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February 6, 2012
What Is a Frequent Flier Mile Worth?

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By Marie Sapirie -- msapirie@tax.org

Citibank became the antagonist in another confused episode over the taxation of airline miles when it gave its customers Forms 1099 that reported the value of miles handed out as a promotion for opening bank accounts.

Airline miles present a troublesome administrative and political issue for the IRS. In some situations, such as when an award is given for opening a savings account, miles are taxable income. But in other situations, such as when an employee earns miles while traveling for his employer but uses the miles to take a personal holiday in the south of France, the employee does not have taxable income. Further confusion stems from the fact that airline miles accumulated through credit cards or debit cards aren't treated as taxable income; they're considered a purchase price adjustment.

Because of the variety of ways businesses deal with the issue, producing guidance on how to value airline miles and when they should be considered income will be difficult, said Abe Schneier of the American Institute of Certified Public Accountants. "Whatever standard the IRS comes up with, it needs to be clear and easily enforceable by business owners and CPAs," he said. That means guidance that covers many different scenarios, he added.

We've seen this before. In 2002 the IRS released an announcement saying it would not devote resources to assessing tax on the personal use of miles earned while on business travel because "there are numerous technical and administrative issues relating to these benefits on which no official guidance has been provided, including issues relating to the timing and valuation of income inclusions." Guidance could help quell the storm that is brewing now.

Miles and Miles to Go

The problem doesn't lend itself to a simple administrative resolution, as the IRS's lack of guidance suggests. A few private letter rulings provide insight into the taxation of airline miles. In one of them, the IRS ruled that frequent flier miles awarded to mutual fund investors would not be treated as preferential dividends but as an adjustment to the purchase price of the shares.

That ruling could be in conflict with the IRS's most recent statement that "when frequent flyer miles are provided as a premium for opening a financial account, it can be a taxable situation to reporting under current law." (At press time, the IRS had not delineated what is included in the definition of a financial account.)

Announcement 2002-18 addressed only the taxability of miles received as the result of business travel and used for personal purposes, stating that until further notice, the IRS would not assert an understatement in those cases. It didn't address the taxability of miles in other situations or valuation and timing concerns.

Valuation issues present a problem in part because the value of a ticket bought with miles on one date may be different than the value of that ticket on another date. Similarly, the offering price for miles varies. For example, an individual customer can buy 25,000 miles from American Airlines (the airline advertises this as though you're buying 21,000 plus 4,000 "bonus" miles) today for about $0.023 per mile. But if the customer buys only 1,000 miles, the price is $0.0295 per mile.

The airlines charge institutional customers, like banks, much less -- generally no more than $0.01 per mile, depending on how many miles a bank buys, said Cheryl Riedlinger of the Tax Reporting Group, who advises financial institutions on the tax reporting consequences of their promotions. Banks then pass the miles on to their customers. According to IRS Publication 550, Investment Income and Expenses (Including Capital Gains and Losses), the value of noncash gifts or services for making deposits or for opening an account in a savings institution is determined by the cost to the financial institution.

Dominic L. Daher, who teaches federal taxation at the University of San Francisco's School of Law and School of Management and is the coauthor of a leading treatise on federal tax law, The Hornbook on the Law of Federal Income Taxation (2008), pointed out that there are online markets for airline miles that could provide a starting point for valuation.

Ira Mirsky, a partner at McDermott Will & Emery, said he'd like to see a bright-line valuation rule that could borrow from current approaches regarding taxable noncash fringe benefits, such as employer-provided cars, for which the regulations provide special valuation rules; compensatory stock awards for nonpublicly traded companies, for which a fair market value is not readily available; or any other personal benefits for which there are several variables that present a range of potential FMVs. In the last two examples, the IRS generally accepts a reasonable cause defense to accuracy-related penalties for taxpayers who take a reasonable approach in determining FMV and apply that method consistently. Adopting those types of principles-based reporting practices should provide a defense from IRS penalties for taxpayers with reporting obligations related to the receipt of taxable items for which there is no clear FMV, Mirsky said.

Timing is problematic, because although some customers use their miles immediately, many never use them and others use them over a period of years. Taxpayers who don't use their miles, or don't use them all in a single year, raise the question whether some of the income reported by banks should be offset to reflect miles actually used, said Schneier. "I could see where there might be some support for that," he said.

