The IRS Looks to Be On the Verge of Imposing a Big Tax Burden on Loyalty Points

The IRS is expected to propose new rules that will mean an increased tax burden on airline and hotel loyalty programs, which will in turn reduce the value of points in those programs.

I noticed a brief mention this week in Politico

Four major travel associations today will send a letter to Treasury Secretary Jack Lew on the future of loyalty programs, calling for him to “reject including any projects related to the elimination of long-standing tax treatment of customer loyalty programs under r §451.” The groups — Airlines for America, U.S. Travel Association, the American Hotel & Lodging Association and American Resort Development Association — write that the IRS is currently considering a plan that would “negatively impact loyalty programs” by making changes to the accounting methods.

“Let us be clear, the IRS’ proposal to alter the tax treatment of loyalty programs will impose a significant new tax on existing and future loyalty points that travel customers enjoy and rely upon,” the letter reads. “… Ultimately, any change or clarification of loyalty program accounting should be made through the legislative process, not IRS promulgation.”

I hadn’t heard anything about this, so stuck this on the list of things to dig into over the holiday weekend. (It’s getting to be a long list.)

And then I was contacted by a reporter asking me about this, and I had to admit that I knew very little. But my interest was certainly piqued and I began digging.

First, the letter sent to the Treasury Secretary itself contains some clues.

Unfortunately, the Internal Revenue Service (IRS) currently has under consideration a plan that would negatively impact loyalty programs. On August 9, 2013, the U.S. Treasury released the 2013-2014 Priority Guidance Plan (“business plan”). Included in the business plan was a project aimed at making changes to loyalty program accounting methods prescribed by the Treasury Regulations under Code Section 451 (“§451”). As you may know, travel companies, including hotels, airlines, and many others, have complied with settled law in the area of loyalty program accounting for decades. These same companies, and those they serve, are now under the threat of wholesale changes to the longstanding tax treatment of their loyalty programs.

So it looks like the concern is over accounting treatment. It’s not that they’re going to ‘tax your miles’ but rather that they’re going to tax the programs.

Or will they? Tax treatment “of customer loyalty programs under r §451” relates to the taxable year in which revenue is recognized. The IRS guidance (.pdf) offers very little beyond that.

Price Waterhouse Coopers offers some insight. (.pdf)

Based on public comments by government officials, this project, which likely will be proposed regulations, is intended to provide a single set of rules for all types of advance payments. Guidance issued by the IRS in recent years suggests that the IRS views the existing rules under Reg. sec.1.451-4, which address the treatment of trading stamps and premium coupons, as made obsolete by the economic performance rules under section 461(h). In order to address this issue, along with the differences in the existing rules under Reg. sec. 1.451-5 and Rev. Proc. 2004-34 for advance payments, the IRS appears to be contemplating one set of rules that would govern the timing of revenue recognition for advance payments and loyalty programs.

At the same time, these four industry groups are talking about a new tax on the loyalty programs.

I am not an expert in taxation or regulation. I think the argument is that when the airline or hotel awards or sells points, they book an expense and accrue a liability related to the redemption of those points. And it’s only when the redemption actually occurs or points are expired that the income off of the transaction is fully recognized.

The IRS is presumably looking to speed that up, tax the transaction on the front end. That would mean more taxes paid sooner, an increased burden on airline and hotel loyalty programs. But that would largely change the timing of the tax, rather than creating a new tax.

Since no rules have yet been promulgated, it’s difficult to ascertain what the IRS is likely to propose. I suppose it’s possible there could even be a new, separate tax as seems to be suggested here.

I’m not sure it matters either way, it certainly looks like pending IRS rulemaking will push for an increased tax burden on loyalty programs. And that likely means a lower value for the points in those programs.

We aren’t there yet. The IRS will come out with a proposed rule, there will be a notice and comment period, and the IRS will then consider and respond to those comments and potentially amend the rule before it goes final (if anything makes it that far).

But the timing of the letter from industry to the Treasury Secretary suggests they believe this is a live issue. And if the IRS wants to tax points as they’re awarded (effectively at the 35% corporate income tax rates) that could be a very big deal, and one we’re going to have to watch.

