Indiana Law Review


FREQUENT FLYER BENEFITS
Substantive and Procedural Tax Consequences

I. Introduction

In 1981, the airline industry developed a new marketing technique

to combat increasing competition for passengers—the frequent flyer bonus
program.^ Designed to create "brand" loyalty,^ the programs allow

travelers to accrue mileage on a specific airline for the purpose of

"spending" the mileage on designated awards.^ As more mileage credits
are accrued, more valuable prizes'^ become available to the program

participant. The bonuses primarily take the form of free flights but can

also include free hotel accommodations,^ free use of rental automobiles^

or even cash.^

In 1984, airlines reported an estimated ten million participants in

frequent flyer programs.^ In 1985, airlines reported that an estimated

100 million dollars of frequent flyer bonuses were awarded.^ In 1986,

the value of the average frequent flyer bonus was $500 while the number
of reported participants had remained constant at ten million.*^ Because

of the popularity of the programs," it appears that the frequent flyer

bonus has become a permanent economic factor in the airline industry.

An unforseen issue raised by the implementation of frequent flyer
bonus programs is the taxability of the bonus awarded to the recipient.

'See, e.g., McNatt, The Richer Rewards of Frequent Flying, Money, Apr. 1985,
at 89 [hereinafter Richer Rewards]; Sherman, The Airlines' Flying Jackpots, Fortune,

Nov. 29, 1982, at 106 [hereinafter Sherman]; The Sky's the Limit in Luring the Frequent

Flyer, Bus. Wk., Oct. 18, 1982, at 152 [hereinafter Sky's the Limit]. The term "flyer"

appears in some publications as "flier." For consistency, unless directly quoting such a

publication, this Note uses "flyer."

^Richer Rewards, supra note 1, at 89.

^The Frequent Flier Game: Now Winning Is a Lot Easier, Bus. Wk., April 2, 1984,
at 93 [hereinafter Game].

"This Note will use interchangeably the terms "award," "prize" and "bonus" to

refer to a frequent flyer free flight. Unless clearly indicated, the terms "prize" and

"award" are not being used as technically defined by the Internal Revenue Code of 1986.

^McNatt, Cashing in on New Deals for Frequent Fliers, Money, May 1986, at 161
[hereinafter New Deals].

^United Airlines, Inc., Mileage Plus Program Guide 33 (1987).
^Midway Airlines, Inc., Flyers First Program (1986).
''Does the Frequent-Flier Game Pay Off for Airlines?, Bus. Wk., Aug. 27, 1984,

at 74 [hereinafter Frequent-Flier Game].

^New Deals, supra note 5, at 160.

''Id.

^'Frequent-Flier Game, supra note 8, at 74. Each airline with a frequent flyer bonus

program claims the program has boosted business 20% to 35%. Id.

823



824 INDIANA LAW REVIEW [Vol. 20:823

If the receipt of 100 million dollars of bonuses in 1985 had been subject

to income taxation, as much as fifty million dollars of tax revenue could
have been generated. '^ Furthermore, many variations of frequent flyer
bonus programs are being created as other industries follow the airlines'

lead. For example, several hotel chains are rewarding frequent guests

with free lodging. ^^ Also, AT&T has initiated "Opportunity Calling,"
a program that awards merchandise discounts for increased AT&T long
distance telephone usage."* As these variations on the bonus program
concept expand, the resulting tax implications compound. Therefore,

taxpayers and tax professionals will increasingly be called upon to de-
termine the taxable status of frequent flyer bonuses and their progeny.

The purpose of this Note is to examine the mechanism and back-

ground of frequent flyer bonus programs and analyze the tax effects

of the receipt of a frequent flyer bonus. The first issue for resolution

is whether the receipt of a bonus constitutes gross income to the recipient

who paid for the flights upon which the bonus is awarded. Second, the
income recognition issue will also be analyzed in light of the employment

relationship, a situation in which the party who is paying for tickets,
the employer, is not the individual using the free flight. Third, this Note

will discuss whether bonuses, if considered to be income, are excludible

under one of the exclusionary sections of the Internal Revenue Code
of 1986^^ (Code). Fourth, this Note will determine whether such bonuses,

when received from an employer, constitute wages subject to withholding.
Finally, this Note will propose an equitable solution to the question of

who should be responsible for reporting receipt of these bonuses to the
Internal Revenue Service.

II. The History and Mechanics of the Bonus

For those who do not travel by air, the concept of the frequent
flyer bonus is a novel one requiring further explanation and a brief

history. In 1981, American AirHnes implemented its AAdvantage Pro-
gram, a new marketing concept, to combat the anticipated increase in
competition in the travel marketplace caused by the deregulation of the

air travel industry.'^ The theory behind the program is that awarding

^^See I.R.C. § 1 (Supp. Ill 1985). This section contains the tax rate schedules used

to compute federal income tax for individuals. Because the maximum possible tax rate
was 50% in 1985, the maximum tax on $100 million of bonuses would have been $50
million, assuming all taxpayers were subject to the maximum tax rate.

"Game, supra note 3, at 93.
'"AT&T Communications, Inc., AT&T Opportunity Calling (1986).
'^26 U.S.C., the Internal Revenue Code, was most recently amended on October 2,

1986 by the Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085.

'^5ee, e.g.. Richer Rewards, supra note 1, at 89; Sherman, supra note 1, at 106;

Sky's the Limit, supra note 1, at 152. Airline fares were deregulated by the Airhne

Deregulation Act of 1978, which required that deregulation be completed by December

3, 1981. Pub. L. No. 95-504, 92 Stat. 1705 (1978) (codified in scattered sections of 49

U.S.C).



1987] FREQUENT FLYER BENEFITS 825

free flights and other bonuses to repeat customers will create brand

loyalty, thereby increasing business for the company.'^ Over time, because

of increased competition and new, cut-rate airlines, the programs were

not terminated as originally planned.'^ Instead, the programs were con-

tinued and expanded to allow travelers to include mileage flown on

affiliated airhnes as credit toward a single award. '^ By 1986, six major

airlines were competing for the bulk of the frequent flyer business, ^°

with other airlines instituting programs in self-defense.^'

Although this Note will assume that the bonus received is a free

flight, many other types of bonuses are available. For example, the six
principal frequent flyer plans^^ offer an upgrade to first class at 10,000

miles. ^^ Therefore, after the traveler has flown 10,000 miles, a program

participant will pay coach fare but will obtain a first class seat. Other

benefits include reduced rates for rental cars and hotel lodging. ^"^ In

addition, bonus miles are awarded for patronizing affiliated hotel chains

and car rental agencies. ^^ For instance, a Delta program participant earns

1,000 extra miles each time he rents a National Rent-A-Car or stays

overnight at a Marriott,^^ while United Airlines awards a 1,000 mile

credit for each night spent on board a Holland America cruise ship.^^

Finally, Midway Airlines, in addition to offering a seven-day, six-night
trip for two in the Virgin Islands, offers one of the more unique bonuses

—

$2,000 in cash.28

Procedurally, all frequent flyer bonus programs operate in a similar

manner. American Airlines is noted for accuracy in record-keeping be-

"Richer Rewards, supra note 1, at 89.

^^Game, supra note 3, at 93.

^°See New Deals, supra note 5, at 170-72. The six competing airlines are American,
Delta, Eastern, Pan Am, TWA and United. Id.

