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February 24, 2012

Citibank Airline Miles Fiasco Illustrates The Difficulty In Determining “Taxable Income”

It’s tax season, which means our mailboxes are filling up with W-2s, 1099s and other tax forms provided to the IRS in order to enlighten them as to just how much income we will have to declare.  We are trained to expect these statements from employers, banks, and brokerage houses, but now it seems that Citibank customers may have an extra surprise in store for them this year.  Citibank is sending 1099-MISC forms to customers who received thousands of “free” airline miles in return for opening a new account and is notifying the Internal Revenue Service that these miles represent miscellaneous income, leaving their customers on the hook for paying the related taxes or possibly facing a greater risk of being audited.

This current controversy serves to highlight an age-old question.  Just what exactly constitutes “taxable income?”  If you ask 100 random people just what exactly qualifies as income that they must report on their tax returns, there’s a good chance that you will get 100 different answers.

Section 61 of the Internal Revenue Code states that “except as otherwise provided in this subtitle, gross income means all income from whatever source derived. . . .”   Section 63 states that “taxable income” is equal to gross income minus either itemized deductions or the standard deduction and personal exemption.  Basically, these two provisions can be extrapolated to reach the conclusion that any income, from any source, received by a taxpayer is considered taxable income unless a deduction, credit or some other exclusion is provided.

So what is the proper tax treatment of free airline miles?  According to IRS spokeswoman Michelle Eldridge, “[w]hen frequent-flier miles are provided as a premium for opening a financial account, it can be a taxable situation subject to reporting under current law.”  But what about miles received for using a credit card or handed out by an airline just for taking a trip?  Eldridge said that in those cases, miles wouldn’t be taxable because they’re more like a rebate.  “A common analogy,” she said, “is buying a $500 television at a retail store and receiving a $50 manufacturer’s rebate.  It’s not income, just a deemed reduction of the cost of the television.”

All of this just goes to show that a seemingly innocuous transaction can ultimately lead to harsh tax consequences.  This is why it is important to discuss your plans with a knowledgeable tax attorney before going forward; as a clear understanding of the tax effects at the outset, can save loads of money, time and aggravation in the future.