Hands off, Uncle Sam. Nearly two out of three rewards card owners say they would stop using their cards if the miles, points and cash back rebates they earn when making purchases were taxed as income.
According to a scientific poll commissioned by CreditCards.com, even if just a portion of their rewards -- the generous sign-up bonus points being offered today -- were taxable, half of those rewards card owners (52%) say they would also give up their cards.
"Everyone loves rewards. Even people who don't understand them, love them" says Brian Kelly, founder of ThePointsGuy.com travel and rewards blog. "The last thing people want is another tax bill to worry about."
Travel and rewards expert Tim Winship says he wasn't surprised by the poll results because he says rewards users, especially frequent fliers, are passionate about their miles. If they were taxed on them in any way, "they're going to go ballistic," Winship says.
Fortunately for those who covet rewards points and miles, the bulk of rewards -- those tied to credit card purchases -- are tax free. The Internal Revenue Service considers those similar to rebates you would get when buying a television or appliance.
However, according to the IRS, rewards received as a gift or "premium" -- such as sign-up bonuses offered to open credit card and checking accounts -- can be taxable if they aren't tied to making a purchase. "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," IRS spokeswoman Michelle Eldridge said in a statement e-mailed to CreditCards.com.
To measure how rewards cardholders feel about the possible tax, the random telephone poll was conducted Feb. 10-12 by GfK Roper and included 1,000 adults (See poll methodology). It found that 65% of rewards card users say they would stop using their credit cards if airline miles, points and cash back rewards that are currently tax-free became taxable.
Only a third of rewards card holders (33%) said that making rewards taxable would not impact their use of their cards.
A taxing question
The issue of how the IRS views all rewards and which rewards are taxable was thrust into the limelight recently when Citi, HSBC and Citizens Bank sent notices to some banking customers that rewards they received in 2011 were considered taxable income. HSBC and Citizens gave gift certificates or rebates as rewards. Citi is the only major bank to send tax notices for airline miles rewards.
People who took advantage of a promotion offering up to 40,000 airline reward miles for opening Citi checking accounts received 1099-MISC tax notices if the value of the miles was more than $600. The 1099s sparked outrage from customers and have already prompted a federal lawsuit.
Citi customers Bertram Hirsch of New York and Igor Romanov of California filed a class-action lawsuit in U.S. District Court in New York on Feb. 14, 2012. The suit accuses Citi of unfair and deceptive trade practices for not fully disclosing the tax implications of the rewards and for inflating the value of the airline rewards.
According to the lawsuit, Hirsch and Romanov were hit with an estimated $350 tax liability when they moved their money to open Citi checking accounts. Had they realized they would be receiving 1099 tax notices, "they would not have signed up for it," their attorney, James C. Kelly, said in a telephone interview. "They're being required to pay in taxes just as much as they would if they had purchased a ticket outright."
"It's not worth it for them to move over to Citibank," Kelly says. "They could have taken advantage of another offer -- one that offered a better return for them."
Citi denied the suit's allegations in a statement released by spokeswoman Emily Collins: "We are confident in the appropriateness of our disclosures and we will vigorously defend our actions from this litigation. The value of airline miles provided as a gift in connection with opening a bank account is generally treated as income and subject to reporting."
Citi's standard disclosure in its ThankYou rewards program warns customers that they are "solely responsible for any personal tax liability arising out of the redemption of points" and that the bank may send a Form 1099-MISC (Miscellaneous Income) for the year in which a reward is issued.
Opening the door for debate
People in the frequent flier community and tax and banking experts are watching the Citi lawsuit with interest -- and unease. Some blame the publicity over the 1099 notices for being the catalyst behind reopening a debate over taxability of rewards that many are reluctant to have.
"They've opened a door here that I don't think ever should have been opened," says Winship, editor and publisher of FrequentFlier.com. "What Citi has done really muddies the waters for a lot of people. It does raise the question that, even though the 1099 that they sent out was for only sign-up bonuses for checking and savings accounts, there's no clear line in the sand between that sort of promotion and a credit card sign-up bonus."
He adds: "The question in my mind, and I think in a lot of people's minds is, 'well, if they are sending out 1099s for these today, does that mean that tomorrow or next week or next month are they also going to send out 1099s for an American Airlines Citibank AAdvantage card?' There's a lot of doubt and uncertainty and anxiety surrounding these sorts of bonuses right now."
Fearful that their customers will shy away from rewards credit cards if there's even a hint of taxation on the miles or points, banking industry representatives have been quick to point out the difference between rewards offered for checking accounts -- which may be taxable -- and those connected with credit card use, which the IRS has deemed tax free.
"It is important to make the distinction that 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," according to Citi's spokeswoman Collins.
Kelly, the rewards points guru, says, "Rewards cards are a billion-dollar business. I don't think anyone wants to shake up a system that's working perfectly fine for consumers and the credit card companies."
Dennis Moroney, a banking industry consultant with Tower Group, says banks rely heavily on rewards programs as a huge driver of credit card acquisition, retention and utilization. Card issuers wouldn't be pleased if customers abandoned their rewards cards at a time when banks are facing declining revenues from credit card and debit card fees.
"The banks have got to be a little concerned about that," Moroney says. "If they stop using the card or cut back, that will certainly make the issuers unhappy."
