsidiaries (APG), each of which two groups leases and sells
aircraft. Accordingly, in seeking to re-lease and sell its aircraft, the
Partnership may be in competition with the General Partner, its affiliates,
AerFi, APG, and other third parties to whom GECAS provides aircraft management
services from time to time.

A brief description of the aircraft owned by the Partnership is set forth in
Item 2. The following table describes certain material terms of the
Partnership's leases to Trans World Airlines, Inc. (TWA) as of December 31,
1998:

Number of Lease
Lessee Aircraft Type Aircraft Expiration Renewal Options
- ------ ------------- -------- ---------- ---------------

TWA McDonnell Douglas DC-9-30 10 11/04 (1) none

(1) TWA may specify a lease expiration date for each aircraft up to six
months before the date shown, provided the average date for the 10
aircraft is November 2004. The TWA leases were modified in 1991 and
were extended for an aggregate of 75 months beyond the initial lease
expiration date in November 1991 at approximately 46% of the original
lease rates. In 1996, the leases were extended for a period of eight
years until November 2004. The Partnership also agreed to share in the
costs of certain Airworthiness Directives (ADs). If such costs are
incurred by TWA, they will be credited against rental payments, subject
to annual limitations with a maximum of $500,000 per aircraft over the
lease terms.

As discussed in Item 7, in October 1994, TWA notified its creditors,
including the Partnership, of a proposed restructuring of its debt.
Subsequently, GECAS negotiated a standstill agreement with TWA which
was approved on behalf of the Partnership by PIMC. That agreement
provided for a moratorium of the rent due the Partnership in November
1994 and 75% of the rents due the Partnership from December 1994
through March 1995, with the deferred rents, which aggregated $2.6
million, plus interest being repaid in monthly installments between May
1995 through December 1995. The Partnership received as consideration
for the agreement $157,568 and warrants for TWA Common Stock (Item 7).

2
<PAGE>

In 1996, GECAS, on behalf of the Partnership, negotiated with TWA for
the acquisition of noise-suppression devices, commonly known as
"hushkits", for the 10 Partnership aircraft currently on lease to TWA,
as well as other aircraft owned by affiliates of PIMC and leased to
TWA. The 10 aircraft were designated by TWA. The hushkits reconditioned
the aircraft so as to meet Stage 3 noise level restrictions. The
installation of the 10 hushkits was completed on the Partnership's
aircraft in November 1996 and the leases for these 10 aircraft were
extended for a period of eight years until November 2004.

The rent payable by TWA under the leases was increased by an amount
sufficient to cover the monthly debt service payments on the hushkits
and fully repay, during the term of the TWA leases, the amount
borrowed. The loan from the engine/hushkit manufacturer is non-recourse
to the Partnership and secured by a security interest in the lease
receivables.

The Partnership transferred three McDonnell Douglas DC-9-10 aircraft, formerly
leased to Midway Airlines, Inc. (Midway), and six Boeing 727-100 aircraft,
formerly leased to Continental, to aircraft inventory in 1992. The three
McDonnell Douglas DC-9-10 aircraft were disassembled for sale of their component
parts, the remainder of which was sold to Soundair, Inc. in 1998. Disassembly of
the six Boeing 727-100 aircraft commenced in December 1994. The leases for three
Boeing 727-200 aircraft to Continental expired in April 1994. These aircraft
were subsequently sold to Continental.

At year end 1998, there were approximately 12,600 jet aircraft in the world
fleet. Approximately 1,500 aircraft were leased or sold during 1998, an increase
of 14% over 1997. Air travel has grown strongly during the past 28 years, with
the last nineteen years showing better than 5.5% annual growth, and not until
recently has it subsided after what had been a robust period from 1994 to 1997.
This strong period has mainly benefited Stage 3 narrow bodies and younger Stage
2 narrow bodies, many of which have been or are being upgraded with hushkits.
During 1998, the industry saw many alliances taking place. There was more
consolidation in the U.S. Airline Industry via alliances than had been seen in
the previous 20 years since deregulation. Booming traffic demand coupled with
reductions in the price of aviation fuel has resulted in record profits for many
airlines in North America and Europe. However, slower traffic lies ahead, the
cycle has peaked in 1998, as may have airline profits. Manufacturers continue to
produce at high levels compared to what demand will require in the future years.
Asia continues its economic turmoil which has brought about a significant
reduction in traffic growth in that region. This is resulting in a number of new
aircraft order deferrals and cancellations, mainly in the wide body sector, with
over capacity moving from Asia into the other regions around the world. Timing
of when the down cycle ends or how severe it will be is still in question, but
will be closely watched as we move into the next millennium. Several airline
accidents that occurred in 1996, involving older Stage 2 aircraft, continue to
dampen the market for such aircraft. The Partnership has been forced in the past
to adjust its estimates of the residual values realizable from its aircraft,
which resulted in an increase in depreciation expense, as discussed in Items 7
and 8. A discussion of the current market condition for the type of aircraft
owned by the Partnership follows:

McDonnell Douglas DC-9-30 - The McDonnell Douglas DC-9-30 is a short- to
medium-range twin-engine jet that was introduced in 1967. Providing reliable,
inexpensive lift, these aircraft fill thin niche markets, mostly in the United
States. Hushkits are available to bring these aircraft into compliance with
Stage 3 noise restrictions at a cost of approximately $1.6 million per aircraft.
As noted above, hushkits have been installed on the 10 remaining aircraft.
Certain ADs applicable to the McDonnell Douglas DC-9 have been issued to prevent
fatigue cracks and control corrosion as discussed in the Industry Update section
of Item 7.

The General Partner believes that, in addition to the factors cited above, the
deteriorated market for the Partnership's aircraft reflects the airline
industry's reaction to the significant expenditures potentially necessary to
bring these aircraft into compliance with certain ADs issued by the FAA relating
to aging aircraft, corrosion prevention and control, and structural inspection
and modification as discussed in the Industry Update section of Item 7.

3
<PAGE>

Item 2. Properties

At December 31, 1998, Polaris Aircraft Income Fund III (the Partnership) owns a
portfolio of 10 used commercial jet aircraft out of its original portfolio of 38
aircraft. The portfolio includes 10 McDonnell Douglas DC-9-30 aircraft leased to
Trans World Airlines, Inc. (TWA). The Partnership transferred three McDonnell
Douglas DC-9-10 aircraft and six Boeing 727-100 aircraft to aircraft inventory
in 1992. The inventoried aircraft were disassembled for sale of their component
parts, the remainder of which was sold to Soundair, Inc. in 1998. Of its
original aircraft portfolio, the Partnership sold eight DC-9-10 aircraft in 1992
and 1993 and three Boeing 727-200 aircraft in May 1994. In June 1997, the
Partnership sold three McDonnell Douglas DC-9-30 aircraft leased to TWA, and
five Boeing 727-200 Advanced aircraft leased to Continental Airlines, Inc.
(Continental) to Triton Aviation Services III LLC.

The following table describes the Partnership's aircraft portfolio at December
31, 1998 in greater detail:

Year of Cycles
Aircraft Type Serial Number Manufacture As of 11/30/98 (1)
- ------------- ------------- ----------- ------------------
McDonnell Douglas DC-9-30 47028 1967 85,687
McDonnell Douglas DC-9-30 47030 1967 85,129
McDonnell Douglas DC-9-30 47095 1967 80,921
McDonnell Douglas DC-9-30 47109 1968 84,331
McDonnell Douglas DC-9-30 47134 1967 79,923
McDonnell Douglas DC-9-30 47136 1968 79,981
McDonnell Douglas DC-9-30 47172 1968 81,333
McDonnell Douglas DC-9-30 47173 1968 84,274
McDonnell Douglas DC-9-30 47250 1968 85,403
McDonnell Douglas DC-9-30 47491 1970 77,527

(1) Cycle information as of 12/31/98 was not available.

Item 3. Legal Proceedings

Midway Airlines, Inc. (Midway) Bankruptcy - As previously reported in the
Partnership's 1997 Form 10-K, in March 1991, Midway commenced reorganization
proceedings under Chapter 11 of the Federal Bankruptcy Code in the United States
Bankruptcy Court for the Northern District of Illinois, Eastern Division. On
August 9, 1991, the Bankruptcy Court approved Midway's rejection of the leases
of the Partnership's four DC-9-10 aircraft, and the aircraft were returned to
the Partnership on August 12, 1991. On September 18, 1991, the Partnership filed
a proof of claim in Midway's bankruptcy proceeding to recover damages for lost
rent and for Midway's failure to meet return conditions with respect to the four
aircraft. In light of Midway's cessation of operations, on April 30, 1992, the
Partnership amended and restated its prior proof of claim and filed an
additional proof. To date no payment or settlement of the Partnership's
bankruptcy claims has been offered.

Kepford, et al. v. Prudential Securities, et al. -On April 13, 1994, this action
was filed in the District Court of Harris County, Texas against Polaris
Investment Management Corporation, Polaris Securities Corporation, Polaris
Holding Company, Polaris Aircraft Leasing Corporation, the Partnership, Polaris
Aircraft Income Fund I, Polaris Aircraft Income Fund II, Polaris Aircraft Income
Fund IV, Polaris Aircraft Income Fund V, Polaris Aircraft Income Fund VI,
General Electric Capital Corporation, Prudential Securities, Inc., Prudential
Insurance Company of America and James J. Darr. The complaint alleges violations
of the Texas Securities Act, the Texas Deceptive Trade Practices Act, sections
11 and 12 of the Securities Act of 1933, common law fraud, fraud in the

4
<PAGE>

inducement, negligent misrepresentation, negligence, breach of fiduciary duty
and civil conspiracy arising from the defendants' alleged misrepresentation and
failure to disclose material facts in connection with the sale of Limited
Partnership units in the Partnership and the other Polaris Aircraft Income
Funds. Plaintiffs seek, among other things, an award of compensatory damages in
an unspecified amount plus interest, and double and treble damages under the
Texas Deceptive Trade Practices Act. The trial court has issued a revised
scheduling order setting the trial date for this action for September 7, 1999.

Ron Wallace v. Polaris Investment Management Corporation, et al. - On or about
June 18, 1997, a purported class action entitled Ron Wallace v. Polaris
Investment Management Corporation, et al. was filed on behalf of the unitholders
of Polaris Aircraft Income Funds II through VI in the Superior Court of the
State of California, County of San Francisco. The complaint names each of
Polaris Investment Management Corporation (PIMC), GE Capital Aviation Services,
Inc. (GECAS), Polaris Aircraft Leasing Corporation, Polaris Holding Company,
General Electric Capital Corporation, certain executives of PIMC and GECAS and
John E. Flynn, a former PIMC executive, as defendants. The complaint alleges
that defendants committed a breach of their fiduciary duties with respect to the
Sale Transaction involving the Partnership as described in Item 7, under the
caption "Sale of Aircraft -- Sale of Aircraft to Triton." On September 2, 1997,
an amended complaint was filed adding additional plaintiffs, and on December 18,
1997, the plaintiffs filed a second amended complaint asserting their claims
derivatively.

