IRS clarifies its stand on whether airline miles are taxable
By David Lazarus
January 30, 2012, 3:43 p.m.

Consumers will owe taxes on miles they receive for opening a bank account, but miles they get for making purchases on credit cards or for taking a trip are tax-free, the federal agency says.

Frequent-flier miles are taxable? Really?

That sentiment sums up the reaction from readers — and particularly accountants and lawmakers — to last week's column on Citibank sending tax forms to customers who received thousands of airline miles in return for opening a new account.

Citi is notifying the Internal Revenue Service that the miles represent miscellaneous income, leaving customers on the hook for paying related taxes or possibly facing a greater risk of being audited.

What does the IRS have to say about the matter? After days of my pestering the tax agency for a response, it finally took a stand on the taxability of miles. I'll get to that in a moment.

First, it's worth noting how confusing the issue is even for those with a deep knowledge of tax law. Financial experts weren't sure what to make of Citi's claim that frequent-flier miles are a prize or award and thus represent taxable income.

Sen. Sherrod Brown (D-Ohio), chairman of the Senate Banking Subcommittee on Financial Institutions and Consumer Protection, was so flummoxed that he wrote a letter to Citi's chief exec, Vikram Pandit, calling on him to stop sending miles-related tax forms to customers.

"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," Brown wrote.

Tax professionals told me Citi's actions raised a lot of questions. If miles are taxable because they're a prize or award, does that mean any corporate freebie, no matter how small, must also be declared?

Since virtually all frequent-flier miles are awarded as an incentive by businesses, does that mean all miles are taxable?

And how should miles be valued for tax purposes — as whatever a company says they're worth, or, as in Citi's case, the almost certainly lower amount the bank paid to originally purchase the miles from American Airlines?

"These are issues I'm going to have to discuss with all my clients," said Michael Eisenberg, a Los Angeles CPA. "This is suddenly a big deal, and the IRS needs to make a definitive ruling on it."

Citi, for its part, added to the confusion by insisting that even though miles given to customers for opening a new account are taxable, miles awarded for using a credit card are not.

"Rewards and airline miles that are provided in connection with a purchase on a credit card are routinely not subject to individual income tax reporting," said Sean Kevelighan, a Citi spokesman. "When a customer receives a gift for opening a bank account — whether cash, a toaster or airline miles — the value of that gift is generally treated as income and subject to reporting.

"This is separate and distinct from miles or points earned by our credit card customers for their purchases."

Rob Seltzer, a Century City CPA, said he couldn't understand that distinction.

"It's completely inconsistent," he said. "How are miles for opening an account considered a prize or award, but miles for using a credit card aren't considered a prize or award? What's the difference?"

That's the big question. And the IRS has stepped up with an answer.

"When frequent-flier miles are provided as a premium for opening a financial account, it can be a taxable situation subject to reporting under current law," said Michelle Eldridge, an IRS spokeswoman.

OK, so Citi apparently has that part right. But what about miles received for using a credit card or handed out by an airline just for taking a trip?

Eldridge said that in those cases, miles wouldn't be taxable because they're more like a rebate.

"A common analogy," she said, "is buying a $500 television at a retail store and receiving a $50 manufacturer's rebate. It's not income, just a deemed reduction of the cost of the television."

What about valuing the miles? In Citi's case, the bank is declaring that miles received by customers are worth about 2.5 cents apiece. But tax pros say Citi almost certainly acquired them for less, probably closer to 1 cent each.

"Under the income tax law," Eldridge replied, "the amount of income to the taxpayer is the value of the property received, not the cost that the business paid to acquire the property."

Therefore, it doesn't matter how much the miles were worth to Citi when the bank deducted them as a business expense. The value that must be reported by taxpayers is whatever Citi says it is.

So if Citi is correct about miles being a prize or award for tax purposes, doesn't that mean virtually all goodies handed out by companies are similarly taxable?

"Whether or not any incentive provided by a business must be reported to the recipient of a Form 1099 depends on the nature, value and other facts and circumstances surrounding the particular incentive," Eldridge answered.

That's a fancy way of saying the IRS doesn't know.

Tom Griffith, a USC law professor who specializes in taxes, said that if frequent-flier miles can be considered income as a prize or award, "in theory, any benefit you get could be taxable."

But he said the IRS would probably shy away from such thinking because of the administrative headache that would ensue if the agency had to make a call on every single little incentive given out by companies.

"As a practical matter," Griffith said, "you can see why the IRS wouldn't want to go there."

I can see that. But I can also see that this whole thing is a perfect illustration of why our tax system is so messed up, and how challenging it can be for taxpayers — and tax experts — to know what's what.

I also know that the next time anyone offers me miles, I'll think long and hard about whether they're a toaster (income) or a TV (rebate).

David Lazarus' column runs Tuesdays and Fridays. He also can be seen daily on KTLA-TV Channel 5. Send your tips or feedback to david.lazarus@latimes.com.