Is an Award Flight Taken for Business Tax-Deductible? / Are credit card rewards taxable? Probably not, but ...

Cathleen McCarthy for Fox Business writes: Question:

I read an article by Randy Petersen entitled "Using Frequent Flier Miles on a tax-deductible trip." In that article, he states that "business expense deductions are covered under IRS 162."

I took a business trip and used my frequent flier mileage to obtain the ticket (no upgrade involved). The IRS has asked me to produce case law or specific section of 162 that authorizes me to deduct fair market value of the ticket as a business-related expense. Can you or Mr. Petersen provide me with any case law or specific Revenue Ruling or specific IRS section that applies?

ANSWER:  In the article you refer to, written in May 2009 for CreditCards.com, Randy Petersen never says a taxpayer is allowed to deduct the fair market value of redeemed frequent flier miles. The way the Internal Revenue Service sees it, you did not pay anything for that ticket so there is no deductible expense. "There are no portions of Section 162 or case law that appear to justify that deduction," says CPA Paul Conway.

Had you paid for your ticket with cash, it would be a different story, and that's where Section 162 of the IRS Code comes in. It covers business expenses, including what items are deductible, required documentation, business nature of the expense and overall reasonableness of the expense.

So, for instance, it is intended to offer guidance on whether a trip that involved both business and pleasure could be considered a business expense. "An airline ticket to meet with a business client to inspect a property in another state prior to purchase would be a deductible item," says Conway. "Taking your family on the Gulfstream to supposedly look at properties near Disney for two hours, and then spending the rest of the week on Splash Mountain, probably won't pass muster."

Your confusion may have come from the fact that Petersen discussed fair market valuation of frequent flier miles -- but that valuation is only relevant in non-tax situations. (Editor's note: Petersen's piece has been updated to avoid confusion caused by discussion of fair market valuation. That section has been removed.)

The normal procedure for the IRS is to forbid a deduction unless you can produce documentation suggesting that the IRS will accept the item or has been ruled in favor of the taxpayer in court. If the taxpayer can't produce that information, the deduction will be refused.

"In an audit, you're guilty until proven innocent," says Conway. "If the IRS questions an expense, you are responsible for proving that the item is allowed under the code. It is the rare auditor who will offer you a specific path to back your position."

No specific cases have been argued relating to taking a fair market valuation for a deduction related to redeeming frequent flier or comparable programs. "The only information related to frequent flier programs relate to the non-inclusion as income when they are earned and/or redeemed," Conway says.

Petersen compared the redemption of miles to using a coupon on a purchase: Only the final sale amount is deductible. In fact, any redemption of rewards to offset the cost of a business deduction results in the loss of the deduction to the extent that the reward pays for the expense. So a cash-back reward that is redeemed to help pay for a business expense would reduce the deduction.

Are credit card rewards taxable? Probably not, but ...

The answer from the IRS isn't cut and dried

Kay Bell for Banrate writes:

After much deliberation, you settled on a credit card that offers the perfect rewards program. But there's always been that nagging question at the back of your mind: Does Uncle Sam consider my card rewards taxable income?
The short answer is maybe.
The practical answer is probably not.

Wise to worryYour concern is not unfounded. It's no secret that that the IRS considers as much as it can taxable income. Heck, if the IRS explicity says illegal earnings are taxable (remember Al Capone), why wouldn't it go after your credit card rewards, too?
However, credit card reward programs, be they redeemable points or cash back, are typically considered rebates. And rebates aren't income.
"If you look at this as a rebate or purchase price adjustment, it's not taxable," says Bob D. Scharin, senior tax analyst with the Tax & Accounting business of Thomson Reuters. "For example, you buy a cell phone and mail in a coupon and get a rebate on that price, it's not income. The same rule would apply if you sent in 10 breakfast cereal box tops and got a $10 check in mail. It's a reduction in the purchase price."

Income or price breakYou say you're still a bit worried because when it comes to card rewards, the rebate isn't direct. You've got a point.
"The credit card company is not the one you're buying the services from, so it appears that the credit card company is giving you a commission for using the card," says Scharin. "And that appears to be income."
But don't panic. You could argue that rather than providing cardholders income, the credit card company is negotiating a price discount for its customers.
Even more encouraging are a couple of reward-related cases in which the IRS has spelled out, at least to a degree, its apparent inclination to leave these programs off the taxable income list.

Frequent fliers precedentIn Announcement 2002-18, published in Internal Revenue Bulletin No. 2002-10 on March 11, 2002, the agency let frequent fliers off the hook for the miles they accrue via credit card programs.
The IRS stated that it "will not assert that any taxpayer has understated his federal tax liability by reason of the receipt or personal use of frequent flier miles or other in-kind promotional benefits attributable to the taxpayer's business or official travel." Basically, the tax man is saying while he might have the right to consider the mileage rewards as income, he's not going to do so.
Then in July of 2002, the IRS issued a private letter ruling concerning a cardholder who wanted to donate program points to a charity. In that case, one of the findings was that the rewards, referred to by the IRS as rebates, "are not includible in Taxpayer's gross income."

Too much troubleOf course, a private letter ruling, as the name suggests, applies to just one, private, tax situation. But these rulings generally are viewed as an indication of IRS thinking in regard to a more general tax issue.

Scharin also points to the phrasing in the air mile case. The IRS said it "would not assert" that taxpayers owe money on the value of the miles.
"Whether that's a strict tax law interpretation or simply a function of 'It's so hard to administer that we're not going to tell people they owe money on this' is the question," says Scharin. "There could be a gap between tax theory and practical application."
For now, the don't-tax position seems to have the upper hand. And for that bit of tax-collection pragmatism, credit card rewards program participants can be thankful.