^^See Frequent-Flier Game, supra note 8, at 79. For example, Continental and

Northwest Airlines had to continue their frequent flyer programs because of business lost

when the programs were discontinued. Also, Braniff instigated the first promotion that

allowed credit for miles flown on competitor's airhnes because of a belief that the major

impediment to their success in attracting passengers was American's AAdvantage Program.

Id.

^The six major frequent flyer programs are American, Delta, Eastern, Pan Am,
TWA and United. New Deals, supra note 5, at 170-72.

^'Id. at 170.

^Richer Rewards, supra note 1, at 89.

^^New Deals, supra note 5, at 161. Some strategies can be used to increase the
available bonus mile points. For example, frequent flyers will turn in a rental automobile

and rent a different one daily or check into a different hotel daily because each automobile

rental and hotel room rental earns bonus miles. Id. at 165.

^'Id. at 161.

^^United Airlines, Inc., Mileage Plus Program Guide 26 (1987).
2*MiDWAY Airlines, Inc., Flyers First Program (1986).



826 INDIANA LA W REVIEW [Vol. 20:823

cause of its computerized mileage log.^^ United Airlines issues a Mileage

Plus card that is used like a credit card to ensure that the traveler is

credited with the accrued mileage. ^^ Trans World Airlines' sticker system

requires that the traveler attach a sticker to the ticket stub and redeem

the stub for mileage credit.^' Midway does not compute the traveler's
accrued mileage; instead, each round trip is one credit, and a bonus is

awarded on the basis of round trips flown. ^^

These programs are subject to some limitations. Pan American offers

the most varied program because of the availability of scheduled flights

to exotic destinations; however, its program costs twenty-five dollars to

join. 33 American's AAdvantage Program offers a variety of prizes but

limits the availability of free travel to certain locations, particularly

during the Christmas holidays. ^^ Midway's literature states that rewards

are subject to change without notice. ^^ United's cruise awards are subject

to availability and may not be booked until ninety days prior to de-
parture. ^^ Despite these restrictions, airhnes attribute sudden business

increases of twenty to thirty percent to the programs, ^'^ which indicates

a strong consumer demand for continuation of frequent flyer bonus
programs.

In addition to the economic inducement of free flights, another

reason for the increasing popularity of the bonuses is their marketability. ^^

For those travelers who would prefer cash to a free trip,^^ forty-four
independent ticket brokers buy and resell the free travel coupons issued

by the airlines to a frequent flyer bonus winner.^^ A $1,900 New York-

^^See New Deals y supra note 5, at 170-72.
^"United Airlines, Inc., Mileage Plus Program Guide 3 (1987).
^'Trans World Airlines, Inc., Frequent Flight Bonus Membership Material

(1985).

^^MiDWAY Airlines, Inc., Flyers First Program (1986).
"New Deals, supra note 5, at 170.
3"American Airlines, Inc., AAdvantage Program, (1987).
"Midway Airlines, Inc., Flyers First Program (1986).
^^United Airlines, Inc., Mileage Plus Program Guide 26 (1987).
^^Frequent-Flier Game, supra note 8, at 74. But see Dahl, Frequently Frustrated:

Travelers Find Frequent-Flier Plans Less Rewarding, Wall St. J., July 15, 1987, at 29, col.

3. Recent restrictions imposed on awards by the airlines, including blackout days and limiting

available number of sets per flight for award winners, may make the awards less valuable. Id.

^^See, e.g.. Toy, A Storm Warning for Frequent Fliers, Bus. Wk., Nov. 10, 1986,
at 88 [hereinafter Toy]; McGrath, The Frequent Flier Coupon Market, U.S. New^s and
World Report, May 19, 1986, at 73 [hereinafter McGrath]; Frequent Flyer Programs:
Who Should Reap Benefits? Dun's Bus. Month, Apr. 1986, at 77 [hereinafter Who?];
Richer Rewards, supra note 1, at 92; Sherman, supra note 1, at 106.

''McGrath, supra note 38, at 73; Sherman, supra note 1, at 106. A travel agent
states, "Many of our customers tell us the last thing they want is more flying." Id.

^°Toy, supra note 38, at 88.



1987] FREQUENT FLYER BENEFITS 827

Honolulu round-trip can be sold for $600 to a broker, who resells it
for $900/' Alternatively, the coupons can be bartered in private trans-

actions/^ One frequent flyer traded his free trip to Hawaii to his dentist
in exchange for bridgework/^ Some airlines are attempting to restrict
transferability,'^ but the coupon market, which has grown into a fifty

million dollar a year industry,'*^ is resisting the airUne's attempts/^ Despite

the uncertain future of the coupon market and the limitations the airlines

impose on their programs, the demand for the bonuses suggests that
frequent flyer programs are here to stay.

III. Bonus Flights in General—Income or Not?
Before considering the income treatment of frequent flyer bonuses

in the context of the employment relationship, it is necessary to determine

if the private individual who purchases and uses airline tickets, and thus
earns a free flight, realizes income upon receipt of the free flight. There

are two possible income treatments applicable to the receipt of a bonus

flight. First, receipt of the free flight could trigger the recognition of

income to the recipient. "^^ Second, the flight could be considered a

discount, in which case the receipt of the flight does not force the

recognition of income but is a reduction of the cost of the underlying

flights that earned the bonus. "^^

*^Richer Rewards, supra note 1, at 92. However, prices on the coupon market vary

with the season and with supply and demand. Id.

''^Sherman, supra note 1, at 106.

'Ud.

""For example, Delta Airlines requires that a traveler appear personally at the ticket

office in order to get a ticket transferred. Who?, supra note 38, at 74. Both United and

TWA allow transfers only within families. Toy, supra note 38, at 88.
"^Toy, supra note 38, at 88.

"•^Details of pending lawsuits concerning program participants' rights to sell their

awards are beyond the scope of this Note. Generally, American AirUnes and TWA have
brought lawsuits to enjoin the largest coupon broker. The Coupon Bank, from selUng
bonus coupons. Brown, American Airlines Files Suit Against Coupon Bank, Travel
Weekly, June 16, 1986, at 3. American Airlines was successful in obtaining a temporary

restraining order against one of Coupon Bank's affiliated travel agencies; however, it
expired October 14, 1986. Godwin, Coupon Bank to File Counterclaims, Travel Weekly,
October 16, 1986, at 8 [hereinafter Godwin]. Coupon brokers have filed counterclaims
alleging anti-trust violations, which one California observer believes the brokers have a

50-50 chance of winning. Toy, supra note 38, at 88. Also, three class actions against

carriers arguing for program participants' rights to sell the coupons have been filed.

Godwin, supra at 2.

In a recent Wall Street Journal article discussing the mounting liability of the airlines

resulting from unused awards, it was noted that one lawsuit brought by American Airlines,

TWA and United Airlines against a California broker was settled. Brown, New Airline
Figures Show Unused Awards Mounting, Wall St. J., July 15, 1987, at 29, col. 5. Without
additional details, it is not possible to assess the effects of this settlement on marketability.

'^''See infra text accompanying notes 49-61.

*^See infra text accompanying notes 62-91.