Mirsky said there is no question that the IRS will require taxpayers to include the FMV of mileage awards in gross income in the year of receipt. For taxable noncash receipts, that requires a determination of FMV for the amount to include in gross income.

What to Do?

Frequent flier miles aren't new or novel -- they were first introduced in 1981, Daher said. The IRS waded into the fray in 1995 with a technical advice memorandum stating that an employer that did not require its employees to return purchase price adjustments received as a result of the use of miles had a non-accountable plan for purposes of section 62(c).

The reaction to that early attempt to tax the employees' accretion to wealth was predictable. The IRS promptly announced that it was reconsidering parts of the memorandum.

The uproar over Citibank's reporting of miles awards is evidence that taxpayers don't want to pay tax on miles now any more than they did in the 1990s. Sen. Sherrod Brown, D-Ohio, wrote a pointed letter to Citibank CEO Vikram Pundit urging the company to halt the practice of reporting miles given out as a reward for opening a savings account on the grounds that "the last thing Citibank should be doing is creating baseless fear in middle-class families, or placing a nonexistent tax burden on the backs of families who are already struggling to make ends meet."

According to Riedlinger, the IRS expects taxpayers to know that nothing in life is free. Yet part of the public consternation about Citibank's reporting of the value of the miles stems from the fact that the bank gave its customers little notice that the miles would be subject to tax information reporting. But Citibank isn't required to give any notice at all.

Customers have found themselves in a legal quandary over what to do if they disagree with the amount that Citibank reported as income from the miles. One option is to appeal to Citibank and seek an amended Form 1099, but practitioners said that might be difficult. Self-help is another possibility for miles recipients. Taxpayers could make a negative adjustment on line 21 of Form 1040 to reflect what they believe is a more accurate amount. Neither option is particularly appealing, and the latter raises the likelihood that the taxpayer will receive a deficiency letter from the IRS.

The taxation of miles "is going to be a hot-button issue," Daher said. And unless banks decide to get out of the miles business, it's one that shows no signs of disappearing. "Financial services companies tend to take a strict compliance approach to their tax information reporting obligations because they want to avoid potentially exposing the information reporting to their customers and account holders to heightened scrutiny by the IRS," Mirsky said. "What could be the fallout of this is that banks reconsider whether miles are a good reward in this context."


Promotional Frequent Flier Miles Are Taxable Income, IRS and Citibank Say

A seemingly routine recognition of award income has caught the attention of the media and Congress, as both the IRS and Citibank insist that the value of frequent flier miles awarded upon opening a financial account should be treated as taxable income.

Scores of individuals reported the week of January 23 that Citibank issued them Forms 1099-MISC, representing the value of frequent flier miles awarded as part of a promotion for opening an account. The story was first reported in the Los Angeles Times on January 24.

Citibank defended its decision to report airline miles as income. "The Internal Revenue Code recognizes rewards as taxable income -- with the exception of promotions tied to credit and debit purchases. This recognition by the [Internal Revenue Code] is disclosed to customers prior to their election to participate in the promotion," it said.

The IRS agreed. "When frequent flyer miles are provided as a premium for opening a financial account, it can be a taxable situation to reporting under current law," it said in a statement.

Typically, when a bank gives a customer a noncash gift for opening an account, IRS Publication 550, Investment Income and Expenses (Including Capital Gains and Losses), explains that the value of the gift is taxable interest. Similarly, Announcement 2002-18 established the Service's position that it will not assert that an individual has understated federal tax liability because he has received or used frequent flier miles or other promotional benefits related to business or official travel. That announcement has typically been read to address only the consequences for business use and does not address promotional miles given for opening an account.

In a January 30 letter to Citibank CEO Vikram Pandit, Sen. Sherrod Brown, D-Ohio, said the bank's practice of issuing Forms 1099 for the promotional value of the miles was "creating baseless fear" by placing a nonexistent tax burden on families. Brown highlighted the 2002 announcement and charged that the valuation of the miles was arbitrary.


-- Shamik Trivedi

Marie Sapirie contributed to this article.

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