Tax your frequent flyer miles?

Last week, Citibank dumped a bombshell on some cardholders: It started issuing IRS form 1099 "miscellaneous income" notices to cardholders that had received big mileage "bonuses" for enrolling. In the past, IRS has generally exempted miles from taxation, but, at least for now, it's drawing a distinction: Miles you earn by flying or by buying things with a credit card are not taxable, but miles you receive as a gift or premium in a promotion are taxable. Here are my early answers to some key questions you might have:

Do I really have to pay? Yes, at least for now. So the real issue is not whether you have to pay a tax, it's how much tax you have to pay. And here, Citi is scamming you by overvaluing the miles.

Is Citi's valuation fair? No, it isn't. Citi calculates its 1099 amounts at 2-1/2 cents a mile, supposedly based on an average price of $625 for a domestic coach ticket -- a trip that you can get for 25,000 miles. This valuation is, of course, ridiculously overpriced:

-- Reported "average" ticket prices are much higher than lowest available prices because they're inflated by mixing expensive business tickets in with the cheap leisure tickets.

-- Value based on prices for purchased tickets does not reflect the lesser value of frequent flyer awards because airlines allocate so few seats to lowest-level mileage awards.

But Citi doesn't care about fair, it cares about profitable. Citi probably pays the airline about 1 cent per mile for the credit. Previously, Citi would write off that 1 cent per mile as a cost offsetting other credit card profits. But if Citi arbitrarily values that credit at 2-1/2 cents per mile, it can write of the full "retail" value of 2-1/2 cents, thereby more than doubling its write off. Say Citi gives 50,000 enrollment bonuses to 10,000 customers, for example, for a total of 500,000,000 miles. On a cost bases, Citi could write off $5 million. But on the inflated value, Citi can write off $15 million, or $10 million more than its true cost, without actually spending another penny.

Can Citi get away with inflating the value? Here, the answer is uncertain. According to some sources, IRS requires that you report only the fair market value (FMV) of a prize, not necessarily an inflated price assigned by the donor. You can't change Citi's policy, but you can challenge the price it assigns.

What can I do? For starters, the one thing you cannot do is ignore any 1099s you receive. Issuers send 1099 copies to IRS as well as to you, and IRS really does reconcile them. Unless IRS changes the rules, you probably can't avoid paying some tax.

But you might be able to base your tax on the real value of the miles, not the bank's inflated value. One source recommends that you enter the full 1099 value, then enter the difference between the inflated value and the FMV as a negative adjustment. Be prepared for a challenge to your valuation, but you should have some useful ammunition: Lots of published reports support a valuation around 1 cent a mile. Whatever you do, however, get what guidance you can from your tax preparer or tax preparation software, and document your entries.

Will other banks copy Citi? Probably -- nothing catches on with banks faster than a new way to gouge their customers.

What happens next? Judging from press reports, I believe that Citi's move blindsided IRS, and that its initial response was pretty much off the cuff. I wouldn't be surprised to see further "clarification" from IRS in coming weeks. Another complication needs resolution: Airlines say you don't "own" your miles; the airlines retain ownership. So can IRS tax you for something that really isn't yours?

I can't believe that frequent flyers will accept this assault without some resistance. We'll likely see a lot more about this question in coming months before the dust settles. Stay tuned.

Send e-mail to Ed Perkins at eperkins@mind.net. Perkins' new book for small business and independent professionals, "Business Travel When It's Your Money," is now available through www.mybusinesstravel.com or www.amazon.com