US Tax Court Weighs In On Whether Points Are Taxable Income; Theories For Why The IRS Chose Their Losing Argument

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There is a fascinating tax court case that was filed yesterday, ANIKEEV v. COMMISSIONER OF INTERNAL REVENUE.

Bloomberg says the case was a big win for the IRS.

However, Green & Sklarz LLC says they won big for their client who was fighting the IRS.

So…who’s actually right?

I’m not a lawyer, but let’s try to dissect what happened.

In general, rewards on credits card signup bonuses and spending are not considered taxable income. That’s true whether the rewards are for miles or cash back as they’re considered a rebate of the purchase price of the products or services bought. On the other hand, rewards earned from banking activities, referrals, and other activities that aren’t based on buying goods or services are considered taxable income.

In this case, the IRS accused husband and wife, Konstantin Anikeev and Nadezhda Anikeev, of failing to declare income earned from points. That’s when you use your credit card to purchase items that can be liquidated into cash in order to earn rewards.

The couple didn’t play small ball. In 2013 and 2014 they deposited $4,028,743 in money orders into their bank accounts!

As I always say, pigs get fat, hogs get slaughtered. That level of cash deposits into your bank account are bound to raise a red flag. I’d assume that enough suspicious activity reports were filed by their bank until the IRS took notice, but it’s unclear how exactly the IRS was tipped off.

They used a grandfathered Blue Cash AMEX that earned 5% at supermarkets and drugstores after spending $6,500 annually. They used that to buy Visa gift cards, debit cards, and money orders with their cards.

AMEX shut down their cards in 2014, but still paid out some 6 figures in statement credits. In 2017, the IRS wanted them to recognize additional income totaling $35,665 for 2013 and $276,381 for 2014 for their rewards points.

To generate the rewards, the Anikeevs bought Visa gift cards that they liquidated via money orders, they paid their bills via MoneyGram, they purchased reloadable debit cards, they reloaded debit cards, and they bought money orders directly with their AMEX cards.

The IRS said the items they bought were cash equivalents, and not goods or services. As such, the rewards were not a purchase rebate, but taxable income.

The Anikeevs argued that rewards on the purchase of gift cards should be considered a purchase rebate and not subject to income tax, regardless of what they are subsequently used for.

The court noted that the IRS policy for credit card rewards is vague and that had the Anikeevs not been so aggressive in their methods, the IRS would not have taken notice. As such, the court calls this an “extreme test of the longstanding nontaxability of credit card reward programs.”

The court found that most of the spending was on Visa gift cards, which were in turn liquidated. In the end, the court ruled that these gift cards are products, offer a service in the form of a plastic card, and are not directly able to be liquidated for cash. As such, earning rewards on these goods is not taxable income, even if a money order is subsequently purchased with them. Similarly, a reloadable debit card is a service and earnings rewards on it would not be considered taxable income

On the other hand, the court found that the direct purchase of money orders with a credit card, and the actual reloading of a reloadable debit card directly from a credit card are not product or service purchases. Therefore the rewards earned on direct purchases of money orders and cash infusions to the reloadable debit card would be subject to taxable income. Those types of transactions are much harder to do these days, so the ruling that rewards from purchasing and liquidating gift and debit cards is not considered taxable income is far more consequential.

That’s all based on the IRS policy to exclude rewards for product and service purchases from taxable income. Whether this case will cause a change to that official policy will be something that we’ll have to watch closely.

In short, as most of the spending was done to buy gift cards, this does appear to be a big win for the Anikeevs and for Green & Sklarz LLC, and they won’t have to pay income tax on most of the rewards! That means hundreds of thousands of dollars will remain in the Anikeev’s pocket.

And I’m not quite sure how Bloomberg got the case so wrong.

But let’s dig a bit deeper into the stranger part of the case that I’ve ignored up until this point. Why did the IRS make the flimsy argument that the rewards should be taxable instead of the obvious argument that the Anikeevs ultimately profited and made taxable income by cashing out the gift card for a money order? It would have been easy for the IRS to win the case with that argument. The IRS would have collected the same amount of unpaid taxes by calculating the amount in which the rebates exceeded the fees to cash out the gift card.

To learn more, I reached out to Green & Sklarz LLC for comment. This was Jeffrey Sklarz’s case, but he was unable to discuss the decision tonight, other than to say he was very pleased with the outcome.

I was able to speak with his partner Eric Green about the case. Mr. Green shared that when he first learned about the case, he told Mr. Anikeev point blank that he would lose. The IRS argument that there was income here would be an open and shut case.

But he was very surprised to see the IRS argue that the AMEX rebate should be considered taxable income due to buying cash equivalents, rather than their much easier argument about making a profit.

His theory as to why the IRS went down the much harder route was that they didn’t want people who are getting involved in rewards points to claim hobby losses when buying gift cards, as they might have if the IRS went after the added income argument.

I offered a theory based on my own usage. I buy Visa gift cards from Staples to earn 5 miles per dollar spent. If the IRS was able to get a broad ruling about rebates from the purchase of gift cards being taxable as they are not goods or services, they could potentially come after people like me even if I only transferred the points into United miles. While miles earned from credit card purchases aren’t taxable, miles earned from checking accounts are taxable and the bank comes up with an estimated value.

With a broad ruling in their favor, the IRS could demand that the value of the miles earned from the gift card purchases be included in taxable income, even if I later gave the gift card to someone as a present or donated it to charity, rather than cashed it out via a money order.

Luckily for us, the court refused to recognize that overly broad and flimsy IRS argument. In trying to create a potential precedent, they swung and missed. They can appeal the court’s decision, but they can’t change arguments against Mr. Anikeev for the easy win. Still, a higher court may disagree with the distinction between buying gift cards and buying money orders.

Let’s hear your theories about this case in the comments below!

HT: R.A.T., via DDF