Court Rules Some Credit Card Rewards Are Taxable

Filed Under: Credit Cards

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)

Comments
  1. I’m not sure you’ve properly explained the ruling. On the last page, the court holds that “Reward Dollars associated with the Visa gift card purchases were not properly included in income” [by the respondent – the IRS]. Isn’t this is a ruling in favor of the cardholders? That would also explain why your quoted paragraph ends with “we do not find it a good fit.”

    The court does rule in favor of the IRS on direct purchases of money orders and reloads of debit cards: “we uphold respondent’s inclusion in income of the related Reward Dollars for the direct purchases of money orders and the cash infusions to the reloadable debit cards.”

    The court also says: “These holdings are based on the unique circumstances of this case. We hope that respondent polices the IRS policy in the future in regulations or public
    pronouncements rather than relying on piecemeal litigation.”

    Thanks.

  2. Ben, practically speaking, I think that this decision is a loss for the IRS and a win for the taxpayer. The court did rule that the cash back earned from buying money orders and reloading debit cards is taxable: “we uphold respondent’s inclusion in income of the related Reward Dollars for the direct purchases of money orders and the cash infusions to the reloadable debit cards.” However, with regard to cash earned from purchasing visa gift cards, the court ruled that that cash is not taxable: “In conclusion, we hold that the Reward Dollars associated with the Visa gift card purchases were not properly included in income.” I think that the opportunities to purchase money orders and load debit cards directly from a credit card are rare while it remains easy to buy VGCs.

  3. To address your question about how the IRS got involved, it probably stemmed from the fact that the cardholders bought money orders with the VGCs. Financial institutions are required file forms called CTRs (currency transaction reports) anytime someone makes a cash or cash-equivalent transaction that exceeds $10,000. Even if we assume that these people did their manufactured spending during every business day of the year, they would have been depositing a minimum of $11,500 per business day, so there were likely a large number of CTRs being filed.

    CTRs are filed with FinCEN, which is the Financial Crimes Enforcement Network, of which many federal agencies including the IRS’s Criminal Investigations division are members. They have access to the entire FinCEN database, which includes the CTRs and a related form called a SAR (suspicious activity report). Financial institutions are required to file a SAR anytime they suspect suspicious activity is occurring, which could have been the case here as well. I would suspect it was the CTRs or a SAR that brought these people to the attention of the IRS.

  4. I suspect the IRS caught onto this because banks are obligated to report deposits over a certain amount (I think $10,000 — but not certain of the amount). In any event, the depositing over time of $300,000 of money orders into a checking account certainly would have triggered automated reports to the IRS. This caught the IRS’s attention — and they went after the taxpayer for income taxes due on $300,000 of income.

  5. @David Ourisman – Banks are obligated to fill out a Form 8300 on every deposit or series of deposits over $10,000 in cash, but what probably got these people on their radar is the requirement of banks to provide FINCEN a suspicious activity report on any activity that appears to be obfuscating the source of the funds deposited. Taking out multiple high dollar money orders and depositing them in a bank account would clearly fit that description. Collect enough SARs and the IRS and anyone else with oversight into money laundering will show up and ask where you got the money.

  6. Ben – please update this post. This is a win for the vast majority of your readers, except for the few who are using a credit card to buy a money order. The

  7. I agree with what eddy said. The problem is that this sentence is awkwardly worded probably because it relies on tax law phrasing and terms of art (IANA tax L):

    “In conclusion, we hold that the Reward Dollars associated with the Visa gift card purchases were not properly included in income.”

    It should read something like “In conclusion, we hold that the Reward Dollars associated with the Visa gift card purchases were included in income improperly by the Respondent, and shall be excluded.”

  8. Thus, it would appear that the taxable event would not be the receipt of Reward Dollars upon the purchase of their Visa gift cards but the transformation of the cards into cash equivalents that could be deposited in a bank account.

    However, petitioners’ direct purchases of money orders and reloads of cash into the debit cards using the American Express cards presents a different question from the purchase of Visa gift cards.

    Therefore, we uphold respondent’s inclusion in income of the related Reward [*22] Dollars for the direct purchases of money orders and the cash infusions to the reloadable debit cards.

    We hope that respondent polices the IRS policy in the future in regulations or public pronouncements rather than relying on piecemeal litigation.

    ================================================================

    From my layman’s interpretation, the court basically said the IRS/respondent was justified in taxing the Anikeevs/petitioners, but that the IRS considered the wrong phase of the manufactured spend process as income.

  9. I’m a tax professional CPA that read the full ruling. This case is probably only bad for people engaged in manufactured spending. The IRS did not change its position on rebates/rewards when purchasing goods and services, and the IRS even conceded a few hundred dollars of additional assessments when the taxpayers provided evidence that the rewards were granted for purchases of non-cash equivalents.

    Likely, the IRS discovered this upon an audit of the taxpayers and requested the taxpayers’ bank account detail as part of the audit. The court case stated that the taxpayers had deposited more than a million dollars from money orders into their bank account, and clearly the IRS was going to have some legitimate questions as to where that money was coming from. It was only a matter of time before a case like this ended up in the tax court.

  10. $6,250,000 in manufactured spending and recycling money as gift cards and then into money orders. I am pretty sure this caught the eye of the IRS, and a few Exchequers. I am pretty sure el chapo and his wife also extended job offers on the spot to these two.

  11. It is alright to be a pig, just not a hog. If you are going to manufacture wealth of that size out of manufacturing credit card spending, then you better give the IRS its cut. What suprises me is that American Express didn’t catch on to them and put a stop to it before they had gotten $312 K back in under 2 years. Someone feel asleep at the wheel ……..

  12. It’s easy to see why irs got involved. You know who else does a lot of gift cards transactions? Scammers, victims of Scammers and money launderers.

  13. @Steve, this happened back in 2014 when it was fairly easy to manufacture spend. Had this happened in recent years I think Amex would have been onto them.

  14. They are kinda clever to do this. I am sure it was a lot of work but even when taxable, $300k is a pretty awesome annual salary (or maybe a bit less because it seems some of it was in the prior year).

    If they were not violating Amex’s terms and it sounds like they were not? then I can’t fault them for doing this. It’s a pity they lost the ruling and I hope they have not spent all the money.

    Surely many people must have taken advantage of this scheme, allbeit to a much smaller extent.

  15. Depositing millions of dollars of money orders into a bank account or series of bank accounts tied to a single person or couple in a year or two is going to generate a lot of Suspicious Activity Reports from the bank. That many bank-filed SARs for that much in deposits using cash or near-cash equivalents getting a manual review and further attention? That shouldn’t be a surprise; it should have been anticipated.

    The taxable income from the couple’s manufactured spending activity comes with a new tax liability as a consequence of this court ruling. Does it also come with interest and penalties for the non-reporting and delay in paying the taxes on the portion of 2013 and 2014 income which they hadn’t previously declared as part of their income in those two years?

  16. Seems to me this couple had a job where they played the point system and earned 300k. If this is a job and not just a hobby then it should be taxed.

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