A variety of "rewards cards" have proliferated in the marketplace lately -- and with them some renewed questions regarding their tax treatment.

Many current offers are all but unrecognizable from the basic frequent flier miles programs of yesteryear. Free airline flights for distance traveled have morphed into miles for credit card purchases of all kinds, as well as offers of points for merchandise, and even "cash back." And unlike in years past, these programs have themselves become billion-dollar businesses. How do these changes affect the tax rules related to them?

The underlying tax principle that challenges the entire rewards cards industry is embodied in the general maxim that any accretion of wealth should be considered income unless otherwise excepted by the Tax Code (see Code Section 61(a)). Congress has made no explicit exceptions for miles or rewards programs.

Nevertheless, the Internal Revenue Service has accommodated concerns by constructing a rebate/discount rational, as well as an administrative convenience safe harbor, to exempt most rewards from tax. Only when used as an incentive not tied to the purchase of goods or services have these protections seemed to falter. Nevertheless, there remains the danger that what the IRS hath giveth, it may be able to taketh away ... at least prospectively.



In a 1993 case (Charley, TC Memo. 1993-558; affd 9th Cir91 F3d 72), a business executive converted business travel frequent flier miles into personal travel credits under a scheme through which he was reimbursed in personal travel credits by a travel agency used by both him and his employer. The personal travel credits amounted to the difference between first class and economy travel, given in return for his using his miles to upgrade his business travel tickets from economy to first class. The Tax Court held simply that the accretion of wealth to the executive -- i.e., the receipt of the personal travel credits -- must be treated as the receipt of income. The Ninth Circuit Court of Appeals affirmed, reasoning that the fact remained that the executive was wealthier after the transaction than before.

Fortunately, the IRS chose to largely ignore the holding in Charley when, in Announcement 2002-18, it advised that it would not seek to impute income to employees in common flier-miles situations. The IRS will not impute income to the employee for frequent flier miles earned on reimbursed business travel but credited to and retained in the employee's personal miles account. It backed off, some speculate, after airlines, transportation trade associations and business groups complained that the IRS's approach in following Charley was unworkable. Announcement 2002-18 remains IRS policy 10 years later.

In Announcement 2002-18, the IRS decided that, consistent with prior practice, it would not assert that any taxpayer has understated their federal tax liability by reason of the receipt or personal use of airline frequent flier miles or other in-kind promotional benefits attributable to the taxpayer's business or official travel. It flatly admitted that too many unresolved issues prevented the pursuit of any effective enforcement program. It specifically listed as problematic those issues related to the timing and valuation of income inclusions and the basis for identifying personal use benefits attributable to business (or official) expenditures versus those attributable to personal expenditures.

While Announcement 2002-18 is sometimes cited as excluding all frequent flier benefits, that is not the case. It only relates to miles earned on a personal card for which a business reimbursement is made. The notice also specifically states, "This relief does not apply to travel or other promotional benefits that are converted to cash, to compensation that is paid in the form of travel or other promotional benefits, or in other circumstances where these benefits are used for tax-avoidance purposes."

The now popular cash-back card programs, precisely because they involve cash, directly challenge the extent to which the above exemption will be applied to present situations. Announcement 2002-18 also advised that, "Any future guidance on the taxability of these benefits will be applied prospectively." This adds to concerns that the IRS may now reconsider its overall policy in light of current programs.



Under the currently accepted rebate treatment for exempting rewards earned in non-business situations, the cost of merchandise purchased through a rewards card is considered discounted in an amount equal to the value of the points or miles. This treatment was developed over time.

LTR 200228001 makes clear the IRS's current position that miles-for-purchases are generally non-taxable. That 2002 letter ruling cited Revenue Ruling 76-96 and Rev. Rul. 84-41 for the principle that a rebate received from the party to whom the buyer directly or indirectly paid the purchase price for an item is a reduction in the purchase price of the item; it is not an accession to wealth and therefore is not includible in the buyer's gross income.

Under a miles-donation program specifically addressed by this letter ruling, the taxpayer could elect to receive rebates personally or donate then to a charity. In either case, the IRS concluded that, "This rebate constitutes a reduction in the purchase price of the product that, pursuant to Rev. Rul. 76-96 and Rev. Rul. 84-41, is not includible in taxpayer's gross income." (It further reasoned that the donation of those rebates to a charity would support a charitable deduction provided substantiation rules for a written acknowledgment from the charity were followed for amounts of $250 or more.)



In an earlier letter ruling, LTR 199920031, the IRS relied on the same rebate theory later cited in LTR 20022801, but with a twist: The basis in the property purchased must be reduced. That has little or no impact on consumer purchases, but can have a significant impact on businesses and investors.

In LTR 199920031, a mutual fund offered a promotion that awarded miles for the purchase of shares. The IRS ruled that the arrangement should be viewed as a rebate, one that did not necessarily eliminate tax on the miles but simply deferred it. In the ruling, the rebate was considered to lower the basis that the taxpayer had in the fund shares and, therefore, the taxpayer would realize and recognize greater gain (or less loss) upon the later sale of the underlying shares as the result of the basis reduction.

Whether those mutual fund shareholders actually lowered their basis upon an eventual sale remains unknown. Of course, broker reporting of basis now required under new Code Section 6045B might test this reduction-of-basis requirement more directly on any similar offers in the future.



The basis reduction requirement in LTR 199920031, if applied today to the now popular business-owner reward card situations, may generate considerable bookkeeping headaches if followed. If the cash-back or other rewards are plowed back into business, no income should be imputed upon their use. However, the basis of any equipment purchased by the business should technically be reduced by the value of the reward. If the business owner pockets the cash back or miles for personal use, that presumably would create either a dividend or compensation income to the owner.



As was the case years ago when toasters given for opening a savings accounts were considered taxable, miles awarded as a premium for opening a checking account or as a sign-up bonus for a credit card appear equally taxable. In fact, at least one bank has been warning customers that such bonus miles awards "may be reported as income to the IRS on Form 1099-MISC, Miscellaneous Income."

The practical side of the present state of affairs is Form 1099-MISC itself. Although the obligation to report taxable income is present whether a Form 1099-MISC is received or not, the reality is that reporting such income is likely to be overlooked if a Form 1099-MISC is not received. Form 1099-MISC is not required to be filed for any person unless the payor has paid that person during the year at least $600 in rents, services (including parts and materials), prizes and awards, or other income payments. Usually not that many miles are paid to open an account to exceed the $600 mark.

A related Form 1099-MISC issue when miles are awarded is the determination of the value of those miles, especially in instances where blackout dates and other restrictions apply. One bank recently valued miles at 2.5 cents each, which apparently drew the ire of a new depositor who received 25,000 bonus miles that year and a Form 1099-MISC as a result.



The "rewards" business has changed considerably since the Internal Revenue Service issued its last piece of limited guidance in 2002. During that time, the dramatic increase in the number and the variety of rewards programs, coupled with the federal government's present need for more revenues, may make their tax treatment more of an issue.

For the present, receipt of Form 1099-MISC should control major violations of whatever rules exist, and audits of small businesses may occasionally turn up some additional taxable compensation in the form of cash back or miles used by business owners.

Considering the number of credit card users who consider rewards as "free," however, further development of a "rewards tax" of any kind may be an issue too hot for Congress to handle directly and yet too elusive for the IRS to control any further through administrative rules.


George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.

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