Frequent flyer programs: Are you at risk from IRS?
Personal use of business-earned frequent flyer program premiums continues as a gray area when it comes to taxability.
Frequent flyer programs have been in existence since 1981. Although the IRS has fired several warning shots over the bow since 1985, specific guidance about the taxability of all aspects of these ubiquitous mileage programs still lacks.
Recently the IRS published new information that does clear up some questions, but leaves others unresolved.
Racking up the miles
In the usual situation, employees traveling on business can earn substantial miles through airline bonus programs. Car rentals and hotel stays add to the pot.
The mileage earned through such deductible expenditures has value. Often, the miles thus earned are used for upgraded seating, future free travel, discounted travel, and other services and benefits. If any of these exchanges represent personal usage, rather than use for more business travel, then the question arises whether the value of those benefits used personally is a form of taxable compensation.
Veterinarians attending seminars and conventions fit into this group of business travelers with deductible expenses. Continuing education registration, attendance and related travel costs are bona fide business expenses. Depending on how mileage earned through such travel is then redeemed, the value could become taxable income to the practitioner.
A closely related issue involves mileage earned through other programs. Consider that many veterinary practices use frequent flyer credit cards to pay for substantial drug and supply purchases. For every dollar spent, a dollar of frequent flyer mileage might be earned. Again, the means for earning the mileage was on the basis of a deductible business expense, that of the supply purchased. When the employee (oftentimes a practice owner) uses the mileage thus earned for personal travel, is there a taxable event?
Past history adds to the debate
In 1996, the U.S. Court of Appeals ruled that a corporate employee's scheme to cash in his/her frequent flyer miles resulted in taxable income. The miles-for-cash redemption ploy was declared compensation.
In 1995, controversy and discussion arose when the IRS adversely ruled against a company. The IRS claimed the company's entire travel expense reimbursement arrangement was not an accountable plan because employees were permitted to retain frequent flyer awards for their personal use.
The 1995 technical advice memorandum implied that if the value of frequent flyer awards were not accounted for through taxed compensation, other aspects of the company's travel expense reimbursement program might be deemed taxable compensation, rather than qualified business expenses allowed for deduction but not included in employee income.
Fortunately, the IRS responded to public backlash and emphasized that the specific ruling involved a specific employer and a specific fact pattern. The IRS clarified that the controversial ruling would not set a precedent for other cases.
Employers sighed relief. The accounting for frequent flyer programs and segregating mileage earned for business travel as compared to personal travel would be extraordinarily burdensome.
Assigning a value for the miles used, when many expire and are never used would present many accounting difficulties. Furthermore, questions would arise as to how mileage could be tracked when workers change jobs, moving to other employers and possibly taking the mileage in their frequent flyer account with them.
In a recent announcement (IRS announcement 2002 18), the IRS states that consistent with prior practice, it will not assert that any taxpayer has understated his/her federal tax liability because of the receipt or personal use of frequent flyer miles or other in-kind promotional benefits attributable to business travel.
The IRS further states any future guidance that might be forthcoming on the taxability of such benefits will only be applied prospectively. In other words, when new guidance becomes known, it will not be retroactively applied against prior transactions.
The IRS clarifies that this relief does not apply to travel or other promotional benefits that are converted to cash or when compensation is paid in the form of travel or promotional benefits. In such situations, the value of such premiums must be included in taxable compensation.
As with any announcement or guidance, situations where the IRS deems that the taxpayer has constructed a fraudulent scheme for the primary purpose of tax avoidance, then the announcement would provide no protection.
Raises many issues
In the announcement, the IRS acknowledges that business-related frequent flyer miles and related benefits used for personal purposes raise numerous technical and administrative issues. This current announcement only addresses miles earned in connection with business travel. A significant unresolved issue affecting many veterinary practices is that of credit card business purchases resulting in frequent flier mileage awards.
Credit cards are now used for all sorts of practice-related expenses, ranging from the entire hospital requirement for drugs and medical supplies to large equipment and practice vehicle purchases. By the letter of the law, if the miles used from those practice purchases are used personally, the value of the redemption is taxable.
Practice owners should be careful to establish and maintain policies that help protect the deductibility of business-related expenditures.
The policy should prohibit conversion of frequent flyer miles and other promotional benefits to cash.
Under no circumstances should compensation negotiations include documentation or discussion that business-earned mileage can be used personally as part of the compensatory package.
Business owners who are especially cautious might want to prohibit the use of business miles at all for personal use, even for upgrades or for purchasing tickets to obtain free travel of a personal nature.
Assure all qualified travel-related expenditures are documented as to the reason and purpose of the travel.
Require receipts for all travel-related expenditures personally paid by an employee, before reimbursing. Reimburse only to the exact amount of documented expense submissions. Any amount paid in excess of actual expenditure is deemed compensation.
Segregate credit card-earned frequent flyer miles in a separate account from those earned through business travel.
Use credit card-earned frequent flyer miles for business use only.
Keep separate credit cards for personal, as compared to business, use.
This new announcement provides temporary relief from the burden of extensive record keeping and tracking potential compensatory benefits for each employee who has business-related frequent flyer mileage. It does not apply to frequent flier miles earned with a credit card. Be prepared for the likely eventuality of the IRS revisiting the question in the future, particularly if individual taxpayer review gives strong evidence of extensive abuse of the use of frequent flyer programs as a disguised form of personal compensation.
Dr. Heinke is a partner of Owen E. McCafferty (OEM), CPA, Inc., in North Olmsted, Ohio. The firm offers tax and accounting and management consulting services. E-mail can be directed to her at [email protected]; phone: (440) 779-1099.