828 INDIANA LAW REVIEW [Vol. 20:823

A. The Bonus Flight as Income

The Code defines gross income as '*all income from whatever source
derived.'"*^ The Treasury regulations (regulations) further clarify this

definition of gross income as follows: "Gross income includes income

realized in any form, whether in money, property, or services. Income

may be realized, therefore, in the form of services, meals, accommo-
dations, stock, or other property, as well as cash."^^ On its face,
therefore, the expansive statutory definition of gross income indicates

that frequent flyer bonuses, whether taken in the form of flights, cash

or other services, may constitute gross income to the recipient.
The contention that frequent flyer benefits constitute gross income

to the recipient is bolstered by the United States Supreme Court's

construction of gross income. First, the Court often construes gross

income broadly by beginning its gross income determinations with the

statements that Congress intended "to use the full measure of its taxing

power" when it created the income tax.^' Then, after using this broad
phraseology, the Court holds that the taxpayer's argument for distin-

guishing the income item at issue as nontaxable is not relevant because

the income item falls within the scope of Congress' broad taxing power

which the Court cannot overrule. ^^ For example, in Commissioner v.

Glenshaw Glass Co., the respondent attempted to characterize punitive

damages as non-taxable because the damages were created by the "culp-

able conduct of third parties. "^^ However, the Court refused to consider

the source of the damages as a reason to distinguish them from other

income items or as relevant to the issue of their taxability because

*'I.R.C. § 61(a) (Law. Co-op. 1986). All Internal Revenue Code citations which cite

"Law. Co-op 1986" as the source are referencing U.S.C.S. Title 26 Internal Revenue
Code of 1986 Pamphlet (reflecting the Code as amended through Dec. 31, 1986).

5°Treas. Reg. § 1.61-l(a) (1957) (emphasis added).

"Commissioner v. Kowalski, 434 U.S. 77 (1977) (state trooper's meal allowances

taxed). E.g., HCSC-Laundry v. United States, 450 U.S. 1 (1981) (cooperative hospital
laundry taxed); Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955) (punitive and

treble damages taxed); Helvering v. CHfford, 309 U.S. 331 (1940) (trust taxed to grantor);

Helvering v. Midland Mut. Life Ins. Co., 300 U.S. 216 (1937) (interest bid by mortgagor

at successful foreclosure taxed); Douglas v. Willcuts, 296 U.S. 1 (1935) (alimony taxable

to payor); Irwin v. Gavit, 268 U.S. 161 (1925) (stock transfer held taxable).

'^See HCSC-Laundry, 450 U.S. at 8; Kowalski, 434 U.S. at 83; Glenshaw Glass

Co., 348 U.S. at 432-33; Clifford, 309 U.S. at 337-38; Midland Mut. Life Ins. Co., 300

U.S. at 223; Douglas, 296 U.S. at 9; Irwin, 368 U.S. at 166.

'^Glenshaw Glass Co., 348 U.S. at 429. Two cases, Glenshaw Glass Co., 18 T.C.
860 (1952), and Commissioner v. William Goldman Theatres, Inc., 19 T.C. 637 (1953)
were consolidated and heard en banc by the Third Circuit Court of Appeals (211 F.2d

928 (1954)) which ruled that exemplary damages for fraud and treble damages for injury

to business through violation of anti-trust laws were non-taxable because the payments

were outside of the scope of the gross income section of the Internal Revenue Code of

1954. 348 U.S. at 427-29. The Supreme Court reversed. Id. at 428.



1987] FREQUENT FLYER BENEFITS 829

Congress intended to retain its broad taxing powers.^'* The Court stated,
*'[C]ongress applied no limitations as to the source of taxable receipts, nor

restricting labels as to their nature. "^^ By the same reasoning, the source
of a frequent flyer bonus as a promotional mechanism has no bearing

on whether the flight should be considered to be income if its receipt

falls within Congress' broad taxing powers.

Second, the Court construed gross income broadly in Glenshaw Glass

Co. when it defined punitive damages as income because they were
'^accessions to wealth, clearly realized, and over which the taxpayers

have complete dominion. "^^ Similarly, the Court has defined meal

allowances^'' and embezzled funds^^ as such
*

'accessions." By analogy,
bonus flights could be considered accessions to wealth that are totally

under the control of the frequent flyer, and thus are taxable as gross

income to the recipient.

Third, the Court has broadly construed the definition of gross income

by stating that it is Congress' intent to tax gains unless specifically

exempted. ^^ As the Court has explained, "[u]nder our system of federal
income taxation . . . every element of gross income of a person, corporate

or individual, is subject to tax unless there is a statute or some rule of
law that exempts that person or element. "^^ Therefore, courts strictly

construe any Code section which circumvents taxation in order to enforce
Congress' broad taxing powers.^'

5'*348 U.S. at 430.

''Id. at 429-30.

'''Id. at 431.

"Commissioner v. Kowalski, 434 U.S. 77, 83 (1977). The Tax Court held that the

meal allowances were gross income under I.R.C. § 61 (1982) and were not excludfble

under I.R.C. § 119(a)(1) (1982), which exempts meals for the convenience of the employer

from taxation. Id. at 81. The Third Circuit Court of Appeals reversed. Id. at 81-82.

Because of a conflict between the circuits, the Supreme Court granted certiorari. Id. at

82. The Supreme Court reversed the Third Circuit. Id. at 97.

'«James v. United States, 366 U.S. 213 (1961); Rutkin v. United States, 343 U.S.

130 (1951). The Rutkin Court further defined control over a receipt as when, "as a

practical matter, [the recipient] derives readily realizable economic value from it." Id. at

137.

"Commissioner, v. Glenshaw Glass, 348 U.S. 426, 430 (1955).

^^HCSC-Laundry v. United States, 450 U.S. 1, 5 (1981). The Court refused to exempt

a cooperative hospital laundry from taxation as an exempt organization because I.R.C.

§ 501(e) (1982) did not specify laundry and hnen services in its listing of activities that

an exempt hospital could perform. 450 U.S. at 5-6. Thus, the court narrowly construed

an exemption allowed by the Internal Revenue Code.

*'See Bingler v. Johnson, 394 U.S. 741 (1969) (tuition payments made in exchange
for promise of future services not exempt as scholarships); Commissioner, v. Jacobson,

336 U.S. 28 (1949) (corporation's buy-back of its own indebtedness results in a taxable
gain); Helvering v. American Dental Co., 318 U.S. 322 (1943) (cancellation of debt not

exempted as gift); Helvering v. Northwest Steel Rolling Mills, Inc., 311 U.S. 46 (1940)

(statutory exemption allowing corporations credit against income for "undistributed profits

surtax" not allowed).



830 INDIANA LAW REVIEW [Vol. 20:823

Thus, frequent flyer bonus flights could be considered as income

because they are income "from any source" that is in the form of

property or services. If the bonuses fall within the ambit of Congress'

broad taxing power or are an accession to the wealth of the party

receiving them, they will be taxable even to the person who paid for
the original tickets unless they fall within an exemption created by statute

or rule of law.

B. The Bonus Flight as Reduction of Cost

In order to perceive the frequent flyer bonus as a discount or a

reduction of cost, some knowledge of accounting principles is required.

Basis is the accounting concept by which a dollar value is assigned to

an asset. ^2 All property must have a basis so that the owner of the

property is able to compute taxable gain or loss upon sale of the property"

and to compute expenses such as depreciation.^"^ As defined by the Code,
one of the possible bases of property is its cost.^^ A discount reduces
cost; therefore, a discount cannot be income to the recipient because it

simply reduces the basis of an asset.^^

The purchaser will record the purchase of an asset at the discount

price. Then the asset is expensed or depreciated on the basis of this

discounted cost. This reduction of expenses results in an increase in the

'^See I.R.C. §§ 1012-15 (Law. Co-op. 1986). These four sections define the four

bases used in the Internal Revenue Code—cost, inventory, death and gift. A discussion
of the last three is beyond the scope of this Note.

