In recent years, credit card reward programs have become a basic component of personal finance. Credit card issuers use them to entice consumers to spend more on a given card. [1] Consumers use them to earn a rebate on amounts spent or as an alternative to save for the next beach vacation. Generally, the value of the item or cash “earned” (the “Reward”) represents a small portion of the amount that must be charged to earn a rebate or “points” that are convertible to a selected item only when the cardholder reaches a specified threshold. Consequently, it can be difficult to classify, calculate the value of, and time the realization of the cardholder’s newly acquired wealth, especially if it is realized in a form other than cash. The situation only gets stickier when evaluating a Reward that a taxpayer earned on a personal credit card by charging a reimbursable business expense (a “business-related Reward”). [2] Ergo, the Service’s current position is that a business-related Reward earned on business or official travel that is cash or convertible to cash is taxable, but a similar business-related Reward that is an in-kind item or converted to an in-kind item, e.g., frequent flyer miles, is not taxable income. [3]
Given the difficulty in determining realization of a business-related Reward, the question is why business-related Rewards are taxed in either situation. Rewards are a marketing gimmick used by profit-making companies – they are not a significant source of income to anyone. They are the thirteenth donut earned by buying a dozen or the taxi fare supplied by an employer after working late. Together they add up, but so do a lot of other small payments that are excluded from a taxpayer’s gross income either as fringe benefits or, indeed, as marketing promotions. In the meantime, taxpayers may not think to include a Reward in taxable income, [4] viewing it as nothing more than a freebie in exchange for all the other charges made on a credit card. And from the Service’s perspective, the nature of business-related Rewards as related to an employment relationship on the one hand and a financing relationship on the other so complicates enforcement that the Service does not know if or when a taxpayer earns this type of benefit. [5] Thus, the taxation of business-related Rewards is not simply about tax evasion, but rather whether the Service’s official position is consistent with tax policy goals.
This article argues that the Service should align its official position with policy and reality by stating that it does not consider any business-related Reward taxable income. In Part I, I narrow the issue and highlight some of the complications discussed by previous commentators. Most of the existing literature is dated and concerns primarily frequent flyer miles, but it presents adaptable frames of analysis and addresses some of the same problems inherent in taxing a cash Reward. Many of these issues are discussed in greater depth in Parts II and III of this article.
In Part II, I present several arguments why cash Rewards should not be taxed. First, the process of valuating cash and in-kind Rewards is not sufficiently disparate to warrant taxing one and not the other. Although in-kind Rewards present valuation issues (one reason why they are not currently taxed), the problems are not insurmountable and can be pragmatically and economically addressed. Second, classification of Rewards is problematic. Although not crucial to recognition, classification is essential to determine if an exemption applies, what other taxes to impose, and what tax rate to assess. Without appropriate classification, a taxpayer is not fairly treated and the transparency of the tax system suffers. Third, taxing cash Rewards, even when appropriately classified, is problematic from a tax policy perspective. Administratively, it would be difficult to comply with or enforce such a tax and enforcement would yield proportionately small benefits. And, if the Service does not enforce the tax, the system becomes less transparent and less equitable.
In Part III, I address the tax avoidance issues related to any nonrecognition policy and argue that there are several reasons why Rewards will not become the next tax shelter. Additionally, I discuss a few current options to address such a situation, should it arise.
In Part IV, I present three proposals to reform the taxation of cash business-related Rewards. These proposals operate on the assumption that the Service’s current position presents insurmountable policy problems. Each proposal has safeguards against the use of Rewards to avoid tax on wages; the latter two proposals proactively address such concerns by drawing on existing anti-avoidance methods.
Finally, in Part V, I conclude with a summary of the arguments presented.