On November 9, 1998, defendants, acting through their counsel, entered into a
settlement agreement with plaintiffs and with the plaintiff in a related action,
"Accelerated" High Yield Income Fund II, Ltd., L.P. v. Polaris Investment
Management Corporation, et al. The settlement agreement does not provide for any
payments to be made to the Partnership. Plaintiff's counsel sought reimbursement
from the Partnership for its attorneys' fees and expenses. A settlement notice
setting forth the terms of the settlement was mailed to the last known address
of each unitholder of the Partnership on November 20, 1998. On December 24,
1998, the Court approved the terms of the settlement and approved plaintiffs'
attorneys' fees and expenses in the amount of $288,949.

Other Proceedings - Part III, Item 10 discusses certain other actions which have
been filed against the General Partner in connection with certain public
offerings, including that of the Partnership. The Partnership is not a party to
these actions.

Item 4. Submission of Matters to a Vote of Security Holders

None.

5
<PAGE>

PART II

Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters

a) Polaris Aircraft Income Fund III's (PAIF-III or the Partnership) units
representing assignments of Limited Partnership interest (Units) are
not publicly traded. The Units are held by Polaris Depositary III on
behalf of the Partnership's investors (Unit Holders). Currently there
is no market for PAIF-III's Units and it is unlikely that any market
will develop.

b) Number of Security Holders:

Number of Record Holders
Title of Class as of December 31, 1998
-------------- ------------------------

Depository Units Representing Assignments 16,333
of Limited Partnership Interests:

General Partnership Interest: 1

c) Dividends:

The Partnership distributed cash to partners on a quarterly basis
beginning April 1987. Cash distributions to Unit Holders during 1998
and 1997 totaled $19,148,468 and $11,100,000, respectively. Cash
distributions per Limited Partnership unit were $38.30 and $22.20 in
1998 and 1997, respectively.

6
<PAGE>

Item 6. Selected Financial Data

For the years ended December 31,
--------------------------------

1998 1997 1996 1995 1994
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Revenues $ 10,055,914 $ 14,959,380 $ 17,077,758 $ 21,096,762 $ 13,486,506

Net Income (Loss) 5,287,954 4,989,096 (6,803,529) 7,897,946 (181,996)

Net Income (Loss)
allocated to Limited
Partners 3,948,438 4,939,205 (8,622,805) 6,694,079 (2,679,926)

Net Income (Loss) per
Limited Partnership Unit 7.90 9.88 (17.25) 13.39 (5.36)

Cash Distributions per
Limited Partnership
Unit 38.30 22.20 37.75 22.50 50.00

Amount of Cash
Distributions Included
Above Representing
a Return of Capital on
a Generally Accepted
Accounting Principle
Basis per Limited
Partnership Unit* 38.30 22.20 37.75 22.50 50.00

Total Assets 40,019,792 58,054,962 67,014,686 82,001,364 86,552,826

Partners' Capital 30,152,885 46,144,927 53,489,164 81,264,915 85,866,969
</TABLE>

* The portion of such distributions which represents a return of capital on an
economic basis will depend in part on the residual sale value of the
Partnership's aircraft and thus will not be ultimately determinable until the
Partnership disposes of its aircraft. However, such portion may be significant
and may equal, exceed or be smaller than the amount shown in the above table.

7
<PAGE>

Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations

At December 31, 1998, Polaris Aircraft Income Fund III (the Partnership) owned a
portfolio of 10 used McDonnell Douglas DC-9-30 aircraft leased to Trans World
Airlines, Inc. (TWA) out of its original portfolio of 38 aircraft. The
Partnership transferred three McDonnell Douglas DC-9-10 aircraft and six Boeing
727-100 aircraft to aircraft inventory in 1992. The inventoried aircraft were
disassembled for sale of their component parts, the remainder of which was sold
to Soundair, Inc. in 1998. Of its original aircraft portfolio, the Partnership
sold eight DC-9-10 aircraft in 1992 and 1993 and three Boeing 727-200 aircraft
in May 1994. In June 1997, the Partnership sold three McDonnell Douglas DC-9-30
aircraft leased to TWA, and five Boeing 727-200 Advanced aircraft leased to
Continental Airlines, Inc. (Continental) to Triton Aviation Services III LLC.

Remarketing Update

General - Polaris Investment Management Corporation (the General Partner or
PIMC) evaluates, from time to time, whether the investment objectives of the
Partnership are better served by continuing to hold the Partnership's remaining
portfolio of Aircraft or marketing such Aircraft for sale. This evaluation takes
into account the current and potential earnings of the Aircraft, the conditions
in the markets for lease and sale and future outlook for such markets, and the
tax consequences of selling rather than continuing to lease the Aircraft.

Sale of Aircraft Inventory to Soundair, Inc. - The Partnership sold its
remaining inventory of aircraft parts from the six disassembled aircraft, to
Soundair, Inc. The remaining inventory, with a net carrying value of $-0-, was
sold effective February 1, 1998 for $100,000, less amounts previously received
for sales as of that date. The net purchase price of $88,596 was paid in
September 1998, and is included in gain on sale of aircraft inventory.

Partnership Operations

The Partnership reported net income of $5,287,954, or $7.90 per Limited
Partnership unit for the year ended December 31, 1998, compared to net income of
$4,989,096, or $9.88 per Limited Partnership unit and a net loss of $6,803,529,
or $17.25 per Limited Partnership unit, for the years ended December 31, 1997
and 1996, respectively. Variances in net income may not correspond to variances
in net income per Limited Partnership unit due to the allocation of components
of income and loss in accordance with the Partnership agreement.

The decrease in rental revenues, depreciation expense and management fees during
1998 and 1997, was primarily attributable to the sale of 8 aircraft to Triton
during 1997. This decrease in rental revenues and depreciation expense was
offset in part by increased depreciation expense attributable to the
acquisition, in November 1996, of noise-suppression devices, commonly known as
"hushkits", for the 10 aircraft currently leased to TWA. The hushkits are being
financed over 50 months at an interest rate of 10% per annum. The leases for
these 10 aircraft were extended for a November 2004. The rent payable by TWA
under the leases has been increased by an amount sufficient to cover the monthly
debt service payments on the hushkits and fully repay, during the term of the
TWA leases, the amount borrowed. The Partnership recorded $908,701, $1,205,566
and $122,197 in interest expense on the amount borrowed to finance the hushkits
during 1998, 1997 and 1996, respectively.

The Partnership recorded other income of $785,094 during 1997 compared to $-0-
during 1998. This other income, in 1997, was primarily the result of the receipt
of $743,476 related to amounts due under the TWA maintenance credit and rent
deferral agreement, as discussed below under TWA Restructuring.

8
<PAGE>

Interest income decreased during 1998, as compared to 1997, primarily due to the
payoff of notes receivable from Continental Airlines, Inc. and Triton during
1997.

Operating expense increased due to legal expense related to the Ron Wallace
Litigation Settlement as more fully described below.

In January 1995, the United States Bankruptcy Court approved an agreement
between the Partnership and Continental which specified payment to the
Partnership by Continental of approximately $1.3 million as final settlement for
the return of six Boeing 727-100 aircraft. The Partnership received an initial
payment of $311,111 in February 1995 and received the balance of the settlement
in equal monthly installments of $72,222 through February 1996. The Partnership
received all payments due from Continental for the settlement, which were
recorded as revenue when received. The Partnership recorded payments of $144,444
as lessee settlements during 1996.

The Partnership recognized substantially higher depreciation expense in 1996, as
compared to the prior year. As discussed in the Industry Update section, if the
projected net cash flow for each aircraft (projected rental revenue, net of
management fees, less projected maintenance costs, if any, plus the estimated
residual value) is less than the carrying value of the aircraft, the Partnership
recognizes the deficiency currently as increased depreciation expense. The
Partnership recognized an impairment loss on aircraft to be held and used by the
Partnership of approximately $12.5 million in 1996 as increased depreciation
expense. In 1996, the impairment loss was the result of several significant
factors. As a result of industry and market changes, a more extensive review of
the Partnership's aircraft was completed in the fourth quarter of 1996 which
resulted in revised assumptions of future cash flows including reassessment of
projected re-lease terms and potential future maintenance costs. As discussed in
Note 4, the Partnership accepted an offer to purchase eight of the Partnership's
remaining aircraft subject to each aircraft's existing lease. This offer
constituted an event that required the Partnership to review the aircraft
carrying value pursuant to SFAS 121. In determining this additional impairment
loss, the Partnership estimated the fair value of the aircraft based on the
purchase price reflected in the offer, less the estimated costs and expenses of
the proposed sale. The partnership is deemed to have an impairment loss to the
extent that the carrying value exceeded the fair value. Management believes the
assumptions related to fair value of impaired assets represents the best
estimates based on reasonable and supportable assumptions and projections.

The increased depreciation expense reduces the aircraft's carrying value and
reduces the amount of future depreciation expense that the Partnership will
recognize over the projected remaining economic life of the aircraft. For any
downward adjustment to the estimated residual values, future depreciation
expense over the projected remaining economic life of the aircraft is increased.
The Partnership's earnings are impacted by the net effect of the adjustments to
the aircraft carrying values recorded in 1996, as discussed later in the
Industry Update section.

Liquidity and Cash Distributions

Liquidity - The Partnership received prepayment in full of all amounts due from
Triton and all lease payments from lessees, except for the $850,000 December 27,
1998 payment due from TWA, which was received on January 4, 1999. This amount
was included in rent and other receivables on the balance sheet at December 31,
1998.

During 1998, 1997 and 1996, the Partnership received net proceeds from the sale
of aircraft inventory of $230,577, $590,981 and $902,733, respectively. This
includes the sale of remaining inventory of aircraft parts from the four
disassembled aircraft to Soundair in 1998 for $100,000.

9
<PAGE>

amounts previously received for sales as of that date. The net purchase price of
$88,596 was paid in September 1998, and is included in gain on sale of aircraft
inventory.

PIMC has determined that the Partnership maintain cash reserves as a prudent
measure to ensure that the Partnership has available funds in the event that the
aircraft presently on lease to TWA require remarketing, and for other
contingencies including expenses of the Partnership. The Partnership's cash
reserves will be monitored and may be revised from time to time as further
information becomes available in the future.

As discussed above and in Note 7 to the financial statements (Item 8), the
Partnership agreed to share the cost of meeting certain Airworthiness Directives
(ADs) with TWA. In accordance with the cost-sharing agreement, TWA may offset up
to an additional $1.0 million against rental payments, subject to annual
limitations, over the remaining lease terms.

Cash Distributions - Cash distributions to Limited Partners were $19,148,468,
$11,100,000, and $18,875,000 in 1998, 1997 and 1996, respectively. Cash
distributions per Limited Partnership unit totaled $38.30, $22.20, and $37.75 in
1998, 1997 and 1996, respectively. The timing and amount of future cash
distributions are not yet known and will depend on the Partnership's future cash
requirements (including expenses of the Partnership) and need to retain cash
reserves as previously discussed in the Liquidity section, and the receipt of
rental payments from TWA.

Impact of the Year 2000 Issue

The inability of business processes to continue to function correctly after the
beginning of the Year 2000 could have serious adverse effects on companies and
entities throughout the world. As discussed in prior filings with the Securities
and Exchange Commission, the General Partner has engaged GE Capital Aviation
Services, Inc. ("GECAS") to provide certain management services to the
Partnership. Both the General Partner and GECAS are wholly-owned subsidiaries
(either direct or indirect) of General Electric Capital Corporation ("GECC").
All of the Partnership's operational functions are handled either by the General
Partner and GECAS or by third parties (as discussed in the following
paragraphs), and the Partnership has no information systems of its own.