About Gary Leff

Gary Leff is one of the foremost experts in the field of miles, points, and frequent business travel - a topic he has covered since 2002. Co-founder of frequent flyer community, emcee of the Freddie Awards, and named one of the "World's Top Travel Experts" by Conde' Nast Traveler (2010-Present) Gary has been a guest on most major news media, profiled in several top print publications, and published broadly on the topic of consumer loyalty. More About Gary »

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  1. I think I can reconcile some of this.

    The “major travel associations”, which is an inside the beltway euphemism for “lobbying group”, stated:

    “Let us be clear, the IRS’ proposal to alter the tax treatment of loyalty programs will impose a significant new tax on existing and future loyalty points that travel customers enjoy and rely upon.”

    This contorted spin is not terribly far removed from your other observations – that the IRS is contemplating altering when the programs, themselves, must recognize income, in their minds constituting a tax on points, however indirect.

    Note that they merely identify a “proposal to alter the tax treatment of loyalty programs”. Were it a “proposal to alter the tax treatment of the awards granted to members of loyalty programs” I presume they would have said so in an effort to gin up popular support.

    At least that is what I hope.

  2. Your comment:

    “And it’s only when the redemption actually occurs or points are expired that the income off of the transaction is fully recognized.”

    Is intriguing. I don’t know myself, but if, indeed, income from the sale of a point is recognized when redeemed, the income from the sale of points which are never redeemed (due to expiration, non-use, and other forms of breakage) is never recognized as income at all. I’m not certain the IRS would be terribly keen on that.

  3. So my F tix with a street value of say, 17K, is going to be taxed at 35%—–in other words, I will pay $5,950 in taxes on that award tix?

    Who’s going to fly on award tix, other than in coach? There aren’t going to be enough seats in the back of the bus!

    The only good use of miles is going to be towards upgrade, and the upgrade rules will have to restructured. Nobody is going to want to upgrade for miles & cash, and then have to pay a 35% tax on top of that.

    There won’t be any incentive to earn award points if the consumer is going to be hit like that. So what are the credit card companies going to lure us with? How will the airlines reward us for loyalty?

  4. On the “FLY” Analysis bc I haven’t read any of the actual code, but on the face of it this sounds like a windfall to the consumer because you’d receive the future value of an asset with the tax burden being shifted to the issuer( i.e. the hotel) now of course as you’ve postulated if the issuer( Hotel) then chooses to charge you more of their currency to offset the cost, then of course you’re going to see something which is not beneficial to those holding points instead of cash.

    My only thoughts are this. WHEN are we ever as a country going to move beyond the politics of “envy”? I’m so sick and tired of people blaming everything in their lives upon those who they feel are more “powerful” then themselves. If you don’t know how to spend your money wisely, it has nothing whatsoever to do with the fact that other people do.

    Stop incessantly whining about the conditions of your life and passive aggressively attempting to harass those who know how to live their own.

    If you’re unhappy or think somebody has gotten a better deal than you, get out of your cubicle and go get what’s yours, and stop trying to use nonsense like the IRS to proactively change something you obviously have never understood.

    My 45 Cents.

  5. @kimmie a. Read the blog post. That isn’t what’s going to happen. This is somebody else’s problem, if it ever happens at all. It is not a tax on the consumer’s points. You never pay tax when you get a rebate or a discount against a purchase. Think of the tax mess if they changed the law so you had “income” every time Walgreen’s had a sale. @gary is welcome to dig deeper but this proposal sounds like it’s the industry’s problem and they want to pretend it’s a consumer issue to stir up emotion for their side. I could give a flying when a hotel has to pay its taxes if I’m honest…especially when the “law” asking them to pay up sooner may or may not ever come to pass.

  6. Here’s what I propose.
    1) When loyalty programs devalue their programs without announcement, there is a tax penalty.
    2) When loyalty programs devalue their programs, they’re technically increasing their profit (Sell something to a customer that decreases in value, so when redeemed, they make more of a profit off it), and the perceived increase in value for the program based on the devaluation is taxed as income.

  7. Let’s see what the NPRM says. I can’t imagine that anything majorly changing the landscape of the value of points/miles would be rammed through in a notice and comment rulemaking. The public comments from the airlines, banks, etc. would be devastating. No one would win but the IRS. Probably not the PR that the Administration wants at this point. I’m thinking that this is indeed just an accounting issue dealing with the time at which different things are accounted for.