Ubiquitous today, but unheard of thirty years ago, credit card Reward programs allow a cardholder to earn cash or other promotional benefits by charging expenses and either earning a percentage rebate or points convertible into goods, services, or cash (collectively, a “Reward”). Reward programs are a permutation of the frequent flyer bonus programs that American Airlines spearheaded in 1981 as a marketing tool to improve brand loyalty.6 In 1986, Discover created the first cash Reward program and soon learned that cardholders used the card more, thus increasing Discover’s receipts from merchants, a primary source of income for many issuers. [7] Now, cardholders use a Reward card in approximately 70% of credit card transactions [8] and card issuers pay out billions in incentives every year. [9]
Although Reward programs have proliferated rapidly, the commentary related to taxing those related to reimbursable business expense primarily concerns frequent flyer miles. Despite this narrow focus, the resulting literature is useful because many of the principles behind the question of taxing in-kind Rewards also apply to cash Rewards. Additionally, the commentary raises several pertinent questions about whether there are salient differences between in-kind and cash Rewards.
A. Earning points: What are Rewards and how are they taxed?
A Reward is the conferral of value on a cardholder by the Creditor that issued the pertinent credit card. At first blush, it appears to be an accretion to wealth, but this is not always true. A cardholder does not earn a Reward without incurring or paying a liability. Therefore, in at least some situations, it is a return of capital and not an accretion to wealth at all. [10] However, despite the terminology often used in the industry, a Reward is not a gift because, at the most basic level it is the product of a contractual relationship between a Creditor and a cardholder. [11] A Reward constitutes value in the form of a good or service, e.g., frequent flyer miles, in cash as a rebate or “kickback” paid directly to a cardholder or credited against future payments due to the Creditor, or as a point that can be converted to cash or in-kind goods or services. A cardholder [12] earns a Reward by charging certain types of expenses as defined by the agreement that the cardholder has with the pertinent Creditor. However, the cardholder may charge an expense for any reason, including for a business or employer. Consequently, a variety of Reward is defined in reference to the transactional relationships formed (personal or business-related) and the type of value that the Creditor confers by way of the Reward (cash or in-kind).
Judgments about the three basic principles of tax policy – efficiency, equity, and simplicity [13] – determine which variety of Reward is excluded from a cardholder’s taxable income. The principles are interconnected – for example, a simplicity goal may affect the equity or economic efficiency of the tax system [14] – but can be separated for definitional purposes.
All three aspects of tax policy influence the Service’s current position, as far as it can be determined, on taxing each variety of Reward. A Reward earned on a personal purchase, i.e., a purchase involving only a cardholder, a merchant, and a Creditor, is generally [29] not considered taxable income, regardless of whether the Reward is received in cash or in-kind. [30] Rather, the Reward is considered a purchase price reduction or rebate because some of the money paid to the Creditor has been repaid to the cardholder and the latter has therefore not truly had an accretion of wealth. [31] Thus, it would be inequitable to include the rebate amount in taxable income.
Rewards earned in connection with a business expense are treated in a variety of ways. The Service will not tax an in-kind “promotional benefit,” e.g., frequent flyer miles or points converted to a toaster, “attributable to” a taxpayer’s business or official travel. [32] Conversely, the Service currently claims to tax cash Rewards attributable to business travel expenses and in-kind Rewards converted to cash. [33] There is no current guidance on the taxation of in-kind Rewards “attributable to” general business expenses (not related to travel), [34] whether converted to cash or in-kind benefits, but they should be treated similarly. The distinction between in-kind and cash Rewards reflects the Service’s stated judgment that in-kind Rewards are more administratively and technically difficult to tax, including in relation to valuation, timing, and separation of basis attributable to benefits earned by personal or business use of a credit card. [35] Properly addressing this difficulty would increase the Service’s administrative costs and taxpayers’ and third party’s compliance burdens. Therefore, the Service has effectively chosen to ignore in-kind Rewards. This presents the question of whether cash Rewards are sufficiently different to warrant the distinction and is discussed in Part II.B., supra.
