October 16, 2014

As a serial credit card churner, I am particularly interested in the IRS’s view on this matter, which is why I awaited with bated breath the United States Tax Court decision on the case between Parimal H. Shankar and the Commissioner of the Internal Revenue, back in August of 2014.

The issue in this case was whether Mr. Shankar had or hadn’t understated his income by $563 when he failed to report the Citibank points he used toward a trip. Mr. Shankar opened an account with Citibank and received some Citibank “Thank Your Points” as a reward. He then used those points toward the cost of a trip. The IRS argued that Mr. Shankar should have reported the savings from the ticket, the $563, as income.

The U.S. Tax Court decided in favor of the IRS. So does this mean all frequent flyer points should be declared as income? Thankfully no, the Tax Court was very careful about how it worded its decision and made it clear the decision was to have only a narrow application. The IRS sometimes considers frequent flyer miles and reward points as income, but not always. (U.S. Tax Court)

Welcome to the shady world of frequent flyer miles and credit card reward points. Hang in with me. We will get some clear answers by the end of the article.

So how does the IRS consider frequent flier miles or credit card points?

That is a good question. Are frequent fliers a prize, interest, a rebate or all of the above? The answer to that question largely determines whether they are a source of income and therefore taxable.

What has the IRS said on this subject in the past?

Nothing definitive or we wouldn’t be having this conversation, but a 2002 private letter ruling does provide insight on the IRS’s view on miles and points. The key section for our purposes says:

“ … the IRS will not assert that any taxpayer has understated his federal tax liability by reason of the receipt or personal use of frequent flyer miles or other in-kind promotional benefits attributable to the taxpayer’s business or official travel.”

When I read that I gave a small sigh of relief. It didn’t last long. The next paragraph had this to say:

“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.”

Another tidbit from the IRS’s collective psyche was revealed in IRS Publication 17 Other Income, which says under the section of Rewards:

“Rewards. If you receive a reward for providing information, include it in your income.”

Before the IRS vs Mr. Shankar case, the last time the taxation of frequent flyer points hit the media was in 2012, when it was reported that Citi had issued 1099-MISC tax forms to clients who had received reward miles for signing up for a new checking or saving account. At least two clients sued Citibank for not disclosing that information when they advertised the extra points. (LA Times)

So are miles or points taxable or not? 

The IRS is playing a wait-and-see game on this issue, so it’s impossible to be dogmatic. However, this much we can say from a careful analyzes of previous decisions, comments and rulings.

The Bottom Line: Rebate vs Interest

As indicated by the Tax Court decision on Mr. Shankar’s case, mentioned above, if you received the points or miles as a bonus for opening a bank account and making a deposit, the IRS could consider it as income.

This is because you are receiving the rewards in exchange for what amounts to “lending” money to the bank, which is interest and therefore a taxable source of income. Also, you didn’t buy anything to qualify for the bonus, so it can’t be considered a rebate.

To illustrate, last month Chase bank offered me $200 for opening an account and leaving my money with them for 6 months. There were no other strings attached so I was happy to transfer my emergency fund to another bank for $200. However, I know I’m going to have to declare the $200 as income.

The same would apply if I received 50,000 points or miles for opening an account. The only problem with points is that their cash value is not always easy to calculate. A ballpark ratio that often works is one cent per mile/reward point, but a lot depends on the rewards program and how you decide to spend your points.

Now the good news.

The IRS considers points you receive from using a credit card as a rebate. Sure, it may feel like free money when you get a signup bonus of $500 to spend on travel expenses, but you probably had to spend $2,000 to $3,000 in three months to receive the bonus. Technically, it’s a rebate.

As long as you had to make some kind of purchase or financial transaction to receive the points or miles, the IRS considers it as a price reduction not interest. This doesn’t mean things couldn’t change in the future, but right now, fellow credit card-churners, we are in the clear.

There is one caveat. The IRS will not allow you deduct a business expense you paid with frequent flyer miles or reward points. For instance, let’s stay you are the owner of a company and you declare the cost of plane tickets on a business trip but you pay for the tickets with points or frequent flyer miles. The IRS considers this as double dipping. If you use miles or points to pay for expenses and then declare the full cost as a deductible expense, you could get into trouble with the IRS.

Learn more about tax deductions for business travel in this article.