GECC and GECAS have undertaken a global effort to identify and mitigate Year
2000 issues in their information systems, products and services, facilities and
suppliers as well as to assess the extent to which Year 2000 issues will impact
their customers. Each business has a Year 2000 leader who oversees a
multi-functional remediation project team responsible for applying a Six Sigma
quality approach in four phases: (1) define/measure -- identify and inventory
possible sources of Year 2000 issues; (2) analyze -- determine the nature and
extent of Year 2000 issues and develop project plans to address those issues;
(3) improve -- execute project plans and perform a majority of the testing; and
(4) control -- complete testing, continue monitoring readiness and complete
necessary contingency plans. The progress of this program is monitored at each
business, and company-wide reviews with senior management are conducted monthly.
GECC and GECAS management plan to have completed the first three phases of the
program for a substantial majority of mission-critical systems by the end of
1998 and to have nearly all significant information systems, products and
services, facilities and suppliers in the control phase of the program by
mid-1999.

As noted elsewhere, the Partnership has ten aircraft remaining in its portfolio
at this time. All of these remaining aircraft are on lease with Trans World
Airlines, Inc. ("TWA"). TWA has advised GECAS that it has adopted procedures to
identify and address Year 2000 issues and that it has developed a plan to
implement required changes in its equipment, operations and systems. To the
extent, however, that TWA suffers any material disruption of its business and
operations due to Year 2000 failure of equipment or information systems, such
disruption would likely have a material adverse effect on the Partnership's
operations and financial condition.

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<PAGE>

Aside from maintenance and other matters relating to the Partnership's
aircraft-related assets discussed above, the principal third-party vendors to
the Partnership are those providing the Partnership with services such as
accounting, auditing, banking and investor services. GECAS intends to apply the
same standards in determining the Year 2000 capabilities of the Partnership's
third-party vendors as GECAS will apply with respect to its outside vendors
pursuant to its internal Year 2000 program.

The scope of the global Year 2000 effort encompasses many thousands of
applications and computer programs; products and services; facilities and
facilities-related equipment; suppliers; and, customers. The Partnership, like
all business operations, is also dependent on the Year 2000 readiness of
infrastructure suppliers in areas such as utility, communications,
transportation and other services. In this environment, there will likely be
instances of failure that could cause disruptions in business processes or that
could affect customers' ability to repay amounts owed to the Partnership or
vendors' ability to provide services without interruption. The likelihood and
effects of failures in infrastructure systems, over which the Partnership has no
control, cannot be estimated. However, aside from the impact of any such
possible failures or the possibility of a disruption of TWA's business caused by
Year 2000 failures, the General Partner does not believe that occurrences of
Year 2000 failures will have a material adverse effect on the financial
position, results of operations or liquidity of the Partnership.

To date, the Partnership has not incurred any Year 2000 expenditures nor does it
expect to incur any material costs in the future. However, the activities
involved in the Year 2000 effort necessarily involve estimates and projections
of activities and resources that will be required in the future. These estimates
and projections could change as work progresses.

Sale of Aircraft

Sale of Aircraft to Triton - On May 28, 1997, PIMC, on behalf of the
Partnership, executed definitive documentation for the purchase of 8 of the
Partnership's 18 remaining aircraft (the "Aircraft") and certain of its notes
receivables by Triton Aviation Services III LLC, a special purpose company (the
"Purchaser"). The closings for the purchase of the 8 Aircraft occurred from June
5, 1997 to June 25, 1997. The Purchaser is managed by Triton Aviation Services,
Ltd. ("Triton Aviation" or the "Manager"), a privately held aircraft leasing
company which was formed in 1996 by Triton Investments, Ltd., a company which
has been in the marine cargo container leasing business for 17 years and is
diversifying its portfolio by leasing commercial aircraft. Each Aircraft was
sold subject to the existing leases.

The General Partner's Decision to Approve the Transaction - In determining
whether the transaction was in the best interests of the Partnership and its
unitholders, PIMC evaluated, among other things, the risks and significant
expenses associated with continuing to own and remarket the Aircraft (many of
which were subject to leases that were nearing expiration). The General Partner
determined that such a strategy could require the Partnership to expend a
significant portion of its cash reserves for remarketing and that there was a
substantial risk that this strategy could result in the Partnership having to
reduce or even suspend future cash distributions to Limited Partners. The
General Partner concluded that the opportunity to sell the Aircraft at an
attractive price would be beneficial in the present market where demand for
Stage II aircraft is relatively strong rather than attempting to sell the
aircraft "one-by-one" over the coming years when the demand for such Aircraft
might be weaker. GE Capital Aviation Services, Inc. ("GECAS"), which provides
aircraft marketing and management services to the General Partner, sought to
obtain the best price and terms available for these Stage II aircraft given the
aircraft market and the conditions and types of planes owned by the Partnership.
Both the General Partner and GECAS approved the sale terms of the Aircraft as
being in the best interest of the Partnership and its unit holders because both
believe that this transaction will optimize the potential cash distributions to
be paid to Limited Partners. To ensure that no better offer could be obtained,
the terms of the transaction negotiated by GECAS included a "market-out"
provision that permitted the Partnership to elect to accept an offer for all
(but not less than all) of the assets to be sold by it to the Purchaser on terms
which it deemed more favorable, with the ability of the Purchaser to match the

11
<PAGE>

offer or decline to match the offer and be entitled to be compensated in an
amount equal to 1.5% of the Purchaser's proposed purchase price. The Partnership
did not receive any other offers and, accordingly, the General Partner believes
that a valid market check had occurred confirming that the terms of this
transaction were the most beneficial that could have been obtained.

The Terms of the Transaction - The total contract purchase price (the "Purchase
Price") to the Purchaser was $10,947,000 which was allocated to the Aircraft and
a note receivable by the Partnership. The Purchaser paid into an escrow account
$1,233,289 of the Purchase Price in cash at the closing of the first aircraft
and delivered a promissory note (the "Promissory Note") for the balance of
$9,713,711. The Partnership received payment of $1,233,289 from the escrow
account on June 26, 1997. On December 30, 1997, the Partnership received
prepayment in full of the outstanding note receivable and interest earned by the
Partnership to that date.

Under the purchase agreement, the Purchaser purchased the Aircraft effective as
of April 1, 1997 notwithstanding the actual closing dates. The utilization of an
effective date facilitated the determination of rent and other allocations
between the parties. The Purchaser had the right to receive all income and
proceeds, including rents and receivables, from the Aircraft accruing from and
after April 1, 1997, and the Promissory Note commenced bearing interest as of
April 1, 1997 subject to the closing of the Aircraft. Each Aircraft was sold
subject to the existing leases.

Neither PIMC nor GECAS received a sales commission in connection with the
transaction. In addition, PIMC was not paid a management fee with respect to the
collection of the Promissory Note or on any rents accruing from or after April
1, 1997 with respect to the 8 Aircraft. Neither PIMC nor GECAS or any of its
affiliates holds any interest in Triton Aviation or any of Triton Aviation's
affiliates. John Flynn, the current President of Triton Aviation, was a Polaris
executive until May 1996 and has over 15 years experience in the commercial
aviation industry. At the time Mr. Flynn was employed at PIMC, he had no
affiliation with Triton Aviation or its affiliates.

Polaris Aircraft Income Fund II, Polaris Aircraft Income Fund IV, Polaris
Aircraft Income Fund V and Polaris Aircraft Income Fund VI have also sold
certain aircraft assets to separate special purpose companies under common
management with the Purchaser (collectively, together with the Purchaser, the
"SPC's") on terms similar to those set forth above, with the exception of the
Polaris Aircraft Income Fund VI aircraft, which were sold on an all cash basis.

The Accounting Treatment of the Transaction - In accordance with GAAP, the
Partnership recognized rental income up until the closing date for each aircraft
which occurred from June 5, 1997 to June 25, 1997. However, under the terms of
the transaction, the Purchaser was entitled to receive any payments of the
rents, interest income and receivables accruing from April 1, 1997. As a result,
the Partnership made payments to the Purchaser for the amounts due and received
from April 1, 1997 to the closing date. Amounts totaling $1,341,968 during this
period are included in rents from operating leases, interest and other income.
For financial reporting purposes, the cash down payment portion of the sales
proceeds of $1,233,289 has been adjusted by the following; income and proceeds,
including rents and receivables from the effective date of April 1, 1997 to the
closing date, interest due from the Purchaser on the cash portion of the
purchase price, interest on the Promissory Note from the effective date of April
1, 1997 to the closing date and estimated selling costs. As a result of these
GAAP adjustments, the net adjusted sales price recorded by the Partnership,
including the Promissory Note, was $9,827,305.

The Aircraft sold pursuant to the definitive documentation executed on May 28,
1997 had been classified as aircraft held for sale from that date until the
actual closing date. Under GAAP, aircraft held for sale are carried at their
fair market value less estimated costs to sell. The adjustment to the sales
proceeds described above and revisions to estimated costs to sell the Aircraft
required the Partnership to record an adjustment to the net carrying value of
the aircraft held for sale of $1,092,046 during the three months ended June 30,
1997. This adjustment to the net carrying value of the aircraft held for sale is
included in depreciation expense on the statement of operations.

12
<PAGE>

TWA Restructuring

In October 1994, TWA notified its creditors, including the Partnership, of
another proposed restructuring of its debt. Subsequently, GECAS negotiated a
standstill arrangement, as set forth in a letter agreement dated December 16,
1994 (the Deferral Agreement), with TWA for the 46 aircraft that were managed by
GECAS, 13 of which were owned by the Partnership. As required by its terms, the
Deferral Agreement (which has since been amended as discussed below) was
approved by PIMC on behalf of the Partnership with respect to the Partnership's
aircraft.

The Deferral Agreement provided for (i) a moratorium on all the rent due to the
Partnership in November 1994 and on 75% of the rents due to the Partnership from
December 1994 through March 1995, and (ii) all of the deferred rents, together
with interest thereon, to be repaid in monthly installments beginning in May
1995 and ending in December 1995. The repayment schedule was subsequently
accelerated upon confirmation of TWA's bankruptcy plan. The Partnership recorded
a note receivable and an allowance for credit losses equal to the total of the
deferred rents, the net of which was reflected in the Partnership's 1994 balance
sheet (Item 8). The Partnership did not recognize either the $1,137,500 rental
amount deferred in 1994 or the $1,462,500 rental amount deferred during the
first quarter of 1995 as rental revenue until the deferred rents were received.
The Partnership received all scheduled rent payments beginning in April 1995,
and all scheduled deferred rental payments beginning in May 1995, including
interest at a rate of 12% per annum, from TWA and has recognized the $2.6
million deferred rents as rental revenue during 1995. The deferred rents were
paid in full by October 1995.

In consideration for the partial rent moratorium described above, TWA agreed to
make a lump sum payment of $1,000,000 to GECAS for the TWA lessors for whom
GECAS provides management services and who agreed to the Deferral Agreement. In
addition, TWA agreed to issue warrants to the Partnership for TWA Common Stock.

