EsquireFlyer

You can "argue" this; it's just not consistent with IRS guidance or, I think, the laws passed by Congress. So the argument is not likely to get anywhere, unless the IRS reverses its own position.

And of course, if you take a return position that's not based on a reasonable interpretation of the law and/or IRS guidance, you can owe penalties on top of any payment deficiency.

redtop43

I think Citi is taking a very reasonable position. Suppose interest rates were higher, say 5%, and suppose Citi had a promotion where they sell a CD with a zero interest rate but a "bonus" of 50,000 miles for a one-year, $10,000 CD. Valuing points at 1 cent, this is $500 equivalent in interest. It seems pretty transparent. The IRS reg that requires reporting of "gifts" of more than de minimus value seems sensible. No, nobody likes paying taxes, but if you get something that seems like interest on an investment, it should be taxable.

OTOH, I don't know who was halcuinating at Citi when they valued the miles at 2.5 cents. Do they pay 2.5 cents per mile? I highly doubt it. Can you sell/trade/redeem them for 2.5 cents? No, you can't. I even wonder if they should be taxable at all given the T&C of the miles. Read your fine print and it will say that the miles remain the property of the airline. Taxes are based on "constructive receipt" and have you actually received anything if it can be taken away at any time? A strong argument could be made that you have only actually received something when you redeem the miles. Of course, it would be a nightmare to track what you got for THOSE miles, and when, and what it was worth.

Why did Citi value them at 2.5 cents? I'm sure they didn't pay that for them, and while some people probably do pay 2.5 cents to buy them in limited circumstances, that's hardly the "market-clearing" price. The only reason you would pay 2.5 cents is because of the restrictive T&C that make them not your property, not transferrable, etc., which actually make them worth LESS.

I can't imagine that Citi got a tax deduction of 2.5 cents per mile. They got a deduction for what they paid for them. It is really hard to figure why they thought it was a good idea to s**** their customers by putting an artificially high value on the miles. Did they think they'd get into trouble with IRS for valuing them too low?

JATR4

What the IRS Spokesperson Said:

...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...

What the IRS Spokesperson Meant:

Those idiots at Citibank issued unnecessary 1099s and now we have to get involved. Idiots!


Note: The spokesperson said can, not is.

nsx

Emphasis added.

It seems to me that this formulation encompasses those credit card bonuses which can be triggered by a single small purchase. For example, 50k miles for buying $1 of gas is more like a prize than a rebate. If I buy a $1 item with a mail-in rebate for $500, I have $499 of income that is legitimately taxable.

In the future, I plan to make sure that my first purchase on one of these offers is a big one, more than 2 cents for every mile earned. That way the rebate will not exceed 100%, which is where tax trouble might lie.

Andy2

My understanding of the rebate rule is that it reduces the basis of what you purchased and there is no prohibition against negative basis. Logically, one would just continue to gradually reduce the basis of everything you bought with the card over the life of the card. But if all you ever bought was the pizza, there still should be no taxable income unless you sold or exchanged the pizza. In other words, if the 100,000 miles were worth $1,000 (it kills me to write that since I think they are worth $0.00) and you bought a slice of pizza for $5, you would have a basis of -$995.00 in the pizza. No tax consequence if you eat the pizza, but big gain if you sold the pizza to someone else for $3.

The more likely scenario is that you buy $5,000 of stuff with the credit card over a long period of time and the basis in that stuff is $4,000. Still no tax consequence unless you sell or exchange that stuff for more than $4,000 (as long as you didn't take a tax deduction for any of the $5,000 of purchases). That is how I look at it anyway, rather than the credit card bonus ever being a prize or award.

But that is so nonsensical, there is really no answer, other than the logical assumption that no rational company would give someone $995 worth of rewards for buying a $5 pizza. So that leads back to the conclusion that the miles must have a FMV of $0.00, or a trivial amount that is less than $5.00

It would be better if Citi hadn't brought all of this theory to the forefront by issuing the 1099s. If they had just valued the miles at 1 cent per mile, no 1099-MISCs would have been required.

Andy2

The only problems I have with this is the fact that the recipient got the same number of miles whether he deposited $10,000 or $100,000, Citi didn't place a value on the miles when calculating the annual percentage yield for the accounts (pursuant to ABA guidance that valued the miles at $0.00), and issued a Form 1099-MISC instead of a Form 1099-INT.

nsx

Negative basis is an extremely rare situation in which liabilities exceed the value of an asset. IMHO there is no chance you could persuade an IRS expert that you do not have some form of taxable income in this example. Especially if you commingle the asset by eating it.

EsquireFlyer

I don't think that's correct. The pizza example was a credit card, not a bank account, and the IRS treats credit card miles differently than bank account miles, doesn't it? (rebate theory vs. interest theory)

For example, this taxpayer was able to persuade the IRS that when it donated its credit card points to charity, the points were rebates that didn't count as taxable income, but the donation did count as a charitable deduction against the taxpayer's other, unrelated taxabale income.

http://www.irs.gov/pub/irs-wd/0228001.pdf

Andy2

You do raise a good point in that we should probably just in case buy enough with the credit card in the first year to absorb the value of the miles ($0.00 in my opinion, $0.025 in Citi's) into positive basis. So if I get 100,000 miles as a bonus, it is probably wise to spend $2,500 on the card. Even if the miles are awarded based on a single purchase, I can't imaging the IRS arguing that the basis spread wouldn't occur over all of the items purchased during the year of membership.

Andy2

Thanks for posting this. It is good food for thought.

nsx

A $1000 rebate on a $5000 purchase is qualitatively different from a $1000 rebate on a $1 purchase. The latter is (approximately) the case for a credit card with a large signup bonus unless your first purchase is very large.

EsquireFlyer

Does it have to be considerd a rebate on your first purchase, though? Could it be a rebate on all of your purchases on that card (pro rata)?

Or, if there is a theshold amount (e.g. $3K or so for Chase Sapphire bonus), a rebate on the entire threshold amount--not just the one purchase that puts you over the threshold.

nsx

My opinion only: If the spending threshold exceeds the value of the miles earned, that's equivalent to a rebate. If the bonus is awarded for the very first transaction, then the IRS would have a solid argument that you have income unless the miles are worth less than the money spent on that first transaction. So I plan to make those first transactions very large ones in the future.

Milezjunkie

You are absolutely correct. The spokesperson responded in writing which meant the response was well thought out and articulated carefully. While they are leaving open the possibility the miles could be taxable they are neither declaring the miles to be non-taxable or taxable. This was a very well calculated answer that basically tells you nothing.

I think there is a very big misconception of the IRS and how taxes are determined. Let's say you are one of the average 1% of Americans that are randomly audited this year and they question your devaluation of the 1099 FMV. You are not dealing with some mystery IRS phantom that works in the shadows in Washington. You are dealing with a local IRS agent. If you present the agent with supporting documentation on why you assessed the value for the miles at a different amount then the agent is likely going to allow that because there is no definitive answer to dispute otherwise. We're not talking about major amounts of money, at most $350 if you got a 1099 for $1,000 and a 35% tax bracket.

dhuey

That's probably why they never say a peep about my FMV determination of 1.5 cents per when I use personally obtained miles for business travel, and deduct that value as a travel expense on Schedule C. Whoever at the IRS reads my statement explaining it all probably has a thought process like this:

okay...frequent flier miles -- oh, great...FMV of 1.5 cents per...he's using personal miles for business travel (WTH does that mean?!)...guy's claiming an expense of about $1,000... a few hundred bucks in taxes at stake...screw it -- do not dispute.