Transcription
If you earn credit card rewards, you may have seen online that credit card rewards are not taxable. Except, sometimes they are taxable, and then the explanations never seem to be too clear on the difference. Since there's limited actual tax law on this topic, so in this video, we're going to outline the actual tax law that does exist and simplify what it means so that you know how to use your rewards in a way that does not generate an extra tax bill.
And if you don't know me, I'm Jasmine Delucci. I'm a tax attorney, CPA, and enrolled agent, and I recently got to social media, even though my day-to-day is actually running my CPA firm and my tax law firm. But I do it to show you actual tax law.
So before we get into some detailed tax law, it's always important to understand the foundation of tax law. We have our three main levels, okay? We have statute, then Treasury regulations, and then court cases. But then below court cases, we do have IRS guidance, like Revenue rulings or even IRS announcements, where the IRS can interpret the law and provide guidance on complying with the law above it. In almost every tax research question, there's typically significant statute, Treasury regulations, or court cases right on point. But despite how widespread this topic is, our guidance is actually limited. So we do have a bit of a gray area.
And if you know anything about my content, you know that I do not jump to call things a gray area because most people use that phrase when it's really just gray in their minds because they don't know how to look up the actual tax law. So just because something has some gray does not mean we have no idea what to do. We have limited guidance, but it does still provide us with clear direction that would provide you with substantial authority to follow.
So let's begin with the applicable statute, IRC 61A, which is our foundational statute defining gross income for income tax purposes as all income from whatever source derived. Gross income was further defined for us in 1955 with a critical US Supreme Court case, Commissioner versus Glen Shaw Glass, which said gross income is instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.
So honestly, you could stop right there and you could say that is it. Rewards are always taxable. And that's typically the limited analysis that we will do for other areas where we don't have statute excluding the item from taxation, like money you find on the ground. Okay, if you walked outside and you find $100 on the ground, it is literally taxable because of the tax law that we just covered, because there are no exclusions in the law to prevent it from being gross income for income tax purposes under IRC 61A.
But we have IRS guidance that tells us to treat rewards differently. That is taxpayer favorable, which is a nice change of pace because that is often not the case. So we'll break this down into two sections. The first is frequent flyer miles or other promotional benefits like hotel points, and two is cashback rewards, which both have different tax treatment, but they are more taxpayer favorable than just treating it as taxable gross income in the year received.
So first, frequent flyer miles or other promotional benefits like hotel points. The problem with these rewards is that there's difficulty with valuation, administration, and timing. Since you get the points in one year, and it's not even clear what they're worth, and then you get the value in another year, and the rewards are usually for dollar amounts that are negligible to the IRS. For us, those reward points can add up. For the IRS, not a great place for them to focus their enforcement efforts. So the IRS has created guidance that tells us that they are non-taxable out of convenience.
So it's outlined in the IRS Announcement 2002-18, where they state, "There are numerous technical and administrative issues relating to these benefits on which no official guidance has been provided, including issues related to the timing and valuation of income inclusions and the basis for identifying personal use benefits attributable to business or official expenditures versus those attributable to personal expenditures. Because of these unresolved issues, the IRS has not pursued a tax enforcement program with respect to promotional benefits such as frequent flyer miles."
So note what the IRS did not say in their guidance. They did not say that they can't legally tax it. Instead, they say, "We are choosing to not pursue it due to administrative difficulty." They could change their policy and begin taxing it, which they allude to when they conclude that any future guidance on the taxability of these benefits will be applied prospectively.
Now, we do have an outlier to be aware of, okay? It's Sean Carr, the commissioner of a 2014 regular Tax Court case, where the taxpayer received points that he converted into an airline ticket in return for opening a bank account and depositing money at the bank. The court compared this exchange to interest income, saying the value was in exchange for the use of money, not for a purchase. And of course, he also received a 1099, which of course is how the IRS learned about it.
And I think the most reasonable interpretation is to narrowly read this case specific to the situation where it applies only to value received in exchange for use of money, because that's actually how another big tax court case that we cover later in this video interpreted it and differentiated their holding. So the IRS policy is pretty clear. Your frequent flyer miles and reward points in exchange for a purchase are safe from the IRS for now and not taxable, which is great news, and probably that's what you're hearing about when you hear that rewards are not taxable.
But what if you are receiving cash as a reward? Because the IRS doesn't have much trouble figuring out the valuation or administration of taxing cash. They know how to do that all day long. So the IRS has guidance from 1976, where they address how to treat cashback in exchange for a purchase. And this specific guidance was in context of when you purchase a car and you receive a rebate. The IRS came in and interpreted the existing law and said that instead of treating the rebate as income, we treat it as a reduction in the purchase price, or what we call a reduction in tax basis of the car.
This is in Revenue Ruling 76-96, and it says, "In the case of a purchase, at the time qualifying retail customers conclude negotiations with M's dealer, section 1012 of the Code establishes a basis for the automobiles, assuming there are no trade-in automobiles involved. The actual purchase price of the new automobiles will be their basis. The rebate represents a reduction in the purchase price of the automobile. Thus, when the qualifying retail customers each receive the $4X rebate, section 1016 requires a downward adjustment to the basis of the automobiles."
