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Frequent-flier mileage awards: recent federal developments.

The IRS Position

Although airline travel frequent-flier award programs have been in existence since 1981, the Internal Revenue Service has only recently begun to address the federal income tax treatment of awards earned by employees for business travel and retained for personal use. To date, no direct authority or specific guidance has been provided concerning the procedure for valuing travel awards.

The IRS has provided guidance to the airline industry regarding the Form 1099 reporting requirements for frequent-flier mileage awards. In Private Letter Ruling 9340007 (June 29, 1993), the IRS ruled that an airline was not subject to the information reporting requirements of section 6041 with respect to its frequent-flier program. The private ruling is significant because it formally states the IRS's position on the taxability of frequent-flier miles. If the miles were earned from personal travel paid for by an individual, the free miles awarded represent only a purchase price adjustment, not taxable income. Frequent flier mileage that was earned in business-related travel and provided to the employee for personal purposes was specifically held to be a taxable fringe benefit. Because the airline lacked access to sufficient information to determine whether the recipient had earned the miles in either personal or business-related travel, however, the IRS held that the mileage value is not required to be reported under section 6041. In spite of the IRS's ruling concerning the taxable nature of business frequent-flier miles, the agency has not enforced its position because of administrative concerns and the difficulties in valuing the mileage awards.

The IRS's non-enforcement policy changed dramatically three years ago with the release of Technical Advice Memorandum 9547001 (July 11, 1995). There, the IRS ruled that a company's air travel reimbursement arrangement was a "nonaccountable" plan for purposes of section 62(c) of the Code. The TAM was issued after the company under audit refused to change its recent written policy permitting employees to retain frequent-flier mileage accrued on business travel for their personal use. The IRS --surprising even its top administrators -- ruled that the company's policy rendered both the air travel reimbursement and the frequent-flier mileage taxable.

Taxation of Expense Reimbursements

In determining adjusted gross income, a deduction from gross income is permitted under section 62(a)(2)(A) for expenses paid or incurred by a taxpayer in connection with the performance of services as an employee under an "accountable" employer reimbursement plan. Section 62(c) provides that an arrangement will be treated as an accountable reimbursement plan if:

(1) The arrangement requires the employee to substantiate his or her business expenses, and

(2) The arrangement requires the employee to return to the employer, within a reasonable period of time, any amount received in excess of the substantiated expenses.

Because employee expenses incurred under an accountable plan may be taken as a deduction from AGI, reimbursements received under an accountable plan are not required to be included in the employee's gross income, since the amounts would net to zero in calculating taxable income. Thus, amounts paid by an employer under an accountable plan are excluded from the employee's gross income, are not reported as wages on the employee's Form W-2, and are exempt from employment tax withholding. Treas. Reg. [sections] 1.62-2(c)(4).

An expense allowance arrangement will not be treated as an accountable plan if such arrangement does not require the employee to substantiate the expenses to the employer or such arrangement allows the employee the right to retain any amount (such as travel advances) in excess of the substantiated expenses.

If the employer reimbursement plan is considered nonaccountable, the federal tax treatment is much less favorable than it would be for an accountable plan for both the employee and the employer. Specifically, because employee expenses incurred under a nonaccountable plan may not be taken as a deduction from AGI, amounts received are required to be included in the employee's gross income. Reimbursement amounts paid under a nonaccountable plan must be reported as taxable wages on the employee's Form W-2 and are subject to employment taxes and withholding. Furthermore, the expenses incurred by the employee, which are attributable to the amounts included in the employee's gross income, may only be deducted as a miscellaneous itemized deduction subject to the two-percent-of-AGI floor. Treas. Reg. [sections] 1.62-2(c)(5). The strict nonaccountable plan rules are designed to prevent taxable compensation from being disguised as a non-taxable expense reimbursement.

TAM 9547001

In TAM 9547001, the IRS ruled that the company's travel reimbursement arrangement was a nonaccountable plan under Treas. Reg. [sections] 1.62-2(c), because the company permitted its employees to retain and use for personal purposes their frequent-flier mileage awards. The IRS National Office reasoned that the accumulated mileage awards were purchase-price adjustments and, by allowing employees to retain these adjustments, the arrangement failed to meet the "return of excess substantiated expenses" requirement. As reimbursements under a nonaccountable plan, the value of both the air travel reimbursements and the mileage awards was taxable compensation subject to Form W-Z reporting, employment taxes, and withholding. Furthermore, the employee travel expenses incurred, less the value of the frequent-flier miles used for personal travel, could be deducted by the company's employees only as an itemized deduction subject to the two-percent floor.

In the past, the company had required its employees to return all earned airline incentives to the company. The company had recently amended its written air travel arrangement to permit the personal use of frequent-flier benefits by its employees. The arrangement's failure to require the return of the frequent-flier benefits meant that all air travel reimbursements were to be treated as taxable compensation. The IRS provided no guidance, however, concerning how the mileage awards should be valued or when the awards became taxable.

