Monday, January 28, 2013

Taxation of Frequent Flyer Miles

In a 1995 non-binding memorandum sent between IRS offices (TAM 9547001), the IRS hinted that frequently flyer miles might be taxable income (the IRS actually said that the employees should give the miles to the employer).  This created one of the largest firestorms in the history of the Internal Revenue Code.  The IRS caved in Announcement 2002-18, in which the IRS said it will not assert that frequent flyer miles are taxable income. 

However, the IRS noted that "[t]his 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."  A taxpayer who sells his frequent flyer miles, or sells a ticket bought with those miles, would be subject to tax. 

When the miles are provided outside the employer-employee context, however, the miles are most likely taxable income, such as when a bank gives frequent flyer miles for opening a bank account.  The value of the miles should be around 1 cent per mile, since that is the equivalent alternative in cash back that most credit cards offer.

Frequent flyer miles given for opening a credit card is another murky area.  If 50,000 miles are given after achieving a minimum spending of $5000, for example, one reasonable view is that the miles are a partial refund for the $5000 in expenses.  The taxpayer has no taxable income but is treated as actually paying $4500 for the purchased goods and services.

What about an employee who:
1. bills his employer's clients for first-class travel,
2. buys a coach ticket with much less cash,
3. uses his frequent flyer miles to upgrade the ticket to first class, and
4. pockets the difference?

Someone did that once, and the 9th Circuit Court of Appeals held in Charley v. Commissioner that the employee has taxable income to the extent of the difference in ticket prices that he pocketed ($3,150 in his case).

The court did not decide whether the income was ordinary income or capital gains, probably because they were taxed at the same 28% rate in 1988.  If the frequent flyer miles were in his account for over a year, one could argue that the taxpayer should have long-term capital gain taxed at preferable rates.

Credit card cash back rewards, on the other hand, might be taxable in some circumstances.  In particular, a business owner, who deducts his business expenses charged to his credit card, should have taxable income when he receives a cash back check from that card (as a recovery of previously deducted expenses).

1 comment:

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