Court Rules Some Credit Card Rewards Are Taxable

Historically credit card rewards haven’t been taxable. However, extreme greed by a couple caught the attention of the IRS, and has set an interesting precedent.

Why credit card rewards usually aren’t taxable

Generally speaking credit card rewards aren’t taxable. The reason is because the IRS views these rewards as being rebates on purchases you’re making. That’s because you’re earning these rewards for spending money on products, so these rewards are considered a discount on your purchase, rather than income.

As it’s described more legally:

“Generally, when a payment is made by a seller to a customer as an inducement to purchase property, the payment does not constitute income but instead is treated as a purchase price adjustment to the basis of the property.”

Couple gets taxed for $300K+ in credit card rewards

Here’s an interesting tax court ruling. In 2013 and 2014 a couple did a significant amount of manufactured spending on the Blue Cash from American Express Card — we’re talking about well over $6 million worth of spending.

I don’t talk about manufactured spending much here because it’s not something that I do or find particularly enjoyable. But this couple’s example is probably a pretty good representation of how this concept works:

• The couple had credit cards offering 5% cash back in certain spending categories
• The couple then purchased Visa gift cards with the credit cards (we’re talking about $6+ million worth of these)
• Then the couple converted the gift cards into money orders
• The couple then profited off of the exchange, earning 5% cash back minus some fees

The couple generated well over $300,000 in rewards in two years, though unfortunately for them, the amount of spending caught the attention of the IRS. The IRS has demanded that the couple recognize an additional $312K+ worth of income — we’re talking about $35,665 in 2013, and $276,381 in 2014.

The argument here is that in this case these purchases can’t be viewed as a purchase price adjustment:

“In this case, however, petitioners did not purchase goods or property to which a basis adjustment may apply. Rather, they purchased cash equivalents, in the form of Visa gift cards, Reloads for the Green Dot card, and money orders, to which no such adjustment can apply. As a result, the Reward Dollars paid to petitioners as statement credits for the charges relating to cash equivalents are an accession to wealth and income to petitioners.”

The court made an interesting distinction here, and decided that:

• Rewards related to Visa gift card purchases wouldn’t be considered income
• Rewards related to direct purchases of money orders and reloadable gift cards would be considered income

As the ruling goes on to explain:

“This case rests squarely in the legal chasm between the basic principle to broadly define income and respondent’s own policy. Petitioners’ aggressive efforts to generate Reward Dollars have created a dilemma for respondent which is largely the result of the vagueness of IRS credit card reward policy. Petitioners clearly acquired economic benefits by cleverly and relentlessly manipulating the Rewards Program. Their actions never offended American Express and had Mr. Anikeev not been so successful in his efforts he likely would have been ignored by the IRS. However, the scale of his success in acquiring rewards makes this case an extreme test of the longstanding nontaxability of credit card reward programs. To avoid offending his own longstanding policy respondent seeks to apply the cash equivalence concept. As we will explain herein we do not find it is a good fit.”

My take on this case

I’m neither a lawyer nor a tax professional, but rather just someone who likes points. 😉 Personally I don’t in any way think this will lead to all credit card rewards being taxable, though I do have a few thoughts on this:

• More than anything else, this seems to me like one of those situations where extreme greed backfires
• This seems consistent with the IRS’ stance that rewards generated where no goods or services are purchased are taxable, which is the same as how credit card refer-a-friend bonuses are also taxable
• While it’s not surprising, I’m curious how exactly the IRS got involved here — did Amex report them, did the bank where the millions of dollars in money orders were deposited report them, or was a red flag raised in another way?
• It’s amazing to me that American Express didn’t shut them down earlier; they didn’t have particularly high credit limits, so how did millions of dollars of purchases like this fly under the radar for so long?
• The distinction between Visa gift cards and money orders/reloadable gift cards is an interesting one; I’ll be curious to see if credit card issuers crack down more on these kinds of purchases going forward

Bottom line

Credit card rewards historically haven’t been taxable because they’ve been viewed as a rebate on a purchase, rather than as income. A couple took that to the extreme, and engaged in millions of dollars of manufactured spending in order to generate $300K+ worth of rewards.

A tax court has ruled that some of these rewards should qualify as income, given that these can’t in good faith be viewed as rebates on purchases, since there were no real products being purchased. Specifically, rewards related to direct purchases of money orders and reloadable gift cards are considered income.

The court ruling seems fair enough. and it seems like the ruling is largely specific to this particular case, and shouldn’t have too many other implications.

What do you make of this tax court ruling?

(Tip of the hat to Miles to Memories)