Which makes sense, right? Like how ridiculous would that be to purchase something with an associated discount in the form of cashback only to be hit with a tax bill at the time of purchase? So in substance, you really have a lower purchase price, and the revenue ruling matched that substance.
So what does this basis adjustment mean when it comes to credit card cashback rewards? Well, it means that you're reducing your purchase price. So when you reduce your purchase price for a business purchase, the deduction is lower. Or another way of saying that is, you were taxed on the cashback, since the original purchase price and the cashback net with each other to create a reduced tax deduction.
But if you are purchasing a personal item, then the reduced purchase price typically doesn't have a tax impact because you don't usually deduct it and also do not usually sell it for more than the original purchase. But if you're even a little bit familiar with this space, this is probably the place where you say, "But Jasmine, what about that recent and huge court case where the taxpayers won and Tax Court found that they didn't have to pay tax on hundreds of thousands of dollars in cash received?"
It's Ani Keb, Commissioner, a 2021 Tax Court memo case, and everyone cites to it and says, "Look, the taxpayer won, cash rewards are not taxable." And boy, did they win. But we care about why to see if it's something that would repeat if you did the same thing and went up against the IRS. And unless you read the case in detail, you might be very surprised by the result in this case.
The taxpayers basically ran millions and millions of dollars in a money circle that resulted in them making actual cash regularly from the rewards, since they were in excess of the fees charged to move the money. Kind of like a business, since the only reason that they did all this was to make money. They would purchase Visa gift cards, debit cards, and money orders on their AMX, and it would ultimately be converted to cash that they deposited into a bank account to restart the process.
But why did the court find that result? It is because the IRS brought the wrong argument to court. I am not kidding. The court directly states that the IRS dropped the argument that they would have agreed with, and then the court proceeds to outline the argument in detail that should have been brought to court and why it would have resulted in a taxable outcome. They state, "The IRS's pre-trial memorandum asserts as an alternative position the analysis of Revenue Ruling 76-96, which would tax as income the gains on petitioners' purchases of money orders with Visa gift cards, reducing petitioners' bases in the Visa gift cards by the reward dollars they received on the purchases of the Visa gift cards. Respondent, which was the IRS, later abandoned this alternative position, although it would appear to be more compatible with the rationale of the IRS credit card reward policy."
Okay, and then they say, "Respondent, which is the IRS, declined to pursue an alternative position, and we should not assume to do it for him." So the court is saying that while there was a great argument for taxing the rewards on the gift cards, we will not make the argument on behalf of the IRS. The court then hand-delivers on a silver platter the tax position that they would have agreed with had the argument been made in court. Probably so that next time the IRS makes the right argument and wins.
They again remind us that the IRS messed up and say, "As stated previously, respondent, the IRS, has not argued that petitioners must recognize gain on the exchange of the gift cards." Then they continue to explain how the transaction would be taxable had the IRS made the right argument. They say, "Theoretically, on the basis of established precedent, the reward dollars reduced petitioners' bases in the Visa gift cards that they purchased, and petitioners generated proceeds when they converted the cards to money orders to the extent the rebates exceeded the fees charged to acquire the gift cards. It seems that gain was generated, similar to the gain that a purchaser of the rebated automobile would generate if the vehicle was sold for more than the purchase price reduced by the rebate. Thus, it would appear that the taxable event would not be in the receipt of the reward dollars upon the purchase of their Visa gift cards, but the transformation of the cards into cash equivalents that could then be deposited in a bank account."
The court then reminds us for a third time that the IRS messed up and closed out the case by saying, "These holdings are based on the unique circumstances of this case, and then continues in reaching our holdings, we have considered all arguments made." So the IRS made a big mistake, and they didn't even bring the basis adjustment argument from Revenue Ruling 76-96 to court. And I think it's safe to assume they won't make that mistake again.
So what are the main takeaways from all of this? One, your frequent flyer miles and hotel points are safe for now. Now, it's protected by IRS policy, not statute, Treasury regulations, or court cases, but the IRS has had time to change their policy and they haven't, so it's likely to stay as is. Two, cashback credit card rewards are taxable when generated from a business purchase and not taxable when generated from a personal purchase. So this is because we know that when you purchase an item, the purchase price is reduced by the cashback reward, or what the IRS calls tax basis adjustment. So said differently, you get to deduct the full purchase price for a business purchase, but then you will pay tax on the cashback reward with a net impact of only deducting the actual cash out of pocket after receiving the cashback. However, for a personal item, a reduction of purchase price doesn't typically have a tax impact since you're not usually deducting the personal item or selling it for more later. So the cash rewards should be tax-free.
So there you have it, the actual tax law. And if you like this video and you have as much fun as I do learning actual tax law, then sign up for my free tax workshops at the link below because real tax education should be accessible and understandable for everyone. And as always, for actual tax law from a tax attorney, CPA, and enrolled agent, subscribe.