Another oddity about the Service’s official position regarding taxing a cash businessrelated Reward is that even within that category, only certain types of Rewards are effectively taxable. As discussed below in Part II.C.1., a per diem expense allowance reasonably calculated to cover an employee’s reimbursable travel expense is deemed a substantiated expense and thus excluded from income. Although the Regulations require an employee to report excess per diem, [36] in the pertinent Revenue Procedure the Service only requires an employee to report certain types of excess per diem. [37] Consequently, any Reward earned on such expenses is effectively not taxed. Additionally, the field of Reward-earning opportunities is practically limited to reimbursed business expenses under Section 162.An employee may exclude a reimbursement from an employer to the extent that the underlying expense would be otherwise deductible under one of Sections 161 through 199. [38] However, most of the expenses otherwise deductible as an employee reimbursement likely would not give rise to a Reward. [39] Consequently, the primary category of Reward-earning opportunities is limited to those deductions available under Section 162.
B. Drawing parallels: Contributions from the literature on frequent flyer miles.
Most of the sparse literature related to the issue of Rewards addresses frequent flyer miles before the 2002 Announcement, but it provides some insight into the issue at hand. First, commentators have repeatedly demonstrated that a Reward earned on a reimbursable business expense is realized income, [40] but they have not fully explored the issues attendant on that conclusion. For example, a few commentators have discussed the timing problems inherent in the realization of Rewards. [41] As discussed below in Part II.B., there may be a significant lag between when the taxpayer makes a charge that leads to a Reward and when that Reward is realized. Additionally, a taxpayer who has “earned” a Reward may never be able to convert it to cash, goods, or services due to contractual restrictions that may arise at any time under some cardholder agreements. [42] These conditions may constitute a substantial restriction [43] and therefore the Reward should not be considered constructively received until the restrictions have lapsed. [44] Additionally, some Reward programs limit the transfer or assignment of Rewards, [45] thereby rendering the cash equivalency doctrine inapplicable. [46] Nonetheless, these commentators have not fully discussed how timing affects the second major topic in the existing literature: classification. Classification is primarily important because of the possibility of excluding economic income from taxable income and, thus, is essential when determining if an employee should be taxed on Rewards earned using a personal credit card and how. Commentators have suggested several classification possibilities, including a purchase price adjustment, [47] a prize,48 a taxable fringe benefit, [49] employment compensation, [50] and, simply, nondeductible income. [51] However, as discussed below in Part II.B., none of these possibilities is free from doubt or complications. And, ultimately, none of the commentators are sufficiently precise to clearly assess the problem.
The available literature also leaves lingering issues, two of which are very important. First, although some have argued that the difficulties of valuation weigh in favor of exempting in-kind Rewards, [52] other commentators have offered plausible, even practical, valuation methods. [53] Consequently, the argument that an in-kind business-related Reward is specially qualified for a formal policy of non-enforcement while a cash business-related Reward is not is more tenuous than it seems. This is discussed at length in Part II.A. Second, previous authors have also failed to appreciate the tax policy issue of effectively enforcing a tax on cash Rewards. That is, by the basic tenets of tax policy analysis, a tax should be efficient, equitable, and relatively simple. [54] Each of these components is interlinked; thus, when one fails, the others suffer as well. Of course, many taxes exist that are not easily administrable from the Service’s perspective or that create compliance costs from the taxpayer’s or a third party’s perspective. The question is whether the cost (financial and political) of enforcing any one tax (or failing to exempt it) outweighs the benefits (financial and political) of enforcement. This issue is also discussed in more detail below in Part II.C. continued
[1] Damon Darlin, Gift Horses to Consider: Credit Cards That Reward, N.Y. TIMES, Dec. 31, 2005, at C6.
[2] This article concerns only business-related expenses reimbursed by a third-party non-related employer or client. Other circumstances may lead to different complications. For example, if a cash method taxpayer takes a Section 162 deduction for non-reimbursed business expenses, the tax benefit rule requires inclusion of the value of a Reward in income. Brad Cripe & Katrina Mantzke, Are Credit Card Rebates Taxable?, 123 TAX NOTES 311, 312 (2009).