In order to resolve certain issues that arose after the execution of the
Deferral Agreement, TWA and GECAS entered into a letter agreement dated June 27,
1995, pursuant to which they agreed to amend certain provisions of the Deferral
Agreement (as so amended, the Amended Deferral Agreement). The effect of the
Amended Deferral Agreement, which was approved by PIMC with respect to the
Partnership's aircraft, is that TWA, in addition to agreeing to repay the
deferred rents to the Partnership, agreed (i) to a fixed payment amount (payable
in warrants, the number of which was determined by formula) in consideration for
the aircraft owners' agreement to defer rent under the Deferral Agreement, and,
(ii) to the extent the market value of the warrants is less than the payment
amount, to supply maintenance services to the aircraft owners having a value
equal to such deficiency. The payment amount was determined by subtracting
certain maintenance reimbursements owed to TWA by certain aircraft owners,
including the Partnership, from the aggregate amount of deferred rents.

On June 30, 1995, TWA filed its prepackaged Chapter 11 bankruptcy in the United
States Bankruptcy Court for the Eastern District of Missouri. On August 4, 1995,
the Bankruptcy Court confirmed TWA's plan of reorganization, which became
effective on August 23, 1995. Pursuant to the Amended Deferral Agreement, on the
confirmation date of the plan, August 4, 1995, the Partnership received a
payment of $881,480 from TWA which represented fifty percent (50%) of the
deferred rent outstanding plus interest as of such date. The remaining balance
of deferred rent plus interest was paid in full to the Partnership on October 2,
1995. TWA has been current with its obligation to the Partnership since August
1995. While TWA has committed to an uninterrupted flow of lease payments, there
can be no assurance that TWA will continue to honor its obligations in the
future.

The Partnership received warrants to purchase 159,919 shares of TWA Common Stock
from TWA in November 1995. The Partnership exercised the warrants on December
29, 1995 for the strike price of $0.01 per share. The fair market value of the
TWA stock at December 31, 1995 was $1,659,159, which was determined based on
quoted market prices. The Partnership sold the TWA Common Stock in February

13
<PAGE>

1996, net of broker commissions, for $1,698,057 and recognized a gain on trading
securities of $38,898 in 1996.

Ron Wallace Litigation Settlement

Industry Update

Maintenance of Aging Aircraft - The process of aircraft maintenance begins at
the aircraft design stage. For aircraft operating under Federal Aviation
Administration (FAA) regulations, a review board consisting of representatives
of the manufacturer, FAA representatives and operating airline representatives
is responsible for specifying the aircraft's initial maintenance program. The
General Partner understands that this program is constantly reviewed and
modified throughout the aircraft's operational life.

Since 1988, the FAA, working with the aircraft manufacturers and operators, has
issued a series of ADs which mandate that operators conduct more intensive
inspections, primarily of the aircraft fuselages. The results of these mandatory
inspections may uncover the need for repairs or structural modifications that
may not have been required under pre-existing maintenance programs.

In addition, an AD adopted in 1990, applicable to McDonnell Douglas aircraft,
requires replacement or modification of certain structural items on a specific
timetable. These structural items were formerly subject to periodic inspection,
with replacement when necessary. The AD requires specific work to be performed
at various cycle thresholds between 40,000 and 100,000 cycles, and on specific
date or age thresholds. The estimated cost of compliance with all of the
components of this AD is approximately $850,000 per aircraft. The extent of
modifications required to an aircraft varies according to the level of
incorporation of design improvements at manufacture.

In January 1993, the FAA adopted another AD intended to mitigate corrosion of
structural components, which would require repeated inspections from 5 years of
age throughout the life of an aircraft, with replacement of corroded components

14
<PAGE>

as needed. Integration of the new inspections into each aircraft operator's
maintenance program was required by January 31, 1994.

The Partnership's existing leases require the lessees to maintain the
Partnership's aircraft in accordance with an FAA-approved maintenance program
during the lease term. At the end of the leases, each lessee is generally
required to return the aircraft in airworthy condition, including compliance
with all ADs for which action is mandated by the FAA during the lease term. The
Partnership agreed to bear a portion of certain maintenance and/or AD compliance
costs, as discussed in Item 1, with respect to the aircraft leased to TWA. An
aircraft returned to the Partnership as a result of a lease default would most
likely not be returned to the Partnership in compliance with all return
conditions required by the lease. In negotiating subsequent leases, market
conditions currently generally require that the Partnership bear some or all of
the costs of compliance with future ADs or ADs that have been issued, but which
did not require action during the previous lease term. The ultimate effect on
the Partnership of compliance with the FAA maintenance standards is not
determinable at this time and will depend on a variety of factors, including the
state of the commercial aircraft industry, the timing of the issuance of ADs,
and the status of compliance therewith at the expiration of the current leases.

Aircraft Noise - Another issue which has affected the airline industry is that
of aircraft noise levels. The FAA has categorized aircraft according to their
noise levels. Stage 1 aircraft, which have the highest noise level, are no
longer allowed to operate from civil airports in the United States. Stage 2
aircraft meet current FAA requirements, subject to the phase-out rules discussed
below. Stage 3 aircraft are the most quiet and Stage 3 is the standard for all
new aircraft.

On September 24, 1991, the FAA issued final rules on the phase-out of Stage 2
aircraft by the end of this decade. The key features of the rule include:

- Compliance can be accomplished through a gradual process of
phase-in or phase-out (see below) on each of three interim
compliance dates: December 31, 1994, 1996 and 1998. All Stage
2 aircraft must be phased out of operations in the contiguous
United States by December 31, 1999, with waivers available in
certain specific cases to December 31, 2003.

- All operators have the option of achieving compliance through
a gradual phase-out of Stage 2 aircraft (i.e., eliminate 25%
of its Stage 2 fleet on each of the compliance dates noted
above), or a gradual phase-in of Stage 3 aircraft (i.e., 55%,
65% and 75% of an operator's fleet must consist of Stage 3
aircraft by the respective interim compliance dates noted
above).

The federal rule does not prohibit local airports from issuing more stringent
phase-out rules. In fact, several local airports have adopted more stringent
noise requirements which restrict the operation of Stage 2 and certain Stage 3
aircraft.

Other countries have also adopted noise policies. The European Union (EU)
adopted a non-addition rule in 1989, which directed each member country to pass
the necessary legislation to prohibit airlines from adding Stage 2 aircraft to
their fleets after November 1, 1990, with all Stage 2 aircraft phased-out by the
year 2002. The International Civil Aviation Organization has also endorsed the
phase-out of Stage 2 aircraft on a world-wide basis by the year 2002.

Hushkit modifications, which allow Stage 2 aircraft to meet Stage 3
requirements, are currently available for the Partnership's aircraft. Hushkits
were added to 10 of the Partnership's Stage 2 aircraft in 1996.

Currently, legislation has been drafted and is under review by the EU to adopt
anti-hushkitting regulations within member states. The legislation seeks to ban
hushkitted aircraft from being added to member states registers after April 1,
1999 and will preclude all operation of hushkitted aircraft within the EU by

15
<PAGE>

April 1, 2002. The effect of this proposal has been to reduce the demand for
hushkitted aircraft within the EU and its neighboring states, including the
former Eastern Block states.

Demand for Aircraft - At year end 1998, there were approximately 12,600 jet
aircraft in the world fleet. Approximately 1,500 aircraft were leased or sold
during 1998, an increase of 14% over 1997. Air travel has grown strongly during
the past 28 years, with the last nineteen years showing better than 5.5% annual
growth, and not until recently has it subsided after what had been a robust
period from 1994 to 1997. This strong period has mainly benefited Stage 3 narrow
bodies and younger Stage 2 narrow bodies, many of which have been or are being
upgraded with hushkits. During 1998, the industry saw many alliances taking
place. There was more consolidation in the U.S. Airline Industry via alliances
than had been seen in the previous 20 years since deregulation. Booming traffic
demand coupled with reductions in the price of aviation fuel has resulted in
record profits for many airlines in North America and Europe. However, slower
traffic lies ahead, the cycle has peaked in 1998, as may have airline profits.
Manufacturers continue to produce at high levels compared to what demand will
require in the future years. Asia continues its economic turmoil which has
brought about a significant reduction in traffic growth in that region. This is
resulting in a number of new aircraft order deferrals and cancellations, mainly
in the wide body sector, with over capacity moving from Asia into the other
regions around the world. Timing of when the down cycle ends or how severe it
will be is still in question, but will be closely watched as we move into the
next millennium.

Effects on the Partnership's Aircraft - The Partnership periodically reviews the
estimated realizability of the residual values at the projected end of each
aircraft's economic life based on estimated residual values obtained from
independent parties which provide current and future estimated aircraft values
by aircraft type. For any downward adjustment in estimated residual value or
decrease in the projected remaining economic life, the depreciation expense over
the projected remaining economic life of the aircraft is increased.

If the projected net cash flow for each aircraft (projected rental revenue, net
of management fees, less projected maintenance costs, if any, plus the estimated
residual value) is less than the carrying value of the aircraft, the Partnership
recognizes the deficiency currently as increased depreciation expense. The
Partnership recognized approximately $12.5 million, or $24.95 per Limited
Partnership unit, of this deficiency as increased depreciation expense in 1996.
In 1996, the impairment loss was the result of several significant factors. As a
result of industry and market changes, a more extensive review of the
Partnership's aircraft was completed in the fourth quarter of 1996 which
resulted in revised assumptions of future cash flows including reassessment of
projected re-lease terms and potential future maintenance costs. As discussed in
Note 4, the Partnership accepted an offer to purchase eight of the Partnership's
remaining aircraft subject to each aircraft's existing lease. This offer
constituted an event that required the Partnership to review the aircraft
carrying value pursuant to SFAS 121. In determining this additional impairment
loss, the Partnership estimated the fair value of the aircraft based on the
proposed purchase price reflected in the offer, and then deducted this amount
from the carrying value of the aircraft. The partnership recorded an impairment
loss to the extent that the carrying value exceeded the fair value. Management
believes the assumptions related to fair value of impaired assets represents the
best estimates based on reasonable and supportable assumptions and projections.

The Partnership periodically reviews its aircraft for impairment in accordance
with SFAS No. 121. The Partnership uses information obtained from third party
valuation services in arriving at its estimate of fair value for purposes of
determining residual values. The Partnership will use similar information, plus
available information and estimates related to the Partnership's aircraft, to
determine an estimate of fair value to measure impairment as required by the
statement. The estimates of fair value can vary dramatically depending on the
condition of the specific aircraft and the actual marketplace conditions at the
time of the actual disposition of the asset. If assets are deemed impaired,
there could be substantial write-downs in the future.

16
<PAGE>

Item 8. Financial Statements and Supplementary Data

POLARIS AIRCRAFT INCOME FUND III,
A California Limited Partnership

FINANCIAL STATEMENTS AS OF DECEMBER 31, 1998 AND 1997

AND FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996

TOGETHER WITH THE

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

17
<PAGE>

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Partners of
Polaris Aircraft Income Fund III,
A California Limited Partnership:

We have audited the accompanying balance sheets of Polaris Aircraft Income Fund
III, A California Limited Partnership as of December 31, 1998 and 1997, and the
related statements of operations, changes in partners' capital (deficit) and
cash flows for each of the three years in the period ended December 31, 1998.
These financial statements are the responsibility of the General Partner. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by the
General Partner, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Polaris Aircraft Income Fund
III, A California Limited Partnership as of December 31, 1998 and 1997, and the
results of its operations and its cash flows for each of the three years in the
period ended December 31, 1998, in conformity with generally accepted accounting
principles.

