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 theIRS has fired several warning shots over the bow since 1985, specific guidanceabout the taxability of all aspects of these ubiquitous mileage programsstill 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 substantialmiles through airline bonus programs. Car rentals and hotel stays add tothe 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 exchangesrepresent personal usage, rather than use for more business travel, thenthe question arises whether the value of those benefits used personallyis a form of taxable compensation.

Veterinarians attending seminars and conventions fit into this groupof business travelers with deductible expenses. Continuing education registration,attendance and related travel costs are bona fide business expenses. Dependingon how mileage earned through such travel is then redeemed, the value couldbecome taxable income to the practitioner.

A closely related issue involves mileage earned through other programs.Consider that many veterinary practices use frequent flyer credit cardsto pay for substantial drug and supply purchases. For every dollar spent,a dollar of frequent flyer mileage might be earned. Again, the means forearning the mileage was on the basis of a deductible business expense, thatof 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'sscheme 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 ruledagainst a company. The IRS claimed the company's entire travel expense reimbursementarrangement was not an accountable plan because employees were permittedto retain frequent flyer awards for their personal use.

The 1995 technical advice memorandum implied that if the value of frequentflyer awards were not accounted for through taxed compensation, other aspectsof the company's travel expense reimbursement program might be deemed taxablecompensation, rather than qualified business expenses allowed for deductionbut not included in employee income.

Fortunately, the IRS responded to public backlash and emphasized thatthe specific ruling involved a specific employer and a specific fact pattern.The IRS clarified that the controversial ruling would not set a precedentfor other cases.

Employers sighed relief. The accounting for frequent flyer programs andsegregating mileage earned for business travel as compared to personal travelwould be extraordinarily burdensome.

Assigning a value for the miles used, when many expire and are neverused would present many accounting difficulties. Furthermore, questionswould arise as to how mileage could be tracked when workers change jobs,moving to other employers and possibly taking the mileage in their frequentflyer account with them.

New guidance

In a recent announcement (IRS announcement 2002 ­ 18), the IRS statesthat consistent with prior practice, it will not assert that any taxpayerhas understated his/her federal tax liability because of the receipt orpersonal use of frequent flyer miles or other in-kind promotional benefitsattributable to business travel.

The IRS further states any future guidance that might be forthcomingon the taxability of such benefits will only be applied prospectively. Inother words, when new guidance becomes known, it will not be retroactivelyapplied against prior transactions.

The IRS clarifies that this relief does not apply to travel or otherpromotional benefits that are converted to cash or when compensation ispaid 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 deemsthat the taxpayer has constructed a fraudulent scheme for the primary purposeof tax avoidance, then the announcement would provide no protection.

Raises many issues

In the announcement, the IRS acknowledges that business-related frequentflyer miles and related benefits used for personal purposes raise numeroustechnical and administrative issues. This current announcement only addressesmiles earned in connection with business travel. A significant unresolvedissue affecting many veterinary practices is that of credit card businesspurchases 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 suppliesto large equipment and practice vehicle purchases. By the letter of thelaw, if the miles used from those practice purchases are used personally,the value of the redemption is taxable.

Protect deductions

Practice owners should be careful to establish and maintain policiesthat help protect the deductibility of business-related expenditures.

The policy should prohibit conversion of frequent flyer miles and otherpromotional benefits to cash.

Under no circumstances should compensation negotiations include documentationor discussion that business-earned mileage can be used personally as partof the compensatory package.

Business owners who are especially cautious might want to prohibit theuse of business miles at all for personal use, even for upgrades or forpurchasing tickets to obtain free travel of a personal nature.

Assure all qualified travel-related expenditures are documented as tothe reason and purpose of the travel.

Require receipts for all travel-related expenditures personally paidby an employee, before reimbursing. Reimburse only to the exact amount ofdocumented expense submissions. Any amount paid in excess of actual expenditureis deemed compensation.

Segregate credit card-earned frequent flyer miles in a separate accountfrom 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 extensiverecord keeping and tracking potential compensatory benefits for each employeewho has business-related frequent flyer mileage. It does not apply to frequentflier miles earned with a credit card. Be prepared for the likely eventualityof the IRS revisiting the question in the future, particularly if individualtaxpayer review gives strong evidence of extensive abuse of the use of frequentflyer programs as a disguised form of personal compensation.

Dr. Heinke is a partner of Owen E. McCafferty (OEM), CPA, Inc., inNorth Olmsted, Ohio. The firm offers tax and accounting and management consultingservices. E-mail can be directed to her at MLHeinke@aol.com; phone: (440)779-1099.