"I.R.C. § 1011(a) (Law. Co-op. 1986) states: "The adjusted basis for determining

gain or loss from the sale or disposition of property, whenever acquired, shall be the

basis (determined under section 1012 [cost basis] or other applicable sections ...)...."
Therefore, the basis for calculating gain or loss under section 1011 begins with one of

the basis sections. See supra note 44.

^I.R.C. § 167 (Law. Co-op. 1986). Section 167(g) states: "The basis on which

exhaustion, wear and tear, and obsolescence are to be allowed in respect of any property

shall be the adjusted basis provided in section 1011 for the purpose of determining gain

on the sale or other disposition of such property."

"See I.R.C. § 1012 (Law. Co-op. 1986) (basis of property shall be the cost of such

property). Cf. I.R.C. §§ 1013-15 (detail of the inventory, death and gift bases which are

for use when cost is unavailable or not applicable). See generally W. Meigs, & R. Meigs,
Financial Accounting 15 (5th ed. 1983); D. Keeso & J. Weygandt, Intermediate
Accounting, 5 (5th ed. 1986) [hereinafter Kieso] (One of the four basic principles of

accounting is the historical cost principle that requires that assets and liabilities be accounted

for and reported on a basis of acquisition price because it has the advantage of being

"definite and verifiable").

^See KiEso, supra note 65, at 330. Purchase discounts have been treated either as

income or as a reduction of the inventory purchases account. However, comparison of

methods shows that "the arguments for a reduction of purchases are stronger than those

usually presented in support of financial revenue" because a business does not realize

income upon purchase of goods, but upon their later sale. Id.



1987] FREQUENT FLYER BENEFITS 831

purchaser's income related to such expensed or depreciable assets. If the

asset is later sold, the gain or loss on the sale is computed on the basis

of the discounted cost. The purchaser recognizes more income because

of the initial lower, or discounted, basis. ^^ As apphed to airline bonus
flights, the recipient of a frequent flyer bonus will not recognize income

if the bonus flight is considered to be a discount; instead, the recipient

has a lower basis in the underlying flights upon which the bonus was

earned.

As will be shown, a discount can be economically defined as the
reduction of an asset's price to its fair market value.^^ In the economic

terms of supply and demand, if the retail price of an item is overstated,

demand for the item is reduced because of the excessive price and the
item will not sell unless the price decreases.^^ Therefore, the discount is

a mechanism that a seller can use to reduce the item's price to true

fair market value in the competitive marketplace.''^

After airhne deregulation in 1981, frequent flyer benefits came into

being as one response by airlines to increased competition and cut-rate

airfares in the changing marketplace.^^ According to senior airline sales

personnel, the bonus programs were
*

'initiated defensively" and are

viewed as "a necessity" to effective competition. "^^ For instance, both

Continental and Northwest lost so much business after they discontinued
their discount programs that they were forced to reinstate them.^^ Thus,

frequent flyer bonus programs are, in effect, discounts that are being

used by the airlines as a mechanism to match the price of a commodity,

pubhc air transportation, with the demand for that commodity.

"'Cf. I.R.C. § 167 (Law. Co-op. 1986) supra note 64; I.R.C. § 62 (Law. Co-op.

1986). If the depreciation deduction as computed under section 167 is smaller because it

is computed on a lower cost item, then adjusted gross income as computed under section

62 will be larger because the deductible trade and business expenses under section 62(1)

will be smaller.

^^See infra text accompanying notes 69-73.

^^See generally R. Lipsey, P. Steiner & P. Purvis, Economics 58-74 (8th ed. 1987)
[hereinafter Lipsey]. One factor that affects demand is the price of the item. As there

is excess supply of a commodity in the marketplace, demand will decrease and suppliers

will be forced to lower their prices in order to sell excess commodities. When supply
equals demand, prices will remain constant at equilibrium price. Id.

'"'See id.

^^See supra text accompanying notes 16-21. "[Equihbrium price] will persist once

estabhshed, unless it is disturbed by some change in market conditions." Lipsey at 70.

Increased competition caused by deregulation of air carriers is a change in the market

condition because regulation was a governmental restriction holding price above the equi-

librium. When such a "price floor" is removed, the retail price will drop to reach the
free-market equilibrium level. See id. at 99-100.

^^Frequent-Flier Game, supra note 8, at 75.

'Ud.



832 INDIANA LA W REVIEW [Vol. 20:823

Tax commentators have characterized frequent flyer bonuses as non-

taxable volume discounts. ^"^ A volume discount is a discount offered to
encourage purchase of larger quantities because it rewards the purchaser

by reducing cost of purchases as more of an item is purchased. ^^ For

example, if the purchaser buys one apple, the price is forty cents; if

he buys three, the price is one dollar.''^ One tax commentator states
"Frequent flyer programs are basically just complicated discounts for

the purchase of multiple airline tickets. Discount purchases generally do

not have income tax consequences. ""^"^ That author also asserts that the

only difference between a regular volume discount and a frequent flyer

award is that the frequent flyer programs allow the purchasers to spread

their expenditures for individual airline tickets over time instead of having

to buy them all at once, as would be required by a "regular" volume

discount. "^^ Another author states that, "[f]requent flyer programs are

elaborate volume discount mechanisms, whereby participants obtain air

transportation at a reduced price. Since no deductions are taken with

respect to personal travel, where an award is received on account of

such travel, its utilization should not give rise to taxable income. "^^ This

reasoning indicates that the free flight is not income, but rather is a

volume discount because it is a reduction in the cost of all previously

purchased tickets.

While frequent flyer bonuses are a relatively new phenomenon, their
taxability may be determined by reference to analogous concepts. ^^ The

'"*E.g., Aidinoff, Frequent Flyer Bonuses: A Tax Compliance Dilemma, 31 Tax Notes
1345 [hereinafter Aidinoff]; Forman, Income Tax Consequences of Frequent Flyer Pro-

grams, 26 Tax Notes 742 [hereinafter Forman].
"J. Smith & K. Skousen, Intermediate Accounting 248 (8th ed. 1984).
^*M In a volume discount situation, each rate is applied to the balance after

subtracting the result of applying the prior discount rates, as follows:

Discount New Invoice Amount
$5,000 X 20«^o $1,000 $5,000 - $1,000 = $4,000
$4,000 X 10% $ 400 $4,000 - $ 400 = $3,600
$3,600 X 5% $ 180 $3,600 - $ 180 = $3,420

Thus the buyer only remits $3,420.

"Forman, supra note 74, at 742.

''Id.

^'Aidinoff, supra note 74, at 1347.

^°One somewhat analogous idea, the windfall, is a taxable event. In Commissioner

V. Glenshaw Glass, 348 U.S. 426 (1955), the respondent attempted to claim that punitive

damages were not within the scope of the gross income section because they were a

windfall. Id. at 429-30. This approach was not accepted by the court. Id. at 430. The

fair market value of another windfall, finding buried treasure, should be computed in

United States dollars and included in the gross income of the finder. Rev. Rul. 53-61,

1953-1 C.B. Also, finding money is a taxable windfall. In Cesarini v. United States, 428
F.2d 812 (6th Cir. 1970), an amount of money found in an old piano belonging to
petitioner was includible in petitioner's gross income in the year it was found. Id. at 814.



