Executive Travel : Frequent-Flier Miles Remain Taxing Issue

The IRS sent a shudder through the frequent-flier community this week with the release of a memorandum that, if applied generally, would require employees who travel on business to pay income tax on the frequent-flier miles they earn on company tabs.

But after a loud outcry, the IRS quickly moved to downplay the possibility of widespread enforcement of a frequent-flier tax. “There’s been a lot of misinformation,” said Wilson Fadely, an IRS spokesman.

But the IRS’ official--albeit unenforced--position is that under certain circumstances it has the right to tax frequent-flier benefits. The memo rekindled the debate over whether the IRS should tax frequent-flier miles, a move that some in the airline industry said could severely damage the popular programs.

The latest uproar was sparked when the Wall Street Journal reported this week on the release of an IRS Technical Advice Memorandum originally issued last summer. The memorandum applied only to one company. “It has no impact on any other taxpayer,” Fadely said. And there is no prospect of taxing miles earned at the traveler’s own expense.

Fadely urged other companies not to try to apply the analysis that was applied to the unidentified company. In fact, the IRS is reconsidering the original memo, noting that it didn’t examine the full range of options, he said.

“The memo may have been issued in error,” said Mike Repass, a senior tax manager at Price Waterhouse in Washington. “It’s clear that there are some people who should have been involved with it who weren’t. Treasury wasn’t approached.”

Nevertheless, the airline industry reacted quickly. In a letter to Treasury Secretary Robert E. Rubin, Air Transport Assn. President Carol Hallett criticized the IRS’ waffling on the frequent-flier matter. “There is a long history of failure to announce any position with regard to the valuation, taxability or reportability of income [if any] generated by frequent-flier miles,” the letter states. The IRS “has opened, closed, reopened and reclosed several projects to address” the issue. Hallett said public comment and debate must precede any formal policy decision.

“Any attempt to tax [miles] is going to introduce very complicated tracking issues,” said John Riepe, spokesman for the Virginia-based National Business Travel Assn.

This is not the first time the IRS has hit this taxpayer hot button. “This is the sixth time that I can recall that there’s been this kind of public or media scare,” said Harris Turner, publisher of The Flyer’s Edge, an Indianapolis-based publication for frequent fliers.

A few in the frequent-flier industry speculated that the IRS takes this issue out for a test flight every year or so to gauge industry and consumer reaction to the prospect of enforcing a tax on mileage benefits. Or, as Chris McGinnis, founder of the Atlanta-based Travel Skills Group, put it: “It’s the IRS’ way of letting everybody know they’re being nice guys for not taxing them when they could.”

According to industry observers, the majority of frequent-flier miles are earned through business travel, but redeemed for leisure travel. With 32 million participants in such programs and an estimated 11 million free trips awarded last year, the potential revenue could be substantial.

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In a nutshell, there are two ways the IRS can tax frequent-flier miles. Technically, if business travelers accumulate miles on trips paid for by their company, then use the miles for personal travel, they are obligated to declare the value of that “free ticket” as taxable income, Fadely said.

Even though the IRS does not have special procedures in place to enforce that rule, taxpayers would be liable if they were audited, he said.

The second way such miles become taxable is when they are seen as part of overcompensation for business expenses. This triggers an accounting rule that requires the full value of the original ticket on which the miles were earned to be reported as income to the employee. The employee could then deduct the cost of the travel--but only to the extent it exceeds 2% of his or her adjusted gross income.

As a result, some employees would not be able to claim enough expenses to offset the extra income and would thus be liable for the tax on the difference.

The logistics of enforcing the reporting of such income would be a nightmare, Turner said. “Do you tax them as you accumulate them, or tax them as you use them?” Many frequent-flier points expire or are never redeemed.

“Also, would they be taxed at the business value or the leisure value of the ticket?” he said. And if many people wouldn’t take the trip if it wasn’t free, does the ticket have any actual intrinsic value?

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Turner and others drew the analogy to other forms of consumer rebates. “If you get a $1,000 rebate off a car, is that a taxable rebate?” he said. The airlines’ official position is that the miles are non-taxable rebates.

The airlines value the miles in different ways. One airline, for example, puts the value of a frequent-flier award at a flat $23 per award, which is what it calculates is the incremental cost of adding one person to the plane. This can make sense because most mileage award tickets do not displace paying passengers--many of those seats would otherwise be empty.

Other airlines value the awards at a flat rate of about 2 cents a mile, which is the price they use to sell blocks of miles to retailers for use in mileage promotion programs.

Individual airlines maintain that a tax would be inappropriate.

“We do not think a frequent-flier travel award benefit is a taxable item,” said David Castelveter, spokesman for USAir. “It’s not any different than any of the other product-loyalty incentives other businesses hand out.” Many companies give employees free food, free or subsidized parking or other forms of non-cash incentives that aren’t taxable, he said.

Even if all the airlines were to agree with the IRS that the miles were taxable under certain circumstances, they wouldn’t be able to sort out which already-accumulated miles were for business and which for pleasure.

“People lost track of that a long time ago,” said Randy Petersen, publisher of Colorado-based InsideFlyer Magazine. And miles earned in other ways, such as credit cards, complicate matters further.

“Everybody feels if frequent-flier points were ever taxed, it would be the end of the programs,” McGinnis said.

Turner, however, doesn’t think the programs would end if they were taxed. “Personally, I’d still rather take a $5,000 vacation and spend $1,250 on taxes,” he said. “I’d still say it’s a good deal for me.”

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Bloomberg Business News contributed to this column.