Do You Have to Pay Taxes on Your Rewards?

by John Kiernan on February 8, 2012

Initial rewards bonuses have been all the rage in the personal finance world ever since economic recovery began following the worst of the Great Recession a couple of years ago. Banks across the country have been using bonus cash, points or miles – given in return for account opening or spending a certain amount in the first few months – to lure some of the best consumers into using their products and services. The benefits of this strategy were obvious: banks got a more consistent customer base and consumers got hundreds of dollars in free money to play with. But with tax season rolling around, the rage inspired by these initial bonuses has been less about popularity and more about actual anger. You see, as it turns out, things like airline miles, hotel points and cash back could actually be taxable!

Uh, what? That’s right, as first reported by the LA Times’ David Lazarus, Citibank has been sending 1099 forms to customers who took the company up on promotional deals offering thousands of American Airlines rewards points in return for opening a checking or savings account. Since Citi values these points at 2.5 cents each (despite the fact that they’re only worth 1-2 cents through redemption), consumers who opened a new bank account thinking they’d get a couple free flights are instead being handed bills of up to around $262.50 payable to good ole’ Uncle Sam. Exactly how much you owe the IRS depends on how many points you were given and what tax bracket you’re in, but perhaps even more concerning is what Citibank’s tax surprise means for rewards in general. Are all rewards taxable, even those tied to rewards credit cards? Or is it limited to account opening throw-ins? If so, how significant must a gift be to be taxed?

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Such questions have characterized the confusion of consumers, tax experts, and the media alike following this story breaking. The issue has even drawn the ire of Sen. Sherrod Brown (D-Ohio), chairman of the Senate Banking Subcommittee on Financial Institutions and Consumer Protection, who sent a letter to Citibank CEO Vikram Pandit, asking for the bank to stop sending customers tax forms related to airline miles.

“I urge Citibank to halt this practice,” Brown wrote. “The last thing Citibank should be doing is creating baseless fear in middle class families, or placing a nonexistent tax burden on the backs of families who are already struggling to make ends meet.”

While critics of the practice have pointed to a 2002 policy brief issued by the IRS saying that frequent-flier miles are not taxable income because of “numerous technical and administrative issues relating to these benefits,” Citi spokeswoman Catherine Pulley told the LA Times that Citi is merely following IRS directions that call for “prizes and rewards” of at least $600 to be taxed.

Pulley’s colleague Sean Kevelighan helped clarify the bank’s position. “Rewards and airline miles that are provided in connection with a purchase on a credit card are routinely not subject to individual income tax reporting,” he said, as quoted by the LA Times. “When a customer receives a gift for opening a bank account — whether cash, a toaster or airline miles — the value of that gift is generally treated as income and subject to reporting. This is separate and distinct from miles or points earned by our credit card customers for their purchases.”

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Apparently, as long as rewards are earned in conjunction with a purchase, they aren’t taxable, but if they are given as a gift in return for opening an account, they are. The reason for this is that rewards tied to a purchase can be considered rebates, while gifts for account opening cannot be.

This, of course, raises questions about whether all corporate gifts – not just those related to financial accounts – are taxable. In other words, do college athletes have to pay taxes on the swag they get from bowl appearances? Do celebs have to do the same for award show giveaways? What about if your family attorney gives you a holiday present?

While the IRS has been noncommittal on the matter, what’s clear for now is that rewards credit card users have nothing to worry about. Credit card initial bonuses are tied to purchases – you typically get them after your first purchase or after spending a certain amount in the first few months – so they are considered rebates and are not taxable.

Those of us who did not open a new bank account due to the allure of up-front rewards can therefore sit back and watch the drama between Citibank, its customers, the media and Congress unfold. Those with a vested interest in the matter may unfortunately have to pay up and hope for a rebate down the road.

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