1987] FREQUENT FLYER BENEFITS 833

concept of a bargain purchase, which is a non-taxable event akin to a

discount, supports the treatment of frequent flyer bonuses as discounts.^'

In a bargain purchase situation, the purchase price of an asset is less

than its fair market value. ^^ By comparison, a discount reduces the

purchase price of an asset to its fair market value in order to promote

its sale.^^ For tax purposes, the bargain purchaser recognizes no income

at the time of the purchase. ^"^ Instead, the low bargain purchase cost is

assigned as the basis of the property. ^^ Similarly, a frequent flyer bonus

flight recipient should recognize no income because the award is a volume

discount that reduces the traveler's cost in the underlying tickets. ^^

In addition to the bargain purchase concept, the Internal Revenue

Service's treatment of rebates^^ supports the assertion that frequent flyer

bonuses are merely a reduction of cost, not gross income. According

to the IRS, a purchaser does not recognize gross income upon receipt

of a cash rebate. ^^ Instead, the rebate reduces the basis of the purchased

asset. ^^ Even the cash refund received by a new car buyer from an

automobile manufacturer is not considered to be income because the

actual purchase price of the automobile is reduced by the amount of

the rebate, thus giving the automobile a lower basis in the hands of

the buyer. ^° The receipt of a rebate is similar to the receipt of a bonus

flight because, in each case, the seller returns a valuable interest to the

buyer after a purchase has been made.^' Therefore, a frequent flyer

However, the windfall analysis is weakened in the case of bonus flights because the

taxpayer has given something for the underlying flights upon which the bonus is based.

Therefore, the receipt of a frequent flyer bonus does not appear to be a taxable event

similar to a windfall.

^^E.g., Commissioner v. Lo Bue, 351 U.S. 243 (1956); Palmer v. Commissioner, 302
U.S. 63 (1937).

'^Palmer, 302 U.S. at 69.

"See supra text accompanying notes 68-79.

^'Lo Bue, 351 U.S. at 248. Stating that no current income recognition is required

in an arm-length bargain purchase transaction, the Court held the transfer of stock options

to Lo Bue to be taxable because the employment relationship is not at arm's length. Id.

^'Id.

^^See supra text accompanying notes 74-79.

«^Rev. Rul. 76-96, 1976-1 C.B. 23.

^^See supra notes 62-67 and accompanying text.

'"Rev. Rul. 76-96, 1976-1 C.B. 23 states: "[R]etail customers who . . . receive the
rebates . . . are not in receipt of gross income. However, under section 1016 of the

Code, a downward adjustment to the basis of the new purchased automobile is required."

See also I.R.C. § 1016(a)(1) (Law. Co-op. 1986). "Proper adjustment in respect of the

property shall in cases be made—(l)for expenditures, receipts, losses or other items properly
chargeable to the capital account . . . ." (emphasis added). Id.

^^See Rev. Rul. 76-79, 1976-1 C.B. 23; see also supra text accompanying notes 38-

46.



834 INDIANA LA W REVIEW [Vol. 20:823

bonus is comparable to a rebate and should receive the same non-taxable

treatment.

In conclusion, when the person who uses the bonus flight is the
same person who paid for the underlying tickets, there should be no
recognition of income by the recipient. Although the concept of gross

income as promulgated by Congress and supported by case law is ex-

tremely broad, ^2 analysis of discounts^^ and examination of the many
similarities between frequent flyer benefits and other concepts that have

no tax consequences, such as the rebate^"^ and the bargain purchase, ^^

indicate that bonuses should also be non-taxable. Therefore, frequent

flyer bonuses are a type of volume discount that is non-taxable as long

as the person who uses the bonus flight is the same person who paid
for the underlying tickets.

IV. The Addition of the Employment Relationship
TO THE Frequent Flyer Situation

The issue of income recognition of frequent flyer bonuses is most
likely to arise in the context of the employment relationship because the

majority of the frequent flyer bonuses are earned by business travelers. ^^

In fact, more than ninety percent of frequent flyers are business travelers,
and twenty percent of all airhne passengers supply seventy percent of

several major airlines' traffic.^^ Therefore, the target market of frequent

flyer programs is the businessman^^ who flies at least 12,000 miles a
year.99

Furthermore, the airlines concede that the programs were structured

to benefit individuals, not their corporate employers, because the strategy

of bonus programs is brand loyalty among individual travelers. ^*^^ One
airhne vice president has said, "Obviously, we wanted the traveler to
get the award .... If companies forced people to turn in their prizes,
we'd try to curtail the program. "i°^ Thus, the bonus flight is most Ukely

to be earned in the context of the employment relationship.

The conclusion that a frequent flyer bonus is not gross income^^^
does not necessarily follow when a third party, the employer, pays for

^^See supra text accompanying notes 49-61.

^^See supra text accompanying notes 62-79.

^*See supra text accompanying notes 87-91.

'^^See supra text accompanying notes 80-86.

'^Sky's the Limit, supra note 1, at 89.

''Id.

^^Richer Rewards, supra note 1, at 89.

''Sherman, supra note 1, at 106.

'°°/<i. (quoting Brian J. Kennedy, TWA vice president for advertising and sales).

^°^See supra text accompanying notes 47-94.



1987] FREQUENT FLYER BENEFITS 835

the employee's tickets and then allows the employee to retain the bonus

flight. Generally, if the person who paid for the underlying tickets gives
the free flight earned on those tickets to a third party, the third party

will not recognize income because of the Code provision which exempts

gifts from inclusion in gross income. '^^ For instance, if a frequent flyer

gives a bonus flight to a friend, it will be a gift unless the donor receives

something in return. On the other hand, if the recipient of the bonus
sells it to a third party, there is no question but that the seller has

realized gain or loss that qualifies as taxable income or loss.^^"^ However,

when an employer pays for an employee's business related travel as an
"ordinary and necessary business expense, "'^^ then allows the employee

to retain the bonus flight for personal use, it must be determined whether

the employee has received taxable income. '°^

A. The Award's Receipt—Who is the Recipient?
Once the employment relationship is added to the frequent flyer

bonus scenario, the preliminary issue for resolution is the identity of

the award recipient. The airlines technically issue the free ticket to the

individual passenger, and not to the employer, '^^ for at least two reasons.

First, if the individual has purchased the underlying tickets and was

subsequently reimbursed by the employer, the airline has no knowledge

of the employment relationship. ^°^ In fact, the airUnes refuse to poHce

allocation of the bonuses because they view the issue as *'an employer/

employee relationship problem. "'°^ Second, in line with the airlines'

poHcy of targeting the traveling businessman market, ''° most airlines

restrict membership to individuals. ^'^

Because frequent flyer bonus flights are awarded by the airline directly

to the traveler"^ it appears that the employee received income from the

airline, a third party, and not from the employer. However, because

'°^5ee infra text accompanying notes 149-64.

^°^See I.R.C. § 1011 (Law. Co-op. 1986). Because the frequent flyer bonus recipient

who paid for the underlying flights is considered to have received a volume discount that
reduces his basis in the underlying flights, his basis for figuring gain or loss upon the

sale of the bonus flight is the amount allocated as discount to the underlying flights. See

id.', see also supra notes 63-64 and accompanying text.