[3] See I.R.S. Announcement 2002-18, 2002-1 C.B. 621 (announcing that the Service will not tax travel promotional benefits that are in-kind benefits earned on business or official travel and stating that the relief provided doesn’t apply to benefits converted to cash); I.R.S. Priv. Ltr. Rul. 93-40-007 (June 29, 1993) (noting that an employee’s receipt of cash earned through a frequent flyer mile program used on business travel constitutes a taxable fringe benefit); I.R.S. Priv. Ltr. Rul. 96-23-035 (June 7, 1996) (determining that a rebate earned on a personal credit card was not income and could be a charitable deduction if the cardholder chose to donate it to a specified charity).
[4] See Charley v. Comm’r, 91 F.3d 72, 75 (9th Cir. 1996) (deciding that at the time, there was nothing in the tax record indicating that a reasonable taxpayer would conclude that a conversion of frequent flyer miles would give rise to taxable income). Since the Charley case was decided, some additional literature on the topic and a handful of IRS publications have been published, but it is unlikely that taxpayer knowledge of the subject is much higher today than it was 13 years ago.
[5] See discussion supra Part II.B.
[6] Lee S. Garsson, Frequent Flyer Bonus Programs: To Tax, or Not to Tax – Is this the Only Question?, 52 J. OF AIR L. & COM. 974, 973 (1986). Of course, many companies have offered incentive programs over the years. The S&H “green stamp” program and various programs operated by cigarette companies are similar to the Reward programs discussed herein. See the Wikipedia article on “green stamps” for a general explanation of the program. S&H Green Stamps, http://en.wikipedia.org/wiki/S&H_Green_Stamps (last visited June 11, 2009).
[7] Darlin, supra note 1.
[8] Nelly Torres, When Reward Cards Are a Smart Option, SEATTLE TIMES, Feb. 15, 2009, at C2.
[9] Cripe & Matzkin, supra note 2, at 311
[10] Cripe & Matzkin, supra note 2, at 311-312.
[11] See Comm’r v. Duberstein, 363 U.S. 278 (1960) (holding that a car given to a business associate was not a gift and constituted remuneration for services rendered). Any legal person may be a cardholder, but this article is solely concerned with cardholders who are natural persons.
[12] Any legal person may be a cardholder, but this article is solely concerned with cardholders who are natural persons.
[13] MICHAEL J. GRAETZ & DEBORAH H. SCHENK, FEDERAL INCOME TAXATION: PRINCIPLES AND POLICIES 27 (5th ed. 2005). The authors note that although these criteria are generally agreed upon for evaluating taxes, there is substantial disagreement about what the terms mean. For example, see Reuven Avi-Yonah, The Three Goals of Taxation, 60 TAX L. REV. 1 (2006) and, using slightly different terms, John A. LeDuc, The Legislative Response of the 97th Congress to Tax Shelters, the Audit Lottery, and Other Forms of Intentional or Reckless Noncompliance, 18 TAX NOTES 363 (1983).
[14] JOEL SLEMROD & JON BAKIJA, TAXING OURSELVES 159 (4th ed. 2008).
[15] GRAETZ & SCHENK, supra note 10, at 28-29.
[16] LAURIE L. MALMAN ET AL., THE INDIVIDUAL TAX BASE 9 (1st ed. 2002).
[17] MALMAN ET AL., supra note 16, at 9.
[18] GRAETZ & SCHENK, supra note 13, at 28-29. 19 MALMAN ET AL., supra note 16, at 9-11.
[20] MALMAN ET AL., supra note 16, at 11-12 (defining a deadweight loss as the “overall loss” that results when some taxpayers pay an imposed tax, but enough people avoid the tax by forgoing income or purchases that the government loses revenue and there is no transfer from one party to another, viz., “individuals are worse off, but the public is no better off as a result”).
[21] GRAETZ & SCHENK, supra note 13, at 27-28.
[22] SLEMROD & BAKIJA, supra note 14, at 59-60, 64-66.