ARTHUR ANDERSEN LLP

San Francisco, California,
January 25, 1999

18
<PAGE>

POLARIS AIRCRAFT INCOME FUND III,
A California Limited Partnership

BALANCE SHEETS

DECEMBER 31, 1998 AND 1997

1998 1997
---- ----
ASSETS:

CASH AND CASH EQUIVALENTS $ 13,423,701 $ 28,632,488

RENT AND OTHER RECEIVABLES 850,748 850,760

AIRCRAFT, net of accumulated depreciation
of $56,439,234 in 1998 and $53,612,863 in 1997 25,745,343 28,571,714
------------ ------------

$ 40,019,792 $ 58,054,962
============ ============

LIABILITIES AND PARTNERS' CAPITAL (DEFICIT):

PAYABLE TO AFFILIATES $ 115,888 $ 123,242

ACCOUNTS PAYABLE AND ACCRUED
LIABILITIES 121,632 80,211

DEFERRED INCOME 1,837,210 626,578

NOTES PAYABLE 7,792,177 11,080,004
------------ ------------

Total Liabilities 9,866,907 11,910,035
------------ ------------

PARTNERS' CAPITAL (DEFICIT):
General Partner (3,642,196) (2,854,104)
Limited Partners, 499,960 and 500,000 units
outstanding in 1998 and 1997 33,795,081 48,999,031
------------ ------------

Total Partners' Capital 30,152,885 46,144,927
------------ ------------

$ 40,019,792 $ 58,054,962
============ ============

The accompanying notes are an integral part of these statements.

19
<PAGE>

POLARIS AIRCRAFT INCOME FUND III,
A California Limited Partnership

STATEMENTS OF OPERATIONS

FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996

1998 1997 1996
---- ---- ----

REVENUES:
Rent from operating leases $ 8,989,368 $ 11,965,617 $ 15,230,936
Interest 835,969 1,617,688 1,438,839
Gain on sale of aircraft
inventory 230,577 590,981 206,781
Lessee settlements -- -- 144,444
Gain on trading securities -- -- 38,898
Other -- 785,094 17,860
------------ ------------ ------------

Total Revenues 10,055,914 14,959,380 17,077,758
------------ ------------ ------------

EXPENSES:
Depreciation 2,826,371 7,930,392 22,661,686
Management fees to General
Partner 347,147 420,482 761,547
Interest 908,701 1,205,566 122,197
Operating 318,160 33,158 24,549
Administration and other 367,581 380,686 311,308
------------ ------------ ------------

Total Expenses 4,767,960 9,970,284 23,881,287
------------ ------------ ------------

NET INCOME (LOSS) $ 5,287,954 $ 4,989,096 $ (6,803,529)
============ ============ ============

NET INCOME ALLOCATED TO
THE GENERAL PARTNER $ 1,339,516 $ 49,891 $ 1,819,276
============ ============ ============

NET INCOME (LOSS) ALLOCATED
TO THE LIMITED PARTNERS $ 3,948,438 $ 4,939,205 $ (8,622,805)
============ ============ ============

NET INCOME (LOSS) PER LIMITED
PARTNERSHIP UNIT $ 7.90 $ 9.88 $ (17.25)
============ ============ ============

The accompanying notes are an integral part of these statements.

20
<PAGE>

POLARIS AIRCRAFT INCOME FUND III,
A California Limited Partnership

STATEMENTS OF CHANGES IN PARTNERS' CAPITAL (DEFICIT)

FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996

General Limited
Partner Partners Total
------- -------- -----

Balance, December 31, 1995 $ (1,392,716) $ 82,657,631 $ 81,264,915

Net income (loss) 1,819,276 (8,622,805) (6,803,529)

Cash distributions to partners (2,097,222) (18,875,000) (20,972,222)
------------ ------------ ------------

Balance, December 31, 1996 (1,670,662) 55,159,826 53,489,164

Net income 49,891 4,939,205 4,989,096

Cash distributions to partners (1,233,333) (11,100,000) (12,333,333)
------------ ------------ ------------

Balance, December 31, 1997 (2,854,104) 48,999,031 46,144,927

Net income 1,339,516 3,948,438 5,287,954

Capital redemptions -- (3,920) (3,920)

Cash distributions to partners (2,127,608) (19,148,468) (21,276,076)
------------ ------------ ------------

Balance, December 31, 1998 $ (3,642,196) $ 33,795,081 $ 30,152,885
============ ============ ============

The accompanying notes are an integral part of these statements.

21
<PAGE>

POLARIS AIRCRAFT INCOME FUND III,
A California Limited Partnership

STATEMENTS OF CASH FLOWS

FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996

1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net income (loss) $ 5,287,954 $ 4,989,096 $ (6,803,529)
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Depreciation and amortization 2,826,371 7,930,392 22,661,686
Gain on sale of aircraft inventory (230,577) (590,981) (206,781)
Changes in operating assets and liabilities:
Decrease in marketable securities, trading -- -- 1,659,160
Decrease (increase) in rent and other
receivables 12 (498,866) (343,337)
Decrease (increase) in other assets -- 104,275 (78,186)
Increase (decrease) in payable to affiliates (7,354) 37,237 (44,579)
Increase (decrease) in accounts payable
and accrued liabilities 41,421 (43,147) (11,925)
Increase (decrease) in deferred income 1,210,632 166,498 (61,701)
------------ ------------ ------------

Net cash provided by operating activities 9,128,459 12,094,504 16,770,808
------------ ------------ ------------

INVESTING ACTIVITIES:
Increase in aircraft capitalized costs -- -- (15,930,822)
Proceeds from sale of aircraft inventory 230,577 590,981 902,733
Proceeds from sale of aircraft -- 1,506,762 --
Payments to Purchaser related to sale of aircraft -- (1,341,968) --
Inventory disassembly costs -- -- (9,282)
Principal payments on notes receivable -- 9,713,711 1,546,407
------------ ------------ ------------

Net cash provided by (used in)
investing activities 230,577 10,469,486 (13,490,964)
------------ ------------ ------------

FINANCING ACTIVITIES:
Increase in notes payable -- -- 12,930,822
Principal payments on notes payable (3,287,827) (1,827,274) (23,544)
Capital redemptions (3,920) -- --
Cash distributions to partners (21,276,076) (12,333,333) (20,972,222)
------------ ------------ ------------

Net cash used in financing activities (24,567,823) (14,160,607) (8,064,944)
------------ ------------ ------------

CHANGES IN CASH AND CASH
EQUIVALENTS (15,208,787) 8,403,383 (4,785,100)

CASH AND CASH EQUIVALENTS AT
BEGINNING OF YEAR 28,632,488 20,229,105 25,014,205
------------ ------------ ------------

CASH AND CASH EQUIVALENTS AT
END OF YEAR $ 13,423,701 $ 28,632,488 $ 20,229,105
============ ============ ============
</TABLE>

The accompanying notes are an integral part of these statements.

22
<PAGE>

POLARIS AIRCRAFT INCOME FUND III,
A California Limited Partnership

NOTES TO FINANCIAL STATEMENTS

DECEMBER 31, 1998

1. Accounting Principles and Policies

Accounting Method - Polaris Aircraft Income Fund III, A California Limited
Partnership (PAIF-III or the Partnership), maintains its accounting records,
prepares its financial statements and files its tax returns on the accrual basis
of accounting. The preparation of financial statements in conformity with
generally accepted accounting principles (GAAP) requires management to make
estimates and assumptions that affect reported amounts and related disclosures.
Actual results could differ from those estimates. The most significant estimates
with regard to these financial statements are related to the projected cash
flows analysis in determining the fair value of assets.

Cash and Cash Equivalents - This includes deposits at banks and investments in
money market funds. Cash and Cash Equivalents is stated at cost, which
approximates fair value.

Marketable Securities, trading - Marketable Securities, trading were carried at
fair value, which was determined based on quoted market prices. These securities
were held for sale in the near term (Note 7).

Aircraft and Depreciation - The aircraft are recorded at cost, which includes
acquisition costs. Depreciation to an estimated residual value is computed using
the straight-line method over the estimated economic life of the aircraft which
was originally estimated to be 30 years from the date of manufacture.
Depreciation in the year of acquisition was calculated based upon the number of
days that the aircraft were in service.

The Partnership periodically reviews the estimated realizability of the residual
values at the projected end of each aircraft's economic life. For any downward
adjustment in estimated residual value or decrease in the projected remaining
economic life, the depreciation expense over the projected remaining economic
life of the aircraft will be increased.

If the projected net cash flow for each aircraft (projected rental revenue, net
of management fees, less projected maintenance costs, if any, plus the estimated
residual value) is less than the carrying value of the aircraft, an impairment
loss is recognized. Pursuant to Statement of Financial Accounting Standards
(SFAS) No. 121, as discussed in Note 3, measurement of an impairment loss will
be based on the "fair value" of the asset as defined in the statement.

Capitalized Costs - Aircraft modification and maintenance costs which are
determined to increase the value or extend the useful life of the aircraft are
capitalized and amortized using the straight-line method over the estimated
useful life of the improvement. These costs are also subject to periodic
evaluation as discussed above.

Aircraft Inventory - Aircraft held in inventory for sale are reflected at the
lower of depreciated cost or estimated net realizable value. Proceeds from sales
are applied against inventory until the book value is fully recovered. The
remaining book value of the inventory was recovered in 1996. The Partnership
sold its remaining inventory of aircraft parts in 1998. Proceeds in excess of
the inventory net book value are recorded as revenue when received.

23
<PAGE>

Operating Leases - The aircraft leases are accounted for as operating leases.
Lease revenues are recognized in equal installments over the terms of the
leases.

Operating Expenses - Operating expenses include costs incurred to maintain,
insure and lease the Partnership's aircraft, including costs related to lessee
defaults and costs of disassembling aircraft inventory.

Net Income (Loss) Per Limited Partnership Unit - Net income (loss) per Limited
Partnership unit is based on the Limited Partners' share of net income or loss
and the number of units outstanding of 499,960 for the year ended December 31,
1998, and 500,000 for the years ended December 31, 1997 and 1996, respectively.

Income Taxes - The Partnership files federal and state information income tax
returns only. Taxable income or loss is reportable by the individual partners.

Notes Receivable - The Partnership had recorded an allowance for credit losses
for certain impaired notes as discussed in Note 9. The Partnership recognizes
revenue on these notes only as payments are received.

1998 1997
---- ----
Allowance for credit losses,
beginning of year $ -- $(160,571)
Collections -- 160,571
--------- ---------
Allowance for credit losses,
end of year $ -- $ --
========= =========

2. Organization and the Partnership

The Partnership was formed on June 27, 1984 for the purpose of acquiring and
leasing aircraft. The Partnership will terminate no later than December 2020.
Upon organization, both the General Partner and the depositary contributed $500
to capital. The Partnership recognized no profits and losses during the periods
ended December 31, 1984 and 1985. The offering of depositary units (Units),
representing assignments of Limited Partnership interest, terminated on
September 30, 1987 at which time the Partnership had sold 500,000 Units of $500,
representing $250,000,000. All unit holders were admitted to the Partnership on
or before September 30, 1987. During January 1998, 40 units were redeemed by the
Partnership in accordance with section 18 of the Limited Partnership agreement.
At December 31, 1998, there were 499,960 units outstanding, net of redemptions.

