Taxability of frequent-flyer miles up in the air

The issue of whether frequent-flyer miles can be taxed has been muddied by a statement by the Internal Revenue Service that awarding miles for opening a financial account can create a “taxable situation.”

Since a 2002 ruling by the IRS, consumers haven't been paying income tax on frequent flyer miles, generally earned through making credit card purchases or by flying. The miles have been considered a nontaxable rebate or price reduction.

But last month, Citibank, a unit of Citigroup Inc., sent out 1099 tax forms for miscellaneous income to its customers who were given frequent flyer miles as an award for opening a checking or savings account. Citi-bank's action spurred an influential senator to demand that the banking giant stop creating fear about “nonexistent” tax liabilities.

The IRS, though, is saying that Citibank may be right.

In a letter last week to Citigroup Inc. chairman Vikram Pandit, Sen. Sherrod Brown, D-Ohio, chairman of the Senate Banking Subcommittee on Financial Institutions and Consumer Protection, cited the 2002 guidance as evidence that the miles shouldn't be taxable. Later in the week, however, the IRS said that the 10-year-old guidance involves a “specific area” involving the receipt or use of miles attributable to a taxpayer's business or official travel, the IRS said.

Although the IRS wouldn't say specifically that Citibank is right to send out the 1099 forms, spokeswoman Michelle Eldridge said: “When frequent-flyer miles are provided as a premium for opening a financial account, it can be a taxable situation subject to reporting under current law.”

The law requires income tax to be paid on awards or rewards worth more than $600. Typically, these rules apply to prize winnings, such as income from a lottery.

SURPRISED CUSTOMERS

Customers who received the 1099 forms from Citibank were likely surprised by the taxability of those miles, as are many financial professionals.

“I think it came as a surprise to a lot of people, especially to those people who opened those accounts,” said Abe Schneier, a member of the tax staff of the American Institute of Certified Public Accountants.

Citibank is the first company to report and evaluate frequent-flyer miles in this way, he said.

Customers are likely to be “borderline angry because they didn't have a clue” the gift would be taxable, said Terry O'Connor, a CPA and principal of O'Connor & Desmarais PC.

“If it happened to me, I'd close my account right away,” he said.

The accounts may end up costing clients, depending on how much the accounts earn in interest and whether the individual ends up using the frequent-flyer miles, said financial adviser Kurt Laubinger.

“The amount of money is not consequential to clients, but it's the principle,” he said.

In addition, if Citibank is claiming the value of the promotions as a deductible expense, that puts them at odds with their clients, Mr. Laubinger said.

Barry Dyke, a financial adviser at Castle Asset Management LLC, said that there is a lesson for clients.

“There is no such thing as a free lunch, and this is another example,” he said.

Some suspect the IRS may view this as another way to collect more taxes at a time when the nation is grappling with how to cut a record deficit. In fact, the IRS said last month that it faces an increasing gap in what taxes American businesses and individuals are supposed to pay and what they actually do.

About $385 billion in taxes went unpaid in 2006, up from $290 billion in 2001, which was the last time that the government calculated this figure, the IRS said. The compliance rate of 86% remained about the same between 2001 and 2006, but the gap grew because the income base expanded, according to the IRS.

“INTENSE OF LATE’

Of the total, $235 billion is a result of underpayment from individuals.

“The IRS has gotten intense of late with new reporting rules because the tax gap shows people aren't reporting all their income,” said Kay Bell, contributing tax editor for Bankrate Inc. “Citibank may be trying to follow the rules extra carefully.”

The IRS has improved the computer systems that track and compare what comes into the government coffers and what is supposed to come in, and several new reporting changes will boost the amount of information that the IRS has available to analyze.

One new tax form, the 1099-K, was unveiled last year to make sure that small businesses report all revenue, including the total amount generated through credit or debit cards or from third-party payers, such as Amazon Inc., eBay Inc. or Paypal Inc., Ms. Bell said.

Banks and third-party providers have to file the forms for each vendor that took in funds, beyond certain thresholds. 

In addition, 1099-B forms have been expanded, starting with transactions in 2011, to require more information about securities sales, Ms. Bell said.

Brokers, banks, custodians and other financial intermediaries will have to report cost basis information on equities (and in later years, mutual funds and other investments) to the IRS, as well as to taxpayers.

“BASELESS FEAR’

Meanwhile, Citibank customers who may have been awarded 25,000 miles to open a financial account will have an additional $625 to add to their income total, based on a Citibank-set rate of 2.5 cents per mile, according to Mr. Brown.

He called that value “arbitrary” in his letter to Mr. Pandit.

“Your actions are leaving working families with the seemingly incorrect impression that when they rack up miles, they are hiking up their taxes, too,” Mr. Brown wrote. “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.”

Citibank spokeswoman Catherine Pulley said that the bank is following current IRS regulations.

“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,” she said.

Rewards and airline miles that are given in connection with credit card purchases aren't subject to individual income tax reporting, Ms. Pulley said.

The IRS also maintains that credit card rebates aren't taxable. It even allows taxpayers to claim tax deductions for gifts of miles to charitable groups, Ms. Bell said.

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