The last holdout for the non-taxable alternate currency may be ending.
Credit card rewards started as a token thank you from the credit card companies. Tips and points have taken on a life of their own. People can buy airline tickets, reserve hotel stays, purchase gift cards, and pay for Amazon purchases with points. There are even brokers who buy and sell reward points and miles.
How has this shadow currency escaped the attention of the taxing authorities? One explanation may be that legislators at both the state and federal level generate rewards from using credit cards and are loath to effectively limit their benefits by taxing themselves on what they may view as a perk. Similarly, the employees of the taxing authorities garner the same services.
The historical rationale of non-taxability of credit card rewards and points is the IRS viewing them as rebates on purchases. The rewards are considered discounts on purchases rather than income. This rationale is questionable because people charge business expenses on credit cards and then use the reward points for personal travel or other benefits.
But, there may be a tipping point. A decision last week by the United States Tax Court could be the beginning of closer scrutiny of people who generate many points and of the rewards industry at large.
Last week, in Konstantin Anikeev and Nadezhda Anikeev v. Commissioner of Internal Revenue, the Tax Court found that the Anikeevs, a married couple, owed taxes more than $310,000 of credit card rewards they earned.
Essentially, the Ainkeevs manufactured the points (something that most people, including legislators, do not do) instead of accumulating points through legitimate purchases.
In two years, the Anikeevs spent over $6 Million on their American Express card. The AmEx card provided 5% cashback on purchases at grocery stores, pharmacies, and gas stations. Almost all of the couple’s AmEx purchases were for Visa gift cards and reloadable debit cards bought at grocery stores and pharmacies. The Anikeevs used the gift cards and debit cards to purchase money orders, which they deposited into their bank accounts, and used the generated funds to pay their AmEx bills. Their credit card purchases generated reward dollars that could be redeemed for gift cards and statement credits.
The couple did not report the over $300,000 they generated in reward dollars as income on their joint tax returns. The IRS later issued a notice of deficiency stating that the reward dollars were taxable as “other income.” The couple challenged the IRS’s position, and the Tax Court found that the couple earned the reward dollars by buying cash equivalents, not a product or service, and as a result, their rewards were taxable income.
The Tax Court’s decision can be downloaded or viewed here: US TAX COURT DECISION
The decision suggests that the IRS would have ignored the couple’s conduct in most circumstances because of its practice of not taxing credit card rewards. The couple tried to get an economic advantage on a large scale by manipulating the rewards program, which triggered an inquiry. Does this mean that the IRS will ignore small-scale manipulation of a credit card rewards program for economic gain? Also, will the purchase and sale of miles or transfer of rewards be subject to IRS scrutiny?
Perhaps there should be legislation addressing exactly when credit card rewards could be deemed income or clear IRS guidelines when it will deem rewards taxable. Until then, if you use your credit cards and earn rewards for buying something that could be deemed a cash equivalent, the government may want a share, depending on your rewards’ size.