Polaris Investment Management Corporation (PIMC), the sole General Partner of
the Partnership, supervises the day-to-day operations of the Partnership.
Polaris Depository Company III (PDC) serves as the depositary. PIMC and PDC are
wholly-owned subsidiaries of Polaris Aircraft Leasing Corporation (PALC).
Polaris Holding Company (PHC) is the parent company of PALC. General Electric
Capital Corporation (GE Capital), an affiliate of General Electric Company, owns
100% of PHC's outstanding common stock. PIMC has entered into a services
agreement dated as of July 1, 1994 with GE Capital Aviation Services, Inc.
(GECAS). Allocations to affiliates are described in Notes 10 and 11.

3. Aircraft

At December 31, 1998, the Partnership owned 10 aircraft from its original
portfolio of 38 used commercial jet aircraft, which were acquired and leased or
sold as discussed below. All aircraft were acquired from an affiliate and
purchased within one year of the affiliate's acquisition at the affiliate's

24
<PAGE>

original price paid. The aircraft leases are net operating leases, requiring the
lessees to pay all operating expenses associated with the aircraft during the
lease term. While the leases require the lessees to comply with Airworthiness
Directives (ADs) which have been or may be issued by the Federal Aviation
Administration and require compliance during the lease term, in certain of the
leases, the Partnership has agreed to share in the cost of compliance with ADs.
The leases generally state a minimum acceptable return condition for which the
lessee is liable under the terms of the lease agreement. Certain leases also
provide that if the aircraft are returned at a level above the minimum
acceptable level, the Partnership must reimburse the lessee for the related
excess, subject to certain limitations. The related liability, if any, is
currently inestimable and therefore is not reflected in the financial
statements. Of its original portfolio of 38 aircraft, the Partnership sold one
aircraft in 1992, seven aircraft in 1993, three aircraft in 1994 and eight
aircraft in 1997. In addition, nine aircraft were disassembled for sale of their
component parts (Note 6), the remainder of which was sold to Soundair, Inc. in
1998.

The following table describes the Partnership's aircraft portfolio at December
31, 1998 in greater detail:

Year of
Aircraft Type Serial Number Manufacture
- ------------- ------------- -----------
McDonnell Douglas DC-9-30 47028 1967
McDonnell Douglas DC-9-30 47030 1967
McDonnell Douglas DC-9-30 47095 1967
McDonnell Douglas DC-9-30 47109 1968
McDonnell Douglas DC-9-30 47134 1967
McDonnell Douglas DC-9-30 47136 1968
McDonnell Douglas DC-9-30 47172 1968
McDonnell Douglas DC-9-30 47173 1968
McDonnell Douglas DC-9-30 47250 1968
McDonnell Douglas DC-9-30 47491 1970

Ten McDonnell Douglas DC-9-30s - Initially thirteen aircraft were acquired for
$86,163,046 during 1986 and 1987, and leased to Ozark Air Lines, Inc. (Ozark).
In 1987, Trans World Airlines, Inc. (TWA) merged with Ozark and assumed the
leases. The leases were modified and extended prior to TWA's bankruptcy filing.
In June 1997, three of the thirteen aircraft were sold, subject to the existing
leases, to Triton Aviation Services III LLC, as discussed in Note 4. The leases
for 10 of the 13 aircraft were extended again for eight years until November
2004, as discussed in Note 8.

The following is a schedule by year of future minimum rental revenue under the
existing leases:

Year Amount
---- ------
1999 $10,200,000
2000 10,200,000
2001 10,200,000
2002 7,450,000
2003 and thereafter 13,200,000
-----------
$51,250,000
===========

Future minimum rental payments may be offset or reduced by future costs as
described in Note 7.

As discussed in Note 1, the Partnership periodically reviews the estimated
realizability of the residual values at the projected end of each aircraft's
economic life based on estimated residual values obtained from independent
parties which provide current and future estimated aircraft values by aircraft
type.

The Partnership's future earnings are impacted by the net effect of the
adjustments to the carrying value of the aircraft (which has the effect of
decreasing future depreciation expense), and the downward adjustments to the

25
<PAGE>

estimated residual values (which has the effect of increasing future
depreciation expense).

As discussed above, the Partnership uses information obtained from third party
valuation services in arriving at its estimate of fair value for purposes of
determining residual values. The Partnership will use similar information, plus
available information and estimates related to the Partnership's aircraft, to
determine an estimate of fair value to measure impairment as required by the
statement. The estimates of fair value can vary dramatically depending on the
condition of the specific aircraft and the actual marketplace conditions at the
time of the actual disposition of the asset. If assets are deemed impaired,
there could be substantial write-downs in the future.

The Partnership recognized an impairment loss on aircraft held and used by the
Partnership aggregating approximately $12.5 million, or $24.95 per Limited
Partnership unit, as increased depreciation expense in 1996. The impairment loss
was the result of several significant factors. As a result of industry and
market changes, a more extensive review of the Partnership's aircraft was
completed in the fourth quarter of 1996 which resulted in revised assumptions of
future cash flows including reassessment of projected re-lease terms and
potential future maintenance costs. As discussed in Note 4, the Partnership
accepted an offer to purchase eight of the Partnership's remaining aircraft
subject to each aircraft's existing lease. This offer constitutes an event that
required the Partnership to review the aircraft carrying value pursuant to SFAS
121. In determining this additional impairment loss, the Partnership estimated
the fair value of the aircraft based on the purchase price reflected in the
offer, less the estimated costs and expenses of the proposed sale. The
partnership recorded an impairment loss to the extent that the carrying value
exceeded the fair value. Management believes the assumptions related to fair
value of impaired assets represents the best estimates based on reasonable and
supportable assumptions and projections.

The General Partner evaluates, from time to time, whether the investment
objectives of the Partnership are better served by continuing to hold the
Partnership's remaining portfolio of Aircraft or marketing such Aircraft for
sale. This evaluation takes into account the current and potential earnings of
the Aircraft, the conditions in the markets for lease and sale and future
outlook for such markets, and the tax consequences of selling rather than
continuing to lease the Aircraft. The General Partner has had discussions with
third parties regarding the possibility of selling some or all of these
Aircraft. While such discussions may continue, and similar discussions may occur
again in the future, there is no assurance that such discussions will result in
the Partnership receiving a purchase offer for all or any of the Aircraft which
the General Partner would regard as acceptable.

4. Sale of Aircraft

26
<PAGE>

prepayment in full of the outstanding note receivable and interest earned by the
Partnership to that date.

5. Ron Wallace Litigation Settlement

27
<PAGE>

General Electric Capital Corporation, certain executives of PIMC and GECAS and
John E. Flynn, a former PIMC executive, as defendants. The complaint alleges
that defendants committed a breach of their fiduciary duties with respect to the
Sale Transaction involving the Partnership as described in Note 4, under the
caption "Sale of Aircraft -- Sale of Aircraft to Triton." On September 2, 1997,
an amended complaint was filed adding additional plaintiffs, and on December 18,
1997, the plaintiffs filed a second amended complaint asserting their claims
derivatively.

6. Disassembly of Aircraft

In an attempt to maximize the economic return from three of the remaining four
McDonnell Douglas DC-9-10 aircraft formerly leased to Midway Airlines, Inc.
(Midway) and the six Boeing 727-100 aircraft formerly leased to Continental
Airlines, Inc. (Continental) (Note 9), the Partnership entered into an agreement
with Soundair, Inc. (Soundair) for the disassembly and sale of these aircraft in
1992.

The Partnership has incurred the cost of disassembly and received the proceeds
from the sale of such parts, net of necessary overhaul expenses, and commissions
paid to Soundair. During 1998, 1997 and 1996, the Partnership received net
proceeds from the sale of aircraft inventory of $230,577 (including the proceeds
discussed below), $590,981 and $902,733, respectively.

The Partnership sold its remaining inventory of aircraft parts from the nine
disassembled aircraft, to Soundair, Inc. The remaining inventory, with a net
carrying value of $-0-, was sold effective February 1, 1998 for $100,000, less
amounts previously received for sales as of that date. The net purchase price of
$88,596 was paid in September 1998, and is included in gain on sale of aircraft
inventory.

7. TWA Reorganization

The Partnership renegotiated the TWA leases after TWA defaulted under its leases
with the Partnership during 1991. The renegotiated agreement stipulated that the
Partnership share in the cost of certain ADs after TWA successfully reorganized.
Pursuant to this cost-sharing agreement, since TWA emerged from its
reorganization proceedings in 1993, expenses totaling $4.7 million have been
offset against rental payments. Under the terms of this agreement, TWA may
offset up to an additional $1.0 million against rental payments, subject to
annual limitations, over the remaining lease terms.

28
<PAGE>

The Deferral Agreement provided for (i) a moratorium on the rents due to the
Partnership in November 1994 and on 75% of the rents due to the Partnership from
December 1994 through March 1995, and (ii) all of the deferred rents, together
with interest thereon, to be repaid in monthly installments beginning in May
1995 and ending in December 1995. The repayment schedule was subsequently
accelerated upon confirmation of TWA's bankruptcy plan. The Partnership did not
recognize either the $1,137,500 rental amount deferred in 1994 or the $1,462,500
rental amount deferred during the first quarter of 1995 as rental revenue until
the deferred rents were received. The deferred rents were paid in full by
October 1995.

In consideration for the partial rent moratorium described above, TWA agreed to
make a lump sum payment of $1,000,000 to GECAS for the TWA lessors for whom
GECAS provides management services and who agreed to the Deferral Agreement.
While TWA has committed to an uninterrupted flow of lease payments, there can be
no assurance that TWA will continue to honor its obligations in the future.

The Partnership received warrants to purchase 159,919 shares of TWA Common Stock
from TWA in November 1995. The Partnership exercised the warrants on December
29, 1995 for the strike price of $0.01 per share. The fair market value of the
TWA stock at December 31, 1995 of $1,659,159, which was determined based on
quoted market prices. The Partnership sold the TWA Common Stock in February
1996, net of broker commissions, for $1,698,057 and recognized a gain on trading
securities of $38,898 in 1996.

8. TWA Lease Extension

GECAS, on behalf of the Partnership, negotiated with TWA for the acquisition of
noise-suppression devices, commonly known as "hushkits", for the 10 Partnership
aircraft currently on lease to TWA, as well as other aircraft owned by
affiliates of PIMC and leased to TWA. The 10 aircraft that received hushkits
were designated by TWA. The hushkits recondition the aircraft so as to meet
Stage 3 noise level restrictions. Installation of the 10 hushkits on the
Partnership's aircraft was completed in November 1996 and the leases for these
10 aircraft were extended for a period of eight years until November 2004.

The aggregate cost of the hushkit reconditioning was $15,930,822, or
approximately $1.6 million per aircraft, which was capitalized by the
Partnership. The Partnership paid $3.0 million of the aggregate hushkit cost and
the balance of $12,930,822 was financed by the engine/hushkit manufacturer over
50 months at an interest rate of approximately 10% per annum. Cash paid for
interest expense on the loan was $912,172, $1,100,648 and $215,416 in 1998, 1997
and 1996, respectively.

29
<PAGE>

engine/hushkit manufacturer is non-recourse to the Partnership and secured by a
security interest in the lease receivables.

9. Continental Lease Modification

The aircraft leases with Continental were modified after Continental filed for
Chapter 11 bankruptcy protection in December 1990. The modified agreement
stipulated that the Partnership pay certain aircraft maintenance, modification
and refurbishment costs, not to exceed approximately $3.2 million, a portion of
which will be recovered with interest through payments from Continental over the
extended lease terms. The Partnership's share of such costs were capitalized and
depreciated over the remaining lease terms, subject to the capitalized cost
policy as described in Note 1. The Partnership approved invoices aggregating
$1,698,106 for interior modifications on the Partnership's aircraft. The
Partnership financed the aggregate amount of these invoices to Continental from
1992 through 1995 to be repaid by Continental with interest over the remaining
lease terms of the aircraft. This note was paid in full during 1996.