Implications of TAM 9547001

If the IRS's ruling under TAM 9547001 were applied to all taxpayers, it would have profound effects on both business travellers and their employers.

First, not only would the retained frequent-flier miles be taxable, but all business travel reimbursements would be considered as paid under a nonaccountable plan and treated as taxable compensation.

Second, the problems associated with determining the value of the frequent-flier miles earned would create an extreme administrative burden. This has been the main reason the IRS has never enforced the taxation of frequent-flier miles in the past. Although air fares constantly fluctuate, no guidance currently exists for determining the proper valuation of frequent-flier miles. The appropriate time for taxing the miles is also unclear: Should the miles be taxed when earned or when used? In addition, considerable uncertainty exists over the treatment of expired miles and the procedure for tracking mileage earned through other means, such as by credit card, long-distance telephone, or car rentals. Without sufficient standards or guidance, the resulting calculations and reporting requirements would be almost impossible to perform accurately and consistently.

Third, treating the retention of frequent-flier mileage, as well as all reimbursed air travel, as a nonaccountable plan would have a high cost for U.S. employers. If amounts spent for employee travel under a nonaccountable plan become taxable wages, affected employers would be subject to additional payroll taxes. All employers that permit their employees to keep frequent-flier awards would have to review their old travel records, determine the cost of each employee's business travel, and calculate the additional business portion of social security tax, as well as federal and state unemployment taxes. This would apply to all years open under the statute of limitations. In addition to the administrative difficulties of issuing corrected W-2 Forms, all affected employers would be subject to interest and penalties for failing to report the reimbursed travel cost and mileage awarded as gross income.

Public Response to TAM 9547001

Publication of the IRS's ruling on air travel arrangements generated an immediate and fierce reaction from the business community, tax professionals, and the travel and airline industries. The commotion resulted in a flurry of media coverage, comments, telephone calls, and faxes to the IRS and Congress. Many taxpayers feared that the TAM signified the beginning of an enforcement effort by the IRS. The controversy also prompted harsh criticism from leaders in the business community and travel industry who believed the ruling, if applied broadly, would subject employees to enormous taxes and companies to burdensome administrative costs. The Wall Street Journal reported on November 28, 1995, that tax lawyers and accountants "expressed alarm that the decision could cast a chill over the frequent-flier programs which have attracted 32 million participants."

The release of the TAM took then-IRS Commissioner Margaret Richardson by surprise and caused top-level IRS officials to hold emergency meetings to decide what formal position the government should take on the issue. The ruling also embarrassed the Treasury Department because Congress had a policy similar to the one maintained by the audited company addressed in the TAM. Congress's written policy provided that lawmakers and their staff may keep frequent-flier miles on trips to and from Washington. Does Congress Have a Nonaccountable Plan?, 69 Tax Notes 1161 (Dec. 4, 1995). Thus, the problems created for all employers would be equally shared by Congress.

The IRS soon announced that it was "reconsidering the analysis in TAM 9547001 because it did not deal with the full range of Regulations potentially applicable to employee reimbursement plans involving frequent-flier miles." Concerned about the pervasive effects of the ruling, the IRS also announced that it had no special enforcement plans for taxing frequent-flier miles and that it would reevaluate and clarify its position in the near future. To date, however, the IRS has not published the result, if any, of its reconsideration.

Pending Federal Legislation

In response to the IRS's position in TAM 9547001, Representative Barbara B. Kennelly (D-Conn.), a member of the House Ways and Means Committee, introduced a bill in March 1996 to clarify that employee frequent-flier mileage awards used for personal trips will not be subject to federal income tax. The proposed legislation (H.R. 533) was reintroduced in the 105th Congress by Representative Kennelly on February 4, 1997.

In reintroducing the legislation, Representative Kennelly said, "I believe that frequent-flier miles are not taxable under current law and should remain that way." She further stated that "the taxation of frequent-flier miles will only result in mindless complication and paperwork of nightmarish proportions for millions of Americans, the airlines, and the Internal Revenue Service" 143 Cong. Rec. E130 (Feb. 4. 1997). No action has been taken on the legislation.

Other Issues

Most frequent-flier programs contain an expiration term of three years, after which unused miles will expire. One way to prevent the expiring miles from being wasted is to donate them to various charitable organizations. Many charities use the donated frequent-flier miles to help unite families with their seriously ill children, for emergency support of suffering families, disaster relief, and for the final wishes of dying children. Such organizations include the Salvation Army, Make-A-Wish Foundation, American Red Cross, Muscular Dystrophy Association, and the Special Olympics.

Although it is worthwhile to donate unused miles to help those in need, federal tax law does not allow a charitable deduction for frequent-flier miles donated to qualified organizations. Again, because of the uncertainties and administrative difficulties in determining the proper valuation of frequent-flier miles, no authority exists for obtaining any tax benefit for the donation.