[23] GRAETZ & SCHENK, supra note 13, at 27-28; SLEMROD & BAKIJA, supra note 14, at 87-96.
[24] INTERNAL REVENUE SERV., U.S. DEPT. OF THE TREASURY, REDUCING THE FEDERAL TAX GAP: A REPORT ON IMPROVING VOLUNTARY COMPLIANCE 50-52 (2007); SLEMROD & BAKIJA, supra note 14, at 57-59.
[25] GRAETZ & SCHENK, supra note 13, at 29-31.
[26] GRAETZ & SCHENK, supra note 13, at 29; SLEMROD & BAKIJA, supra note 14, 160-164.
[27] SLEMROD & BAKIJA, supra note 14, at 165-67.
[28] INTERNAL REVENUE SERV., supra note 24, at 50-52.
[29] However, Cripe and Matzkin point out that if a personal expense is deductible, the tax benefit rule requires that the Reward reduce the deduction or be included in income if it occurs in a different taxable period. supra note 2, at 312.
[30] I.R.S. Priv. Ltr. Rul. 96-23-035 (June 7, 1996) (cash or charitable contribution); see I.R.S. Priv. Ltr. Rul. 93-40- 007 (June 29, 1993) (noting that an individual who receives cash or an airline ticket as a result of personal flights taken with the airline has not realized gross income).
[31] I.R.S. Priv. Ltr. Rul. 96-23-035 (June 7, 1996) (treating a reward donated to charity as a rebate), Cripe & Matzkin, supra note 2 at 311.
[32] I.R.S. Announcement 2002-18, 2002-1 C.B. 621. The Announcement does not differentiate between “promotional benefits” earned by charging a business travel expense and those earned through an airline’s frequent flyer miles program.
[33] I.R.S. Announcement 2002-18, 2002-1 C.B. 621; Charley, 91 F.3d 72 (9th Cir. 1996) (holding that a conversion of frequent flyer miles to cash constituted either wages or a gain from the disposition of property). An in-kind Reward can be earned without using a personal credit card and then converted to cash. For example, some frequent flyer programs allow an individual to convert frequent flyer miles to dining gift cards, which are likely cash equivalents because they are “freely transferable,” “readily marketable,” and “immediately convertible to cash.” See, e.g., Rev. Rul. 73-173, 1973-1 C.B. 40 (using this criteria to find that breeding rights in thoroughbred stallions were a cash equivalent); United Airlines, Lettuce Entertain You, http://www.united.com/page/article/0,6722,52130,00.html (last visited Apr. 16, 2009) (allowing a frequent flyer mile account holder to convert miles into dining certificates). Additionally, some individuals sell miles in the secondary market. Michelle Higgins, Playing Markets That Trade Miles, N.Y. TIMES, June 29, 2008, available at http://www.nytimes.com/2008/06/29/travel/29pracfflier.html?_r=1&scp=1&sq=playing%20markets%20that%20tra de%20miles&st=cse. Cash equivalents earned in the former way is likely wage income and cash earned in the latter way is likely considered a gain from the sale of property. See Charley, 91 F.3d at 74 (holding that a conversion of frequent flyer miles to cash constituted either wages or a gain from the disposition of property). This article does not address Rewards earned through allegiance programs without charging a business expense on a personal credit card. Another issue for further study that is not analyzed here is the availability of deductions for donations of frequent flyer miles to charity. Since Announcement 2002-18 effectively exempts frequent flyer miles earned on business travel, a taxpayer is not taxed on the value of those miles. 2002-1 C.B. 621. Consequently, there is a question as to whether taxpayer-employee should also receive a deduction for a donation of those miles.
[34] In a typical large business an individual likely charges general business expenses only sporadically, but the opportunity exists to earn Rewards in this way using reimbursements under an employer’s accountable plan. I.R.C. § 62(a)(2)(A) (West 2009); see also supra Part II.B.1. Since these Rewards are also deductible is sufficiently attributable to business, they are included in the “business-related Rewards” category used herein.