The agreement with Continental included an extended deferral of the dates when
Continental would remit its rental payments for the period from December 3, 1990
through September 30, 1991 and for a period of three months, beginning in
November 1992, aggregating $9,917,500 (the Deferred Amount). The Partnership
recorded a note receivable and an allowance for credit losses equal to the total
of the deferred rents and prior accrued interest. The note receivable and
corresponding allowance for credit losses were reduced by the principal portion
of payments received. In addition, the Partnership recognized rental revenue and
interest revenue in the period the deferred rental payments were received.

The allowance for credit losses on the principal and prior interest portion due
was $160,571 as of December 31, 1996. The unrecognized Deferred Amount as of
December 31, 1996 was $159,582. In accordance with the aforementioned agreement,
Continental began making supplemental payments for the Deferred Amount plus
interest on July 1, 1992. During 1996, the Partnership received supplemental
payments of $1,942,267, of which $1,781,940 was recognized as rental revenue in
1996.

10. Related Parties

Under the Limited Partnership Agreement (Partnership Agreement), the Partnership
paid or agreed to pay the following amounts to PIMC and/or its affiliates in
connection with services rendered:

a. An aircraft management fee equal to 5% of gross rental revenues with
respect to operating leases or 2% of gross rental revenues with respect to
full payout leases of the Partnership, payable upon receipt of the rent.
In 1998, 1997 and 1996, the Partnership paid management fees to PIMC of
$300,000, $369,396, and $752,014, respectively. Management fees payable to
PIMC were $104,676 and $57,530 at December 31, 1998 and 1997,
respectively.

b. Reimbursement of certain out-of-pocket expenses incurred in connection
with the management of the Partnership and supervision of its assets. In
1998, 1997 and 1996, the Partnership reimbursed PIMC for expenses of
$714,049, $470,603, and $396,504, respectively. Reimbursements totaling
$11,211 and $65,712 were payable to PIMC at December 31, 1998 and 1997,
respectively.

c. A 10% interest to PIMC in all cash distributions and sales proceeds, gross
income in an amount equal to 9.09% of distributed cash available from
operations and 1% of net income or loss and taxable income or loss, as
such terms are defined in the Partnership Agreement. After the Partnership
has sold or disposed of aircraft representing 50% of the total aircraft
cost, gains from the sale or other disposition of aircraft are generally
allocated first to the General Partner until such time that the General

30
<PAGE>

Partner's capital account is equal to the amount to be distributed to the
General Partner from the proceeds of such sale or disposition.

d. A subordinated sales commission to PIMC of 3% of the gross sales price of
each aircraft for services performed upon disposition and reimbursement of
out-of-pocket and other disposition expenses. Subordinated sales
commissions will be paid only after unit holders have received
distributions in an aggregate amount equal to their capital contributions
plus a cumulative non-compounded 8% per annum return on their adjusted
capital contributions, as defined in the Partnership Agreement. The
Partnership did not pay or accrue a sales commission on any aircraft sales
to date as the subordination threshold has not been met.

e. In the event that, immediately prior to the dissolution and termination of
the Partnership, the General Partner shall have a deficit balance in its
tax basis capital account, then the General Partner shall contribute in
cash to the capital of the Partnership an amount which is equal to such
deficit (see Note 11).

11. Partners' Capital

The Partnership Agreement (the Agreement) stipulates different methods by which
revenue, income and loss from operations and gain or loss on the sale of
aircraft are to be allocated to the General Partner and the Limited Partners
(see Note 10). Such allocations are made using income or loss calculated under
GAAP for book purposes, which, as more fully described in Note 13, varies from
income or loss calculated for tax purposes.

Cash available for distributions, including the proceeds from the sale of
aircraft, is distributed 10% to the General Partner and 90% to the Limited
Partners.

The different methods of allocating items of income, loss and cash available for
distribution combined with the calculation of items of income and loss for book
and tax purposes result in book basis capital accounts that may vary
significantly from tax basis capital accounts. The ultimate liquidation and
distribution of remaining cash will be based on the tax basis capital accounts
following liquidation, in accordance with the Agreement.

Had all the assets of the Partnership been liquidated at December 31, 1998 at
the current carrying value, the tax basis capital accounts of the General
Partner and the Limited Partners is estimated to be $3,015,288 and $27,137,597,
respectively.

12. Income Taxes

Federal and state income tax regulations provide that taxes on the income or
loss of the Partnership are reportable by the partners in their individual
income tax returns. Accordingly, no provision for such taxes has been made in
the financial statements.

31
<PAGE>

The net differences between the tax basis and the reported amounts of the
Partnership's assets and liabilities at December 31, 1998 and 1997 are as
follows:

Reported Amounts Tax Basis Net Difference
---------------- --------- --------------

1998: Assets $40,019,792 $23,550,781 $16,469,011
Liabilities 9,866,907 8,144,706 1,722,201

1997: Assets $58,054,962 $42,276,950 $15,778,012
Liabilities 11,910,035 11,323,507 586,528

13. Reconciliation of Book Net Income (Loss) to Taxable Net Income (Loss)

The following is a reconciliation between net income (loss) per Limited
Partnership unit reflected in the financial statements and the information
provided to Limited Partners for federal income tax purposes:

For the years ended December 31,
--------------------------------

1998 1997 1996
---- ---- ----

Book net income (loss) per Limited
Partnership unit $ 7.90 $ 9.88 $(17.25)
Adjustments for tax purposes represent
differences between book and tax revenue
and expenses:
Rental revenue 2.40 (0.53) (3.65)
Management fee expense (0.15) 0.06 0.16
Depreciation (1.37) 5.12 16.36
Gain or loss on sale of aircraft - 9.00 -
Basis in inventory - (0.40) (0.62)
Other revenue and expense items 0.84 - (0.48)
------- ------- ------

Taxable net income (loss) per Limited
Partnership unit $ 9.62 $ 23.13 $ (5.48)
======= ======= =======

The differences between net income and loss for book purposes and net income and
loss for tax purposes result from the temporary differences of certain revenue
and deductions.

For book purposes, rental revenue is generally recorded as it is earned. For tax
purposes, certain temporary differences exist in the recognition of revenue. For
tax purposes, management fee expense is accrued in the same year as the tax
basis rental revenue.

The Partnership computes depreciation using the straight-line method for
financial reporting purposes and generally an accelerated method for tax
purposes. The Partnership also periodically evaluates the ultimate
recoverability of the carrying values and the economic lives of its aircraft for
book purposes and, accordingly recognized adjustments which increased book
depreciation expense. As a result, the current year book depreciation expense is
greater than the tax depreciation expense. These differences in depreciation
methods result in book to tax differences on the sale of aircraft. In addition,
certain costs were capitalized for tax purposes and expensed for book purposes.

For book purposes, aircraft held in inventory are reflected at the lower of
depreciable cost or estimated net realizable value. Differences in book and tax
revenue and loss from inventory result from the differences in the book and tax
carrying value of the inventory.

32
<PAGE>

14. Subsequent Events

The Partnership made a cash distribution of $2,299,816 or $4.60 per Limited
Partnership unit, to Limited Partners, and $255,535 to the General Partner on
January 15, 1999.

33
<PAGE>

Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

None.

34
<PAGE>

PART III

Item 10. Directors and Executive Officers of the Registrant

Polaris Aircraft Income Fund III, A California Limited Partnership (PAIF-III or
the Partnership) has no directors or officers. Polaris Holding Company (PHC) and
its subsidiaries, including Polaris Aircraft Leasing Corporation (PALC) and
Polaris Investment Management Corporation (PIMC), the General Partner of the
Partnership (collectively Polaris), restructured their operations and businesses
(the Polaris Restructuring) in 1994. In connection therewith, PIMC entered into
a services agreement dated as of July 1, 1994 (the Services Agreement) with GE
Capital Aviation Services, Inc. (GECAS), a Delaware corporation which is a
wholly owned subsidiary of General Electric Capital Corporation, a New York
corporation (GE Capital). GE Capital has been PHC's parent company since 1986.
As subsidiaries of GE Capital, GECAS and PIMC are affiliates.

The officers and directors of PIMC are:

Name PIMC Title
------------ -------------------

Eric M. Dull President; Director
Marc A. Meiches Chief Financial Officer
Barbara Macholl Director
Norman C. T. Liu Vice President; Director
Ray Warman Secretary
Robert W. Dillon Assistant Secretary

Substantially all of these management personnel will devote only such portion of
their time to the business and affairs of PIMC as deemed necessary or
appropriate.

Mr. Dull, 38, assumed the position of President and Director of PIMC effective
January 1, 1997. Mr. Dull previously was a Director of PIMC from March 31, 1995
to July 31, 1995. Mr. Dull holds the position of Executive Vice President - Risk
and Portfolio Management of GECAS, having previously held the positions of
Executive Vice President - Portfolio Management and Senior Vice President -
Underwriting Risk Management of GECAS. Prior to joining GECAS, Mr. Dull held
various positions with Transportation and Industrial Funding Corporation (TIFC).

Mr. Meiches, 46, assumed the position of Chief Financial Officer of PIMC
effective October 9, 1995. Previously, he held the position of Vice President of
PIMC from October 1995 to October 1997. Mr. Meiches presently holds the
positions of Executive Vice President and Chief Financial and Operating Officer
of GECAS. Prior to joining GECAS, Mr. Meiches has been with General Electric
Company (GE) and its subsidiaries since 1978. Since 1992, Mr. Meiches held the
position of Vice President of the General Electric Capital Corporation Audit
Staff. Between 1987 and 1992, Mr. Meiches held Manager of Finance positions for
GE Re-entry Systems, GE Government Communications Systems and the GE Astro-Space
Division.

Ms. Macholl, 45, assumed the position of Director of PIMC effective February 27,
1999. Ms. Macholl presently holds the position of Senior Vice President,
Marketing Finance for GECAS. Prior to joining GECAS, Ms. Macholl has been with
the General Electric Company (GE) and its subsidiaries since 1977. Ms. Macholl
previously held the position of Vice President Finance for CBSI Inc., a wholly
owned subsidiary of the General Electric Company. Ms. Macholl has also held
various financial management positions for the GE Lighting business.

35
<PAGE>

Mr. Liu, 41, assumed the position of Vice President of PIMC effective May 1,
1995 and Director of PIMC effective July 31, 1995. Mr. Liu presently holds the
position of Executive Vice President - Marketing and Structured Finance of
GECAS, having previously held the position of Executive Vice President - Capital
Funding and Portfolio Management of GECAS. Prior to joining GECAS, Mr. Liu was
with General Electric Capital Corporation for nine years. He has held management
positions in corporate Business Development and in Syndications and Leasing for
TIFC. Mr. Liu previously held the position of managing director of Kidder,
Peabody & Co., Incorporated.

Mr. Warman, 50, assumed the position of Secretary of PIMC effective March 23,
1998. Mr. Warman has served as a GECAS Senior Vice President and Associate
General Counsel since March 1996, and for 13 years theretofore was a partner,
with an air-finance and corporate practice of the national law firm of Morgan,
Lewis & Bockius LLP.