Mileage Awards Converted to Cash

In Charley v. Commissioner, 91 F. 3d 72 (1996), the Ninth Circuit addressed the tax treatment of frequent-flier miles obtained in connection with business-related travel and converted into cash. In this case, the taxpayer's employer had an unwritten policy that permitted frequent-flier miles earned for business travel to be retained by its employees. Under an arrangement with the company's travel agent, the taxpayer's employer paid for first-class air travel, but the taxpayer purchased coach-class tickets and used his frequent-flier program mileage -- largely earned in connection with his business travel -- to upgrade to first class. The travel agent then transferred the difference in cost between the first-class and coach tickets from the employer's account to the taxpayer's separate personal account.

For example, if the first-class airfare was $700 and the coach fare was $300, the employer paid for the $700 ticket and charged that amount to the client. The taxpayer, however, purchased a coach ticket that he upgraded to first class, and the $400 difference was credited to his personal travel account and converted to cash. The taxpayer accumulated more than $3,100 in his account in this manner during 1988, which he did not include on his tax return. Upon audit, the IRS treated the taxpayer's conversion of frequent-flier miles into cash as taxable income and assessed a deficiency on the amount realized.

The Ninth Circuit agreed with the Tax Court that the arrangement resulted in taxable income. The court held that whether the situation was considered employee theft or a highly technical "sale" of the frequent-flier miles, the taxpayer was wealthier after the transaction than he was before it. Furthermore, the amounts credited to the taxpayer's personal accounts were held to be taxable without regard to whether they were characterized as additional compensation received from the employer or as the employee's gain from the disposition of property.

The taxpayer in Charley argued that frequent-flier miles were not property and did not constitute taxable income when earned in business travel. Although the Ninth Circuit specifically declined to address the taxability of frequent-flier miles in general, the appellate court (and Tax Court) treated the frequent-flier miles as property that could be sold or exchanged. Thus, free miles are no longer viewed as only a discount or purchase-price adjustment, but also as property representing gross income to the recipient.

In Charley, the value of the frequent-flier miles was readily apparent because of their conversion to cash. Were it not for the valuation difficulties absent a cash conversion option, this decision could be applied to frequent-flier miles in general and would strengthen the IRS's ability to tax the free miles awarded. (Recent legislation extending the aviation excise tax to third-party cash payments for mileage awards may portend future averse congressional action on the income taxability of these programs.)

P.L.R. 9746048

A recent IRS ruling also treated frequent-flier miles as property that can be sold or exchanged. Private Letter Ruling 9746048 (Aug. 14, 1997) involved a mutual fund company that awarded frequent-flier miles as a sales incentive to attract investors. The IRS held that the mileage award was an integral part of the purchase of the mutual fund shares. Specifically, it was additional consideration received for the transaction. The IRS held that the fund's investors must reduce their cost basis in the shares purchased by the fair market value of the additional consideration received -- the frequent-flier mileage -- as required under section 1016 of the Code.

Once again, the IRS failed to provide guidance for determining the fair market value of the frequent-flier mileage. In addition, the IRS failed to acknowledge that an investor may not actually use the mileage received.


Travel industry experts estimate that approximately 95 percent of all U.S. employers permit their employees to keep their frequent-flier miles for personal use. IRS Wrestles with Frequent Flyers, 69 Tax Notes 1159 (Dec. 4, 1995). Thus, if TAM 9547001 were applied to all taxpayers, the problems created for both business travelers and their employers would be monumental.

The IRS's reconsideration of the TAM's position does not necessarily mean that the agency plans to withdraw the ruling. It has been two years since the announcement and no guidance has been provided. Furthermore, the recent treatment by the courts only strengthens the IRS's ability to tax frequent-flier mileage as a taxable fringe benefit.

The IRS's position in TAM 9547001 was predicated on the company's developing a written policy permitting its employees to retain their frequent-flier miles earned. Therefore, until the uncertainty over the taxation of frequent-flier miles is formally resolved, such a written policy should not be maintained. If a written policy is maintained, the employer should require all employees to surrender their frequent-flier miles earned on business travel.

To mitigate the potential costs of expense reimbursements being treated under the nonaccountable plan rules, employers should consider segregating airline travel into a separate expense reimbursement plan. Again, if treated as a nonaccountable plan, all reimbursements -- not just the frequent-flier mileage -- will be treated as taxable compensation subject to Form W-2 reporting, employment taxes, and withholding.

The uncertain tax treatment of frequent-flier miles requires either a statutory exemption or clear and sufficient guidance to overcome the problems created concerning the proper valuation, administration, and required reporting. The simplest solution would be the enactment of Representative Kennelly's bill to exempt frequent-flier miles from taxation. Without a clear resolution of this issue, the potential cost to all U.S. employers and employees would be unimaginable.

EARL B. JOHNSTON is a Senior Tax Accountant for FMC Corporation in Chicago, where he is involved in federal tax research and planning. Mr. Johnston earned his B.S. degree in accounting from the University of Illinois at Chicago and his M.S. degree in taxation from Depaul University. He is a member of TEI's Chicago Chapter.
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Title Annotation:taxation
Author:Johnston, Earl B.
Publication:Tax Executive
Date:Jul 1, 1998
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