Tax Consequences of Frequent Flyer Mileage Earned on Business Travel

From Employee Benefits Alert

May 1997

Frequent flyer mileage has become almost a second national currency, with many individuals accumulating mileage from numerous airlines, credit cards and other programs. The taxation of frequent flyer miles earned in such ways has long been a problem for which the Internal Revenue Service has not had a ready answer. When employees earn mileage on flights that are paid for by the employer and are allowed to keep that mileage, the mileage is a fringe benefit that has a value and should be taxable to the employee. Section 61 of the Internal Revenue Code, gross income includes "all income from whatever source derived." Section 1.61-21(a)(1) of the Treasury Regulations provides that gross income includes the value of fringe benefits such as employer-provided free or discounted air travel. Nevertheless, the timing of the income inclusion and the value of the benefit have been so difficult to determine that most employers have not reported it as such and the IRS has not issued guidance on how and when to report the income.

In 1985, the IRS issued proposed regulations on employee fringe benefits and requested comments on the taxation of frequent flyer miles. Although many comments were submitted, the IRS regulations did not provide guidance and the issue is not on the current IRS regulations project list.

There have also been few court decisions regarding the taxation of frequent flyer miles. In Charley v. Commissioner, 91 F.3d 72 (9th Cir. 1996), aff'g and rev'g 66 T.C.M. (CCH) 1429 (1993), the Ninth Circuit Court of Appeals affirmed a Tax Court decision holding that a corporate president was required to include in his gross income the value of frequent flyer miles. The employer permitted the employees to retain the frequent flyer miles accrued during business travel. When traveling on business, the employee directed the company travel agent to book coach class tickets, but bill for the cost of a first class ticket. He then used his frequent flyer miles to upgrade the coach ticket to a first class ticket, and had the travel agent credit the excess amount paid by the employer (and charged to its clients) to the his personal travel account. In this way he effectively sold his frequent flyer miles to the employer for cash. The court held that the employee was taxable on the cash credited to his personal account, either as a sale of the frequent flyer miles or simply because the employer made this extra cash available for the employee's use. Although the court upheld the Tax Court's decision regarding the taxation of the mileage, it reversed the Tax Court's imposition of a negligence penalty.

It is interesting to note that the IRS apparently did not argue in Charley that the employee was taxable on the frequent flyer miles earned by the employee, but only on the cash credited to his personal account. Although the taxpayer asked the Ninth Circuit to consider whether, in the abstract, frequent flyer miles constitute gross income, the court stated that the issue was not raised by this case and declined to reach that decision. The court stated that the transaction could be taxed as the receipt by the employee of travel credits to his personal account or as the sale of the frequent flyer miles.

In 1995, the IRS released Private Letter Ruling 9547001 (Nov. 24, 1995), which considered an employer's frequent flyer mileage program. The employer permitted employees to keep frequent flyer miles and use them for personal travel. The IRS treated the frequent flyer miles as a rebate to the employer. Because the employee was not required to return the mileage to the employer, the IRS ruled that the employer failed to satisfy the requirement for "accountable plans" that employees return "excess expense advances." Under section 62(c) of the Internal Revenue Code an arrangement does not constitute a qualified reimbursement arrangement (i.e., an accountable plan) unless the employee is required to return to the employer all amounts in excess of the substantiated expense.

Amounts paid under an accountable plan need not be reported by the employee as an income or expense item on his personal tax return. The failure to qualify as an accountable plan would mean that all travel expense reimbursements to employees on flights that generate frequent flyer miles would be taxable income to the employees. Although the employees could claim an itemized deduction for the expenses, that deduction would be subject to the 2 percent floor on itemized deductions as well as the phase out of itemized deductions that applies to high income taxpayers.

The effect of the 1995 ruling would be equally harsh on employers. The employer may be subject to various penalties for underwithholding and underreporting income because the amounts paid under the nonaccountable plan would be additional wages to the employee. In addition the employer may find its deduction of such expenses limited because of the improper substantiation and tax reporting of the reimbursements. Section 274(d) disallows a deduction for travel expenses unless the employer either reports the expense as compensation or meets rigorous substantiation requirements.

The 1995 ruling caused an uproar among employers and employees. Many employers have travel plans similar to the one considered in the ruling and the potential for back taxes and penalties if the IRS were to apply this ruling broadly were massive. As a result of the furor caused by the ruling, the IRS stated that it would reconsider the results of the ruling and reiterated that private letter rulings apply only to the taxpayer to whom they are issued. The IRS also stated that it had no special enforcement program regarding the taxation of frequent flyer miles. Nevertheless, the position taken in the ruling is not without reason, and could be applied to other taxpayers. To date the IRS has not revoked the ruling or provided any further guidance.

In the absence of guidance, what is an employer to do about frequent flyer miles that employees earn on business travel? In most cases, mileage earned by employees cannot be transferred to employers because of the airlines' restrictions. In Southmark v. United Airlines, 132 Misc. 2d 586, 590 (Sup. Ct. N.Y. County 1986), the plaintiff brought a class action against seven major airlines maintaining frequent flyer programs in an attempt to force the airlines to permit the transfer of mileage to the employers. The court dismissed the complaint for failure to state a cause of action.

Some employers have required employees to use miles earned on business travel only for subsequent travel undertaken for the employer. This requires that the employer monitor business travel and the amount of miles earned by each employee on each airline in order to determine how many business miles the employee had credited to her account. In Southmark, the court held that the airlines were not required to provide an employer with employee account information of miles earned and benefits received by the employee under frequent flyer programs. There are travel services, software programs and websites designed to facilitate corporate tracking of employees' frequent flyer miles. Nevertheless, only a small percentage of employers actually restrict an employee's use of business miles, because of the unpopularity of that policy among employees and the perceived difficulty of enforcement.

Employers who do not wish to undertake the administrative burdens of tracking business mileage should be safe, for now, if they permit employees to retain the frequent flyer miles for personal use. The lack of IRS guidance over when the mileage constitutes income (i.e., when earned, when redeemed for a ticket, or when the ticket is used) and how to value the miles (i.e., resale value, a uniform amount per mile earned, or an amount determined by the value of the ticket received) makes it impossible for employers to accurately report the miles as income. In addition, taxpayers have argued that the mileage earned by employees is not a "rebate" which should result in a "nonaccountable plan" as described in the 1995 IRS ruling.

Some employers who permit their employees to retain frequent flyer mileage have adopted programs under which they offer to pay an employee for using the miles to procure tickets for business travel. Employers using this approach usually pay about 50% of the cost of the ticket. The payment is taxable income to the employee, but should not be taxed as compensation (i.e., should not be subject to employment taxes) because it is being paid to the employee for the mileage and not for services rendered. Paying the employee permits the employer to save on the cost of business travel and permits the employee to use benefit from mileage that she might not be able to use for vacation travel.

Until the IRS issues further guidance, employers should be permitted to continue treating frequent flyer miles earned by business travelers as an intangible nontaxable benefit despite the lack of a clearly discernable income exclusion. The IRS has indicated that there is no current enforcement program regarding frequent flyer miles, and there are no instructions in the Internal Revenue Manual regarding the audit of such programs. Legislation was introduced in Congress in 1996 and reintroduced earlier this year that would exclude from income frequent flyer miles earned and awards received by business travelers. Passage of such legislation would be the most certain resolution to a problem that has existed ever since American Airlines introduced the first frequent flyer program in 1981.

For additional information about the taxation of frequent flyer miles or other corporate travel programs or fringe benefits, please contact Paul J. Powers, Jr. or Kirk H. O'Ferrall.