  8. This seems like much ado about nothing promoted by industry lobbyists. Programs already incur the bookkeeping and accounting. If it’s a question of revenue recognition timing as you suggest, I’m not convinced that this isn’t just the IRS closing a loophole based on the split of income recognized at points origination vs. redemption. It’s only in the news because the IRS is such an easy punchbag.

    Considering the industry is on the verge of getting away with a major anti-consumer coup on airfare pricing laws based on their lobbying, this is such a minor impact that you would think they would remain quiet. Why draw attention to yourself for such a small issue when you’re about to rob the bank?

  9. As @steve mentioned, I’d be curious what implications this might have for devaluations. I know just enough about accounting to know that it would significantly impact the tax implications of a devaluation.

  10. Why do people think kimmie is so off-base? This isn’t a tax burden on the consumer but what says the airline wouldn’t pass it on? It’s going to be passed on in some fashion even if it isn’t a direct cash co-pay.

  11. This is potentially a large windfall for the IRS if they rule that the points are taxable when they are awarded, as opposed to at redemption or expiration. We can only imagine the loss of tax revenue currently with the “zillions” of points that just never are redeemed, and therefor never taxed. You might conclude that the “Points never expire” programs were built for the issuers tax departments, and not for an consumer loyalty. If they never expire, they never are taxed. Either way, it’ll cost us consumers more in the long run.

  12. We are not far from the day the US Government will impose taxes on the air we breathe. We will all carry a breather meter and we will pay taxes based onthe amount of air we used.

  13. @Scott C –

    Taxes imposed on goods sold (e.g., departure taxes) are easily and routinely passed onto the consumer.

    Taxes imposed on corporate income (generally revenues minus expenditures) not so much.

    While there are some questions to ask, this appears to involve an IRS effort to make programs recognize revenue when points are sold. To the extent a program is part of the airline and the FF plan is selling the miles to itself for miles flown, it is a wash. But if they are selling the miles to a credit card company, a shopping portal, etc., etc., or when Aeroplan sells miles to AC, there is revenue coming whether or not identifiable revenue goes out.

  14. Gary — I believe this is almost entirely about the accounting treatment of what is known as “breakage.” The regulation is 1.451.4. It gives loyalty programs (and issuers of gift cards) broad discretion in how they calculate and book future liabilities associated with breakage. The way it works is that for purposes of calculating income in a tax year, you take the amount you recognize from the sale of the future instrument (in this case miles) and subtract out the value of redemptions you provide in that year, plus the expected value of redemptions in the future.

    In calculating this second component, you get wide latitude to estimate your breakage. For example, say you sell 1 million miles to citibank in 2014. Accounting principles are well settled on how to calculate the redemption value of those miles, so let’s say you book it a .8 cents per mile. In 2014, 500,000 of those miles are redeemed. That’s an expense of $400,000. Now, you have to also book the expected future value of the remaining 500,000 miles you issued in 2014 as an expense.

    How do you do this? The regulation is all about how you do it. You are allowed to take breakage into account. So, for example, if you predict that 100,000 of those miles will go unclaimed, you book in 2014 another liability of 400,000 x .8, or $320,000. You have to keep historical data. You can also make changes in your program in order to tweak breakage, so long as you have a good faith basis to back it up.

    This is partially about taxation, but in my opinion what it’s really about is Airlines (and gift card companies that have massive breakage like spa finder) using the discretion in breakage rules to manipulate their reported income and loss. The numbers are massive, so even a tiny tweak in breakage calculation can affect the balance sheet. For example, I read a report online indicating that when Alaska Airlines reduced their expiration period on miles, they were able to, in that tax year, increase their reported profit by over $40 million.

    In this way, breakage calculation can be used as a safety valve. Obviously, I don’t know if anyone is actually doing this, but you could. If you’re profitable, and want to move some of that profit into future quarters, you can adjust breakage methodology a tiny bit to depress reported income and “save” that income into future quarters when actual performance exceeds you depressed breakage. When you have a bad quarter, you can inflate earnings by tweaking breakage the other way, and postpone the earning hit into future years or quarters. I think the proposal here is really just about the IRS finally getting a handle on this and standardizing breakage calculations and reporting.