Tax laws need rewarding update
George Jones, a senior federal tax analyst for CCH, a tax and business law consulting firm, says IRS rules have not kept up with the changing landscape of the credit card and rewards market.
The IRS made its last official tax ruling on rewards points in 2002, when it said that "the IRS will not assert that any taxpayer has understated his federal tax liability" by using miles earned on business trips for personal use. The rule was narrowly worded, and left open the possibility of future amendment.
When the ruling was issued, the rewards were relatively small and the potential taxable income was minimal. Jones says the IRS took the position that all those frequent flier miles held a very small value and weren't worth the administrative hassle of reporting and tracking it. "The reasoning was that it would be so difficult to administer that the IRS was setting the issue aside for the time being," says Jones.
"The tax law says that all income is taxable unless otherwise excepted," says Jones. "One of the exceptions is a rebate of any kind."
According to the IRS, miles awarded when goods or services are purchased are not income because they are purchase price adjustments -- rebates. For example, if you buy a television for $500 and receive a $50 manufacturer's rebate, the rebate is not income. It's considered a reduction in the cost of the television.
"The tax law does not say explicitly that credit card miles are taxable in these situations and not in these," says Jones. "It applies in general. That leaves it open for different interpretation."
"The IRS has not explicitly set forth rules that address the cash back and the recent proliferation of rewards programs," says Jones, a 30-year tax law veteran. He says current tax laws limit what the IRS can do.
Congress flies, too
Ultimately, Congress may have to weigh in on the issue, says Jones, but lawmakers and their constituents may be reluctant to change the laws as well.
"If you're in Congress, you're probably doing a round trip a week from Washington back to your home state," Winship notes. "It's generally assumed that Congress people are pretty sympathetic to the plight of frequent fliers, being as how they are themselves road warriors."
How much are airline miles worth?
Jones the tax expert says the question of how banks assign value to frequent flier miles is legitimate and worthy of debate. Banks have the power to assign any value to the frequent flier miles that they choose. According to the class-action lawsuit, Citi valued the airline miles at 2.5 cents a mile -- more than double the amount many industry experts place on them. According to the suit, some estimates are the miles may be worth as little as 0.76 cents each.
Assigning that higher value to the miles meant Citi crossed the threshold for the IRS's mandatory 1099 reporting requirement. Income over $600 must be reported to the IRS on a 1099 tax notice. Anything under that amount is still taxable, but it's left up to the taxpayer to report it to the IRS.
"For Citi to have put a value of 2.5 cents per mile on those tickets really adds insult to injury to anyone who received those miles," says Winship, the frequent flier. He calculates the value at only 1.2 cents a mile.
Citi's standard disclosure tells customers: "The valuation of ThankYou Point redemptions for Form 1099-MISC tax reporting purposes will be at Citibank's sole discretion."
Kelly, the attorney representing consumers in the class-action lawsuit, says there wouldn't be a problem if customers knew up front how much Citi valued the miles.
"We want Citibank to not only disclose that it will issue a 1099 if a customer accepts an airline miles offer, but also to disclose the value that Citibank places on the airline miles," Kelly says. "For example, Citibank can easily state that if you accept this award, a 1099 will be issued for the value of the American Airline miles and Citibank currently values airline miles at 2.5 cents per mile."
An argument against taxing airline miles earned as rewards is the question of ownership. Airline miles that are earned are not owned by fliers until they redeem them. Miles and other rewards can be revoked -- for instance if you default on your credit card bill or close your account.
"The consumer doesn't own them," Winship says. "In the fine print in all of the programs, it says the account holder does not own the miles. It has to make you wonder if it makes sense to tax something that you don't own."
Just a matter of time?
Moroney, the card industry consultant, says it may just be a matter of time before all rewards are taxed -- especially with the federal government looking for revenue sources to help pay down the national debt. "It's not unheard of to think the IRS might tax rewards," Moroney says.
Kelly, the points blogger, says taxing rewards would be shortsighted for a number of reasons: "I don't think that taxing points is going to put a dent in what our nation owes."
"People would start using their credit cards less," Kelly says. "The economy depends on people spending money. If there are factors out there discouraging people from spending, in the end it would have a negative effect on the economy."
Kelly says he would join the 65% of rewards card users in the CreditCards.com poll in abandoning his cards if rewards earned while using the cards were taxable. "I would probably change my habits as well," he says. "Let's just hope that doesn't happen."
The survey was conducted Feb. 10-12, 2012, by GfK Roper, a division of GfK Custom Research North America, and was commissioned by CreditCards.com. Random digit dialing phone interviews were completed with 1,005 adults 18 years old or older. The raw data were weighted by a custom designed computer program that automatically developed a weighting factor for each respondent, employing five variables: age, sex, education, race and geographic region.
The poll asked three questions:
- Do you have a credit card or debit card that offers you things such as rewards points, miles or cash back for using your card?
- If any rewards, such as airline miles, points and cash back that you earn for using your credit card were taxable by the IRS -- meaning you had to pay income taxes on the value of the reward -- would that make you stop using your rewards card?
- If only the sign-up bonus points were taxable, but not the points you earn for making purchases, would even that make you stop using the card?
45% of respondents said they had rewards cards while 53% did not. Those who had rewards cards were asked the remaining questions. The margin of error on the full sample was +/- 3 percentage points and +/-4.5 percentage points on the smaller sample.