'°'See I.R.C. § 162 (Law. Co-op. 1986); see also infra note 122.

^'^See supra text accompanying notes 56-58.

'"^Sherman, supra note 1, at 106.

'°^Many employees enrolled in frequent flyer bonus programs have their mileage

statements sent directly to their homes. Id.

'"^Who?, supra note 38, at 74.

^^°Richer Rewards, supra note 1, at 89.

'"Sherman, supra note 1, at 106; Dubin, Guess Who Wants Your Frequent Flier
Coupons, Bus. Wk., Aug. 5, 1985, at 37.

"^Sherman, supra note 1, at 106.

y



836 INDIANA LA W REVIEW [Vol. 20:823

the employer has paid for the underlying tickets as ordinary and necessary

expenses of doing business, ^'^ it will be shown that the employer has
the right to the income realized or the discount created by the receipt

of the bonus flight.

In Fritschile v. Commissioner, ^^"^ the United States Tax Court has

held that the person in a position analogous to the employer's is the

one who earned income.''^ In that case, the petitioner contracted to
make award ribbons such as those awarded for winning athletic events.''^
Her children made most of the ribbons and the taxpayer allocated seventy
percent of the income to them; therefore, her tax return reflected only

thirty percent of the income from the ribbon-making enterprise. ^'"^ The

court held that the income was allocable to the parent because the parent

contracted to do the work, was responsible for the work, and had the

right to the proceeds of the work.''^ In so holding, the court followed

the "fruit and tree doctrine" of Lucas v. Earl,^^^ which requires that

income must be taxed to the individual by whom it is earned. However,
the Fritschile court extended that doctrine and stated: "Recognizing that

the true earner cannot always be identified simply by pointing *to the

one actually turning the spade or dribbling the ball,' this Court has

applied a more refined test—that of who controls the earning of the
income. "'2^ Because Mrs. Fritschile "managed, supervised, and otherwise

exercised total control over the entire [ribbon-making] operation," the

Tax Court attributed all the ribbon-making income to her.'^*

By comparison, the earning of a frequent flyer bonus is under the
total control of the taxpayer who is paying for the tickets upon which
the bonus is earned. If an employer decides not to pay for the underlying

tickets, the employee cannot earn the bonus flight. The employer allocates

plane tickets to frequently traveling employees in the same way that

"^I.R.C. § 162 (Law. Co-op. 1986), infra note 122.

"^Fritschile v. Commissioner, 79 T.C. 152 (1982).

'''Id. at 158-59.

' */£/. at 154.

'•«M at 155-56.

"^281 U.S. Ill (1930). In 1901, Lucas and his wife contracted that all of their assets,

present and future, were to be held as joint tenants with rights of survivorship. Id. at

113-14. Because of this contract, Lucas and his wife each claimed half of Lucas' salary

for tax purposes. Id. at 114. The Court held that Lucas should be taxed on the total

salary because, despite the contract, "fruits" could not be separated from the "tree" on

which they grew. Id. at 115.

'^Fritschile, 79 T.C. at 155 (quoting Johnson v. Commissioner, 78 T.C. 882, 890

(1982) aff'd without op., 734 F.2d 20 (9th Cir.), cert, denied, 469 U.S. 857 (1984)). The

Johnson court held that a personal service corporation created by a professional basketball

player was not the true earner of basketball related income and would not be taxed on

the income. Instead, the player would be taxed. 78 T.C. at 893-94.

'^'Fritschile, 79 T.C. at 156.



1987] FREQUENT FLYER BENEFITS 837

Mrs. Fritschile allocated work and ribbon-making materials to her chil-

dren. Without her allocation, the children could not earn money by
making ribbons; similarly, without the employer's allocation of plane

fare, the salesmen could not earn enough time in flight to be awarded

the bonus trip. It follows, then, that even the employer who is unaware
that a bonus flight has been awarded to an employee is the *'true earner"

of the flight because he paid for the underlying tickets. Therefore, if

the employee receives, retains and uses a frequent flyer bonus for a

personal purpose, it was received from the employer, not from the

airline.

B. Taxability of Employer Awarded Bonus Flights

Once it has been determined that the free flight was, however briefly

or constructively, the property of the employer, the thrust of the income

recognition analysis must center on the actual or implied transfer of the

bonus from the employer to the employee. ^^^ If the traveling employee

appears to have received an accession of wealth that qualifies as *'all

income from whatever source derived, "*^^ the employee must include

the flight in gross income and it will be subject to taxation unless a

statute or rule of law exempts it.'^"^ The following analysis and precedents

specifically refer to and define taxability of various employer payments

to the employee.

The Supreme Court has stated that the definition of gross income,

"is broad enough to include in taxable income any economic or financial

benefit conferred on an employee as compensation, whatever the form

or mode by which it is effected. "'^^ In the frequent flyer situation,

'^^Although a transfer, whether actual or implied, also occurs when the bonus, however

briefly, is owned by the employer, analysis of the employer's income recognition should

result in the conclusion that the employer has received a volume discount, not income.

See supra text accompanying notes 62-95. Furthermore, even if the opposite conclusion

that the employer has received income is reached, there will be no tax effect on the

employer because if income must be recognized, an equal offsetting deduction for an

ordinary and necessary business expense will accrue when the employee receives the free

flight. See I.R.C. § 162(a) (Law. Co-op. 1986). "There shall be allowed as a deduction

all the ordinary and necessary expenses paid or incurred during the taxable year in carrying

on any trade or business, including—(1) a reasonable allowance for salaries or other
compensation for personal services actually rendered . . . ." Id. The employer will be

entitled to the deduction regardless of whether the trip is considered to be sales expense

when used as another business trip or as salary or bonus if it is given to the employee

to use as he wishes. See I.R.C. § 162(a)(1) (Law. Co-op. 1986). Thus, there is no net

taxable effect to an employer who allows the bonus flight to be used by an employee
for any purpose. See LR.C. § 62(a)(1) (Law. Co-op. 1986).

'^^LR.C. § 61 (Law. Co-op. 1986); see also supra text accompanying notes 56-58.

^^See supra text accompanying notes 59-61.

'^^Commissioner v. Smith, 324 U.S. 177, 181 (1945).



838 INDIANA LA W REVIEW [Vol. 20:823

because the employer is considered to have a right to retain the bonus,

an economic benefit is conferred by the employer when the employer
allows the employee to retain the bonus for personal use.'^^ Therefore,

gross income, by definition, is broad enough to include a frequent flyer

bonus flight as compensation for the employee.

This reasoning is supported by the Supreme Court's analysis in

Commissioner v. Lo Bue.^^^ In that case, the Court held that a distribution
of stock options to employees could not be considered a gift because

the lack of "detached and disinterested generosity. "'^^ Reasoning that

the employer must have distributed the stock options to the employees

to '* secure better services, "^^^ the court characterized the distribution as

compensation. '3° In Lo Bue, the Court declined to recognize the existence
of any gratuitous motives in the employment relationship.'^*

Similarly, an employer who allows an employee to retain a frequent
flyer bonus should not be imputed with gratuitous motives. For instance,

the employer may believe that the employment relationship might be
damaged if the employee is forced to release the bonus. '^^ However, if

the employee is allowed to retain the bonus to maintain a satisfactory

employment relationship, the employer is attempting to "secure better

services" under the Lo Bue definition.'" Thus, the bonus is not gra-
tuitous, is received as compensation and should be included in the

employee's gross income.