[35] I.R.S. Announcement 2002-18, 2002-1 C.B. 621.
[36] Treas. Reg. § 1.274-5(g) (as amended in 2003).
[37] The Service does not require an employee to include in income the excess, if any, of the substantiated per diem amount over the amount actually spent on business expenses if the employee satisfies the given substantiation rules. Treas. Reg. § 1.274-5(g) (as amended in 2003); Rev. Proc. 2008-59, 2008-41 I.R.B. 857 ¶ 7.03. The substantiated per diem amount is the lesser of the federal per diem rate for a locality or the per diem paid. Rev. Proc. 2008-59, 2008-41 I.R.B. 857 ¶ 4.01.
[38] See I.R.C. § 62(a)(2)(A) (West 2009).
[39] For example, a personal credit card has no place in accounting for a business’ bad debts under Section 166. And, while a credit card could be used to pay interest expenses and taxes under Sections 163 and 164, respectively, such method would likely only be used in very small companies. Additionally, a credit card could be used to purchase depreciable equipment, but much of such equipment is impractical or too expensive singly (e.g., screen-printing equipment) or in the aggregate (e.g., 10 laptops) to purchase for even a small business with a personal credit card.
[40] Dominic L. Daher, The Proposed Federal Taxation of Frequent Flyer Miles Received From Employers: Good Tax Policy But Bad Politics, 16 AKRON TAX J. 1, 4 (2001); Sharon Alice Pouzar, Frequent Flyer Awards as Taxable Income: Time to Pay the Taxman, 5 TEX. WESLEYAN L. REV. 55, 60-61 (1998); Darrell L. Oliveira, The Taxability of Frequent Flyer Credits Earned by Employees: Why the IRS Has Remained Silent on the Issue, 4 U. PA. J. LAB. & EMP. L. 643, 646-47 (2002).
[41] Oliveira, supra note 40, at 660-663; Pouzar, supra note 40, at 77.
[42] Restrictions on the American Express Membership Rewards program. www.membershiprewards.com/terms (last visited Apr. 9, 2009).
[43] For example, the Second Circuit once held that required permission from a co-executor of an estate to release stock and cash was a substantial restriction and, therefore, the constructive receipt doctrine did not apply. Wolder v. Comm’r, 493 F.2d 608, 613 (1974); see generally BORIS I. BITTKER & LAWRENCE LOKKEN, FEDERAL TAXATION OF INCOME, ESTATES, AND GIFTS ¶ 5.9 (3d ed. 2001).
[44] Treas. Reg. § 1.451-2(a) (as amended in 1979).
[45] See, e.g., Restrictions on the American Express Membership Rewards program, www.membershiprewards.com/terms (last visited Apr. 9, 2009) (noting in paragraph titled “Point Accrual” that points are not the property of the cardholder and not transferable).
[46] Cowden v. Comm’r, 289 F.2d 20 (5th Cir. 1961).
[47] Kathy Krawczyk & Lorraine Wright, How Should Frequent Flyer Miles Be Taxed?, 79 TAX NOTES 1029 (1998).
[48] Jennifer A. Cunningham, Are Frequent Flyer Benefits Really Benefits?: An Analysis of the Frequent Flyer Tax Debate and a New Theory of Taxability for Frequent Flyer Benefits, 47 CLEV. ST. L. REV. 281 (1999).
[49] Daher, supra note 40, at 7-10.
[50] Id. at 4-7.
[51] Pouzar, supra note 40, at 59-71.
[52] Oliveira, supra note 40, at 656-658.
[53] Pouzar, supra note 40, at 75-77.
[54] GRAETZ & SCHENK, supra note 13, at 27-31; U.S. GOV’T ACCOUNTABILITY OFFICE, PUB. NO. 05-1009SP UNDERSTANDING THE TAX REFORM DEBATE: BACKGROUND, CRITERIA, AND QUESTIONS 24 (2005).
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