The Tax Treatment Mystery of Frequent Flier Miles

For many years now, there has been much discussion about the tax implications of those free frequent flyer miles you sometimes earn. This issue has recently gained attention following the disclosure that Citibank customers were notified that miles they received for opening new accounts last year produced taxable income. Citi sent these customers '1099-Misc' forms, which tell taxpayers that income is being reported to the Internal Revenue Service. The recipients were then required to include that income on their 2011 tax returns. Needless to say, there were some that expressed surprise and anger.

In an effort to make this issue somewhat less confusing, here are some guidelines to help you determine if your frequent flyer miles are considered taxable income:Basically, most miles earned by most taxpayers most of the time are probably tax-free. In tax theory, rebates are treated as a reduction of the purchase price, which isn't taxable. But promotions and prizes count as income. Much remains unclear, however, because the IRS hasn't issued definitive rulings on many aspects of frequent-flier miles. That being said, there are at least six categories of frequent-flier miles, and several different ways of taxing them. This naturally lends itself to some confusion, but basically, with these frequent-flier miles, the taxability issue usually comes down to whether the miles were awarded as a rebate (not taxable), a promotion (taxable), or a prize (taxable.)

Here's how the experts say they see the taxation of different categories of frequent-flier miles.

• Miles awarded by the airlines in return for flying with them: these are almost certainly a nontaxable rebate
• Miles awarded in connection with credit-card use: these also appear to qualify as a nontaxable rebate
• Miles awarded in connection with business travel: In 2002, the IRS said it didn't consider such miles taxable and that if it changes its mind, the new rules will apply only in the future. The agency hasn't addressed the matter since.
• Miles awarded as a promotion for opening an account, such as a bank account: such miles are taxable, according to the IRS.
• Miles awarded as a promotion for putting money in a mutual fund. Ms. Labant found an IRS private-letter ruling declaring such miles taxable. Investors who received them had to adjust their cost basis downward by the amount of income for funds held in taxable accounts.
• Miles awarded as prizes. Mr. Petersen notes that sometimes firms award miles to a few customers chosen at random, as in a sweepstakes. These qualify as 'prizes,' which are generally taxable, just as lottery winnings would be. He has seen cases in which winners rejected the miles because they didn't want to owe the tax involved.