Furthermore, the employer may not intend to compensate the em-
ployee but may allow the employee to retain the bonus for other rea-
sons.'^"* For instance, the employer may allow all employees to retain
frequent flyer bonuses earned because the employer believes that the

cost of implementing a fair monitoring system to reclaim the bonuses

is too high. '3^ However, because of the Supreme Court's construction

of the intent of Congress to use the full measure of its taxing power,

courts will not consider as relevant the fact that the employee is only

retaining the bonus because of the employer's record-keeping problems '^^

and the bonus flight will be included in gross income.

'^^See id.

•"Commissioner v. Lo Bue, 351 U.S. 243 (1956).
'^«M at 246.

'^^Id. at 247.

'''See id. at 245-48.

'"Sherman, supra note 1, at 106; Who?, supra note 38, at 74.

'"Lo Bue, 351 U.S. at 247.

'^•See Who?, supra note 38, at 74.

'^^See supra text accompanying notes 51-55.



1987] FREQUENT FLYER BENEFITS 839

Finally, the employer might choose to allow the employee to retain

the bonus as additional compensation.'^^ Frequent flyer bonus flights

are analogous to any other taxable incentive bonus trips includible in

the employee's gross income as compensation for services rendered. '^^

Employer and employee are receiving equivalent benefits regardless of

the source of the flight—improved performance for the employer and
a free vacation for the employee. '^^ Therefore, it is irrelevant whether

the trip was earned through a frequent flyer program or whether the

employer paid for the vacation as a bonus for services rendered; the

trip should be included in the employee's gross income.

In conclusion, for income determination purposes, the employee has

received a free flight from the employer, not the airline. Because of a

lack of gratuitous motives by the employer, the bonus must be considered

to be compensation to the employee. Thus, it must be included in the

employee's gross income.

IV. Exclusion of the Frequent Flyer Bonus from
Gross Income

Once it has been determined that the frequent flyer bonus constitutes

gross income to the employee who is allowed to retain the flight for
personal use, it must be decided whether the income is excludible under

an exception to one of the income inclusionary sections of the Code''*^

or under one of the income exclusionary sections of Code.'"^' However,

the applicability of these sections must be discussed in light of Congress'

intention, as interpreted by the Supreme Court, to create broad income

inclusionary powers; therefore, these exceptions should be strictly con-

strued so that the intent of Congress to include all income will be

followed. '^2

A. General Exclusionary Sections

The inclusionary Code section concerning certain nontaxable prizes
and awards may provide a basis for a claim of exclusion for frequent

'"ffTio?, supra note 38, at 77. As long as it does not cost the company anything

beyond the loss of the free flight, most companies do not mind letting the traveling

employee retain the bonus for personal use. Id.

'''See, e.g., McCann v. United States, 696 F.2d 1386 (Fed. Cir. 1983) (trips that
were primarily vacations furnished to employee were taxable to the employee despite some

business purpose); Lynch v. Commissioner, 45 T.C.M. (CCH) 1125 (1983) (Japan seminar
and vacation was includible in gross income).

'''See McCann, 696 F.2d at 1389.
'^See I.R.C. §§ 71-89 (Law. Co-op. 1986). These sections comprise Part II of the

Code subtitled "Items specifically included in gross income."

""See I.R.C. §§ 101-35 (Law. Co-op. 1986). These sections comprise Part III of the

Code subtitled "Items specifically excluded from gross income."

'*^See supra text accompanying notes 49-61.



840 INDIANA LA W REVIEW [Vol. 20:823

flyer bonuses. '"^^ Code section 74 was amended by the Tax Reform Act
of 1986^'*'^ so that an award can be excluded in only two situations.

First, the recipient of any award, even previously non-taxable awards

such as the Pulitzer or Nobel Prize, will be taxed on the amount received
unless it is donated to charity.'"*^ Second, the award may be excluded
if it qualifies as an employee achievement award. ^"^^ These awards, as

defined in the new tax act, are exempt only if they are items of personal
property given to the employee for length of service or safety achievement

and which are awarded as a part of a meaningful presentation under

circumstances that do not create a significant likelihood of the payment

of disguised compensation.'"*^ The definition of employee achievement

awards is too narrow to allow frequent flyer benefits to qualify because

they are unlikely to be presented for length of service or safety achieve-

ment in a meaningful ceremony. '"^^ Therefore, an employee who receives
a frequent flyer bonus will not be able to exclude it as a non-taxable

prize or award.

Code section 102, an exclusionary section concerning gifts, states
that gifts are not generally includible as gross income. ''^^ However, it

must be determined whether a frequent flyer bonus given to an employee

is truly a '*gift" within the meaning of section 102. In Helvering v.

American Dental Co.,'^° the Supreme Court defined the relationship

between income and gifts in light of section 102 by stating: "Gifts,

however, is a generic word of broad connotation, taking coloration from

the context of the particular statute in which it may appear. Its plain
meaning in its present setting denotes, it seems to us, the receipt of

financial advantages gratuitously."'^' Therefore, if the frequent flyer

"*^I.R.C. § 74(a) (Law. Co-op. 1986) ("Except as otherwise provided in this section

. . . gross income includes amounts received as prizes and awards.").

'^I.R.C. § 74(a) (Law. Co-op. 1986). This section prior to amendment in 1986 had

provided that various recognition awards were not included in gross income if the recipient

met certain tests. I.R.C. § 74(a) (1982).

'"^LR.C. § 74(b) (Law. Co-op. 1986). Recognition awards exempt under prior law,

are not exempt unless the award-winner was selected without action on his part, he is

not required to render "substantial future service" as a condition of receipt, and the

award is transferred to a governmental unit or a qualified charitable organization. Id.

'M.R.C. § 74(c) (Law. Co-op. 1986). This section exempts from income employee

awards to the extent they are an allowable deduction under § 274(j) (Law. Co-op. 1986).

'"^I.R.C. § 274(j) (Law. Co-op. 1986). This section sets monetary hmits for the awards.

Therefore, even if a frequent flyer bonus could qualify as a safety or length of service

award, it would not qualify if it was worth more than the upper limit for an employee

achievement award.

''^See LR.C. § 74(c) (Law. Co-op. 1986).

'^'I.R.C. § 102 (Law. Co-op. 1986).
'="318 U.S. 330 (1943).

'''Id. at 330.



1987] FREQUENT FLYER BENEFITS 841

bonus is given gratuitously, it will be excluded from the employee's

income under Code section 102. •"

In Commissioner v. Duberstein,^^^ the Court further defined gifts

and added a standard for determining whether a transfer is gratuitous.