  15. Just a quick tag on — in the comment above, I used the word “manipulate” after mentioning airlines and spa finder. To be clear, I was just trying to pick out an example of a company that, I expect, has large breakage on sales of future liabilities. I was not suggesting anyone actually engages in any manipulation — my point was instead to identify the concern that is possibly motivating the IRS. Specifically, the concern over potential manipulation.

  16. @Haldami- thank you for adding so eloquently to the discussion that some of us are interested in.

  17. @hobo — I would put it in slightly less pejorative terms. Frequent flier miles are a pretty amazing product, if you think about it. Maybe unique. What other product can you sell on day 1 and then yourself decrease the value of on day 2? The dollar amounts here are staggering. Let’s say AA sells 2 billion miles to citibank this year, and takes a corresponding deduction for the liability created. In year 2, AA raises standard award redemptions by 10k miles. It just reduced the value of the miles it sold and booked. Maybe only incrementally so, but when you’re talking about a industry that is expected to have over 20 trillion loyalty points outstanding by the end of 2015, this is a real economic benefit. It is income. I have no problem with the IRS keeping up with the various instruments that companies use to create income, and with the methods they use to create it.

  18. Larry pretty much summed up my thoughts on it: not a “new tax” per se, but a rejiggering of accounting standards that force loyalty programs to report differently. It will probably create larger liability on the front end if and when the new regs are put into force and will decrease the flexibility the programs use to minimize the revenue they report.

  19. I fully understand how this may increase the net income, and therefore taxes, loyalty programs must pay (especilly in the short run).

    But my view is that this merely impact post tax profitability to the programs, and that they are not particularly equipped to reclaim that lost post tax income from participants by tweaking points availability or redemption levels.

    To the contrary, I think the programs are generally in some sort of crude equilibrium, and if they thought they could get away with tweaking points availability or redemption levels, they would do so (or, rather, do so to a greater extent) without respect to modifications to the tax code.

  20. @Larry – thanks so much for your explanation! And Gary – usually love your writing, but in this case – please revise your post so it’s less fear-mongering and more informative. The travel industry already has enough lobbyists, doesn’t need you as well….

  21. Fox Business went with this story yesterday (Thursday).

    It’s really the Obama Administration attempting to “redistribute” wealth from elite travelers who have earned it for the “Obamaphone constituents” instead that will never earn it, want minimum wage at McDonalds, and then demand that the highest elite members sit in coach because an Obama-ite must sit in 1st too because they are a human being, nothing more. It’s not the airlines/hotels at all, but an administration of anti-business, anti-capitalism. The rise of Conrads to 80K Hilton HHonors points is a reaction to this administration of garbage and trash.

    Occupy Wall Street in one second will sit in 1st Class seats, laugh at it, and nose the elite members sitting in coach. That’s what we have here, the same Obama-ite people who use the 1st Class bathrooms when they are booked in coach and have to stay in coach.

    But in the rules of the rich, fortunately, this proposal won’t “fly” anywhere. All that we are looking at is an administration of trash that is losing its power faster than the Concorde can make Mach 1. Just my opinion, but it is a fact.

    Get ready for the next economic collapse—the only way to lower the free point stays ‘cuz the Obama-ite McDonalds trash won’t be able to pay to fly in a recession/depression, SARS, MERS, whatever, to earn those points.


  22. Yawn

    If I had a dollar for every proposal thrown around in Washington…

    There will be no tax for the consumers.

    No changes in accounting either most likely. So far down in the priority list is just laughable.

    Let’s get back to the Chase links please 🙂

  23. Santastico-You are so right you cannot earn a free gift without more and more government involvement.

  24. If I recall correctly, the government floated this very idea of taxing frequent flyer miles and establishing accounting rules for such, shortly after the airlines frequent flyer programs were launched. It didn’t go anywhere because there was a hue and cry about whether a “free” ticket was actually a taxable benefit to the frequent flyer; flyers correctly pointed out that they had paid for those tickets via higher fares, etc. just another money grab by the government in my opinion.

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