Mr. Dillon, 57, held the position of Vice President - Aviation Legal and
Insurance Affairs, from April 1989 to October 1997. Previously, he served as
General Counsel of PIMC and PALC effective January 1986. Effective July 1, 1994,
Mr. Dillon assumed the position of Assistant Secretary of PIMC. Mr. Dillon
presently holds the position of Senior Vice President and Managing Counsel of
GECAS.

Certain Legal Proceedings:

On or around February 17, 1993, a civil action entitled Einhorn, et al. v.
Polaris Public Income Funds, et al. was filed in the Circuit Court of the 11th
Judicial Circuit in and for Dade County, Florida against, among others, Polaris
Investment Management Corporation and Polaris Depositary Company. The
Partnership is not named as a defendant in this action. Plaintiffs seek class
action certification on behalf of a class of investors in Polaris Aircraft
Income Fund IV, Polaris Aircraft Income Fund V and Polaris Aircraft Income Fund
VI who purchased their interests while residing in Florida. Plaintiffs allege
the violation of Section 517.301, Florida Statutes, in connection with the
offering and sale of units in such Polaris Aircraft Income Funds. Plaintiffs
seek rescission or damages, in addition to interest, costs, and attorneys' fees.
On May 7, 1993, the court granted the defendants' motion to stay this action,
and subsequently this suit was dismissed.

On or around September 27, 1995, a complaint entitled Martha J. Harrison v.
General Electric Company, et al. was filed in the Civil District Court for the
Parish of Orleans, State of Louisiana. The complaint names as defendants General
Electric Company and Prudential Securities Incorporated. The Partnership is not
named as a defendant in this action. Plaintiff alleges claims of tort, breach of
fiduciary duty in tort, contract and quasi-contract, violation of sections of
the Louisiana Blue Sky Law and violation of the Louisiana Civil Code concerning
the inducement and solicitation of purchases arising out of the public offering
of Polaris Aircraft Income Fund IV. Plaintiff seeks compensatory damages,
attorney's fees, interest, costs and general relief.

On or around December 8, 1995, a complaint entitled Overby, et al. v. General
Electric Company, et al. was filed in the Civil District Court for the Parish of
Orleans, State of Louisiana. The complaint names as defendants General Electric
Company and General Electric Capital Corporation. The Partnership is not named
as a defendant in this action. Plaintiffs allege claims of tort, breach of
fiduciary duty, in tort, contract and quasi-contract, violation of sections of
the Louisiana Blue Sky Law and violation of the Louisiana Civil Code in
connection with the public offering of Polaris Aircraft Income Funds III and IV.
Plaintiffs seek compensatory damages, attorneys' fees, interest, costs and
general relief.

36
<PAGE>

In or around November 1994, a complaint entitled Lucy R. Neeb, et al. v.
Prudential Securities Incorporated et al. was filed in the Civil District Court
for the Parish of Orleans, State of Louisiana. The complaint named as defendants
Prudential Securities, Incorporated and Stephen Derby Gisclair. On or about
December 20, 1995, plaintiffs filed a First Supplemental and Amending Petition
adding as additional defendants General Electric Company, General Electric
Capital Corporation and Smith Barney, Inc. The Partnership is not named as a
defendant in this action. Plaintiffs allege claims of tort, breach of fiduciary
duty, in tort, contract and quasi-contract, violation of sections of the
Louisiana Blue Sky Law and violation of the Louisiana Civil Code in connection
with the public offering of Polaris Aircraft Income Funds III and IV. Plaintiffs
seek compensatory damages, attorneys' fees, interest, costs and general relief.

In or about January of 1995, a complaint entitled Albert B. Murphy, Jr. v.
Prudential Securities, Incorporated et al. was filed in the Civil District Court
for the Parish of Orleans, State of Louisiana. The complaint named as defendants
Prudential Securities Incorporated and Stephen Derby Gisclair. On or about
January 18, 1996, plaintiff filed a First Supplemental and Amending Petition
adding defendants General Electric Company and General Electric Capital
Corporation. The Partnership is not named as a defendant in this action.
Plaintiff alleges claims of tort, breach of fiduciary duty in tort, contract and
quasi-contract, violation of sections of the Louisiana Blue Sky Law and
violation of the Louisiana Civil Code in connection with the public offering of
Polaris Aircraft Income Funds III and IV. Plaintiffs seek compensatory damages,
attorneys' fees, interest, costs and general relief.

On or about January 22, 1996, a complaint entitled Mrs. Rita Chambers, et al. v.
General Electric Co., et al. was filed in the Civil District Court for the
Parish of Orleans, State of Louisiana. The complaint names as defendants General
Electric Company and General Electric Capital Corporation. The Partnership is
not named as a defendant in this action. Plaintiffs allege claims of tort,
breach of fiduciary duty in tort, contract and quasi-contract, violation of
sections of the Louisiana Blue Sky Law and violation of the Louisiana Civil Code
in connection with the public offering of Polaris Aircraft Income Fund IV.
Plaintiffs seek compensatory damages, attorneys' fees, interest, costs and
general relief.

In or around December 1994, a complaint entitled John J. Jones, Jr. v.
Prudential Securities Incorporated et al. was filed in the Civil District Court
for the Parish of Orleans, State of Louisiana. The complaint named as defendants
Prudential Securities, Incorporated and Stephen Derby Gisclair. On or about
March 29, 1996, plaintiffs filed a First Supplemental and Amending Petition
adding as additional defendants General Electric Company and General Electric
Capital Corporation. The Partnership is not named as a defendant in this action.
Plaintiff alleges claims of tort, breach of fiduciary duty in tort, contract and
quasi-contract, violation of section of the Louisiana Blue Sky Law and violation
of the Louisiana Civil Code concerning the inducement and solicitation of
purchases arising out of the public offering of Polaris Aircraft Income Fund
III. Plaintiff seeks compensatory damages, attorneys' fees, interest, costs and
general relief.

On or around February 16, 1996, a complaint entitled Henry Arwe, et al. v.
General Electric Company, et al. was filed in the Civil District Court for the
Parish of Orleans, State of Louisiana. The complaint named as defendants General
Electric Company and General Electric Capital Corporation. The Partnership is
not named as a defendant in this action. Plaintiffs allege claims of tort,
breach of fiduciary duty in tort, contract and quasi-contract, violation of
sections of the Louisiana Blue Sky Law and violation of the Louisiana Civil Code
concerning the inducement and solicitation of purchases arising out of the
public offering of Polaris Aircraft Income Funds III and IV. Plaintiffs seek
compensatory damages, attorneys' fees, interest, costs and general relief.

37
<PAGE>

On or about May 7, 1996, a petition entitled Charles Rich, et al. v. General
Electric Company and General Electric Capital Corporation was filed in the Civil
District Court for the Parish of Orleans, State of Louisiana. The complaint
names as defendants General Electric Company and General Electric Capital
Corporation. The Partnership is not named as a defendant in this action.
Plaintiffs allege claims of tort concerning the inducement and solicitation of
purchases arising out of the public offering of Polaris Aircraft Income Funds
III and IV. Plaintiffs seek compensatory damages, attorneys' fees, interest,
costs and general relief.

On or about March 4, 1996, a petition entitled Richard J. McGiven v. General
Electric Company and General Electric Capital Corporation was filed in the Civil
District Court for the Parish of Orleans, State of Louisiana. The complaint
names as defendants General Electric Company and General Electric Capital
Corporation. The Partnership is not named as a defendant in this action.
Plaintiff alleges claims of tort concerning the inducement and solicitation of
purchases arising out of the public offering of Polaris Aircraft Income Fund V.
Plaintiff seeks compensatory damages, attorneys' fees, interest, costs and
general relief.

On or about March 4, 1996, a petition entitled Alex M. Wade v. General Electric
Company and General Electric Capital Corporation was filed in the Civil District
Court for the Parish of Orleans, State of Louisiana. The complaint names as
defendants General Electric Company and General Electric Capital Corporation.
The Partnership is not named as a defendant in this action. Plaintiff alleges
claims of tort concerning the inducement and solicitation of purchases arising
out of the public offering of Polaris Aircraft Income Fund V. Plaintiff seeks
compensatory damages, attorneys' fees, interest, costs and general relief.

Other Proceedings - Part I, Item 3 discusses certain other actions arising out
of certain public offerings, including that of the Partnership, to which both
the Partnership and its General Partner are parties.

Item 11. Executive Compensation

PAIF-III has no directors or officers. PAIF-III is managed by PIMC, the General
Partner. In connection with management services provided, management and
advisory fees of $300,000 were paid to PIMC in 1998 in addition to a 10%
interest in all cash distributions as described in Note 10 to the financial
statements (Item 8).

Item 12. Security Ownership of Certain Beneficial Owners and Management

a) No person owns of record, or is known by PAIF-III to own beneficially
more than five percent of any class of voting securities of PAIF-III.

b) The General Partner of PAIF-III owns the equity securities of PAIF-III
as set forth in the following table:

Title Name of Amount and Nature of Percent
of Class Beneficial Owner Beneficial Ownership of Class
-------- ---------------- -------------------- --------

General Polaris Investment Represents a 10.0% interest 100%
Partner Management of all cash distributions,
Interest Corporation gross income in an amount
equal to 9.09% of distributed
cash available from operations,
and a 1% interest in net income
or loss

38
<PAGE>

c) There are no arrangements known to PAIF-III, including any pledge by
any person of securities of PAIF-III, the operation of which may at a
subsequent date result in a change in control of PAIF-III.

Item 13. Certain Relationships and Related Transactions

None.

39
<PAGE>

PART IV

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K

1. Financial Statements.

The following are included in Part II of this report:
Page No.
--------

Report of Independent Public Accountants 18
Balance Sheets 19
Statements of Operations 20
Statements of Changes in Partners' Capital (Deficit) 21
Statements of Cash Flows 22
Notes to Financial Statements 23

2. Reports on Form 8-K.

No reports on Form 8-K were filed during the quarter ended December 31,
1998.

3. Exhibits required to be filed by Item 601 of Regulation S-K.

27. Financial Data Schedule (in electronic format only).

4. Financial Statement Schedules.

All financial statement schedules are omitted because they are not
applicable, not required or because the required information is
included in the financial statements or notes thereto.

40
<PAGE>

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

POLARIS AIRCRAFT INCOME FUND III,
A California Limited Partnership
(REGISTRANT)
By: Polaris Investment
Management Corporation
General Partner

March 24, 1999 By: /S/ Eric M. Dull
-------------- -------------------------
Date Eric M. Dull, President

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.

Signature Title Date
--------- ----- ----

/S/Eric M. Dull President and Director of Polaris March 24, 1999
--------------- Investment Management Corporation, --------------
(Eric M. Dull) General Partner of the Registrant

/S/Marc A. Meiches Chief Financial Officer of Polaris March 24, 1999
------------------ Investment Management Corporation, --------------
(Marc A. Meiches) General Partner of the Registrant

/S/Barbara Macholl Director of Polaris Investment March 24, 1999
------------------- Management Corporation, General --------------
(Barbara Macholl) Partner of the Registrant

/S/Norman C. T. Liu Vice President and Director of March 24, 1999
------------------- Polaris Investment Management --------------
(Norman C. T. Liu) Corporation, General Partner
of the Registrant

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<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<CASH> 13423701
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<ALLOWANCES> 0
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