First, the term "gift" does not have the same meaning in tax law as

it does in common law;*^'* therefore, the colloquial meaning of the term
gift as a transfer without consideration is not controlling if other factors

indicate insufficient donative intent. '^^ Second, a gift must be made from
detached or disinterested generosity. '^^ Third, the transferor's intention

is the most critical consideration in whether or not there is a gift;

however, that intention should be judged by objective, not subjective,

criteria. ^^^ Finally, wishes or agreements of taxpayers as to tax treatment

are not controUing; instead, the criteria should be an objective inquiry

into the substantive reason for transfer. ^^^ In applying these concepts to

frequent flyer bonus receipts, the intent of the airline is to create brand

loyalty among individual travelers in order to generate business'^' and
the intent of the employer is to encourage the employee's performance.^^

Viewed objectively, neither of these reasons for awarding the bonus

show sufficient donative intent to support the finding that the free flight

is a gift subject to exclusion under Code section 102.^^'

Finally, a new subsection has been added to the Code section 102'^^

that states in pertinent part: "[This section] shall not exclude from gross

income any amount transferred by or for an employer to, or for the
benefit of, an employee."^" Thus, the new law, supported by the Amer-
ican Dental and Duberstein cases, provides that frequent flyer benefits

'"However, in Commissioner of Internal Revenue v. Lo Bue, 351 U.S. 243 (1956),
the Supreme Court reasoned that there are few gratuitous transfers in the context of the

employment relationship. Id. at 245-48; see also supra text accompanying notes 127-39,

"363 U.S. 278 (1960).

'''Id. at 285.

'"/c?. at 286.

''''Id. at 285.

'''Id. at 286.

"^Id.

"'^See supra text accompanying notes 16-21.

'^See supra text accompanying notes 132-39.

'^'363 U.S. at 286. Another case, Robertson v. United States, 343 U.S. 771 (1952),

further defined excludible gifts. In that case, the Court held that the winner of a prize

for composing a symphony did not receive a gift because the transfer was considered to

be payment for services rendered in writing the symphony; payment was simply a release

of the contract created by the contest entry. Id. at 713. Similarly, free flights are a

contract between airline and passenger to award a free flight if a certain number of miles

are flown; therefore, the receipt of the flight should not be exempted from income as a

gift.

'"I.R.C. § 102(c) (Law. Co-op. 1986).



842 INDIANA LA W REVIEW [Vol. 20:823

will constitute "any amount transferred by or for an employer to, or

for the benefit of, an employee, "'^'* and therefore will not be excluded

from gross income as a gift.

B. Fringe Benefits

A final exclusionary Code section under which an employee could
attempt to exempt the income from frequent flyer bonus awards was

created by the Tax Reform Act of 1984.^^^ Section 132^^^ Hsts specific

fringe benefits that may be excluded from an employee's income. The
general rule is that fringe benefits are taxable. '^"^ Before determining if

frequent flyer benefits qualify under the exclusionary exception to this

general rule, it must be determined whether frequent flyer bonuses are

fringe benefits to the employee.

Fringe benefits must be defined by examples because they are not

generically defined in the Code or accompanying regulations. In 1984,
the Joint Committee on Taxation named various items as examples of

employee benefits. '^^ This Hst included employee benefits specifically

exempted by the Code such as health plan benefits, cafeteria plans, and

lodging for the convenience of the employer. ^^^ In addition, the Committee

listed many fringe benefits that have been held to be includible in the
employee's gross income such as personal use of a company automobile,
airplane or yacht; employer provided clothing; reimbursement of lunch

expenses; reimbursement of expenses for convention trips not primarily

for business purposes; and reimbursement of loss on sale of a personal

residence. '^^ All of these items are of benefit to the employee and are

given by the employer; similarly, frequent flyer bonuses are given by

the employer for the benefit of the employee.'"^' Thus, it appears that

'*^See id.

'"I.R.C. § 132 (Law. Co-op. 1986) (originally enacted as the Tax Reform Act,

Division A, Deficit Reduction Act of 1984, Pub. L. 98-368, 98 Stat. 494-1210).

"^^I.R.C. § 61(a) (Law. Co-op. 1986). Section 531(a) of the Tax Reform Act of 1984

specifically modified LR.C. § 61 to identify fringe benefits as a taxable component of

gross income because of taxpayers' erroneous belief in the non-taxable status of fringe

benefits. See infra text accompanying notes 175-80. Before the Act, LR.C. § 61(a)(1)

(1982) included in gross income "compensation for services, including fees, commissions,

and similar items." After the Act, LR.C. § 61(a)(1) (Supp. Ill 1985) included in gross

income "compensation for services, including fees, commissions, fringe benefits, and similar

items."

'*^Joint Committee on Taxation, 98th Cong., 2d Sess., General Explanation of
THE Revenue Provisions of the Deficit Reduction Act of 1984 838 (Comm. Print
1985) [hereinafter Explanation].

'^°M at 838 n.68.

'''See id.



1987] FREQUENT FLYER BENEFITS 843

frequent flyer bonuses have the characteristics of other employee fringe

benefits and should be classified as such.

Because of the breadth of the concept of gross income, all fringe

benefits are taxable unless specifically excluded. '^^ As yet, there is no
case law to help to determine whether Congress intended frequent flyer

bonuses to be a type of fringe benefit that fall within the scope of the

exclusion provided by Code section 132.'^^ Therefore, Congress' intent
must be determined by examining Committee reports, which indicate

that Congress was influenced by the history of fringe benefit taxation. '^"^

In 1975, the Treasury Department promulgated a discussion draft of

regulations to ensure that fringe benefits would be properly included in

gross income; however, no permanent regulations ensued. '"^^ Apparently,

Congress did not agree with the intent of these regulations because, in

1978, it issued a moratorium on the issuance of fringe benefit regulations

that extended until January 1, 1984.^^^ Thus, despite Code section 6Vs
all-inclusive income concept, ^^^ both employers and employees have be-

Ueved that many fringe benefit items were non-taxable even though the
benefits fell within the broad definition of gross income. '^^ Also, because

of this confusion as to the tax treatment of various benefits, tax law

administrators have not treated taxpayers in similar situations equally. ^^^

In enacting the fringe benefit legislation. Congress intended to cure these

inequities. '^^ Furthermore, Congress intended to strike a balance between

two competing objectives, the valid business purpose of the employer

and the delineation of clear boundaries outside of which an employee

cannot be compensated without tax consequences.^^'

First, Congress realized that businessmen often have valid business

reasons other than compensation for giving employees discounts. '^^ The

Committee Report states, 'Tor example, a retail clothing business will

want its salespersons to wear, when they deal with customers, the clothing
which it seeks to sell to the public, rather than clothing sold by its

competitors."'^^ Congress intended that under these types of circum-

^''^See supra notes 49-61 and accompanying text.

•^^I.R.C. § 132 (Law. Co-op. 1986).

'^"Explanation, supra note 168, at 839.

'''Id.

''''See id. at 839-40.

'''See supra notes 49-61 and accompanying text.

''^Explanation, supra note 168, at 840. In many industries, there are long established
practices of providing employees free, or discounted goods and services "which the employer

sells to the general pubhc." Id. These practices in the past "have been treated by employers,

employees, and the Internal Revenue Service as not giving rise to taxable income," Id.

"^Id. at 841.

''°Id.

'''Id. at 840-41.

"^Id. at 840.

'"Id.



844 INDIANA LAW REVIEW [Vol. 20:823

Stances both employers and employees might continue to act in the best

interests of the business without penalty.*^'* Therefore, if a frequent flyer

bonus is given to an employee for a valid business purpose other than

compensation, it should be excluded from the employee's gross income. '^^

If, however, an employee retains a frequent flyer bonus for personal

use and there is no corresponding benefit to the employer, then Congress'

intent to protect the business purpose of the employer would not be

served by allowing the employee to exclude the bonus from gross in-

come. '^^

Second, by promulgating section 132 to exempt certain fringe benefits

from taxation, Congress intended to define the non-taxable fringes in

order to "set forth clear boundaries for the provision of tax-free

benefits. "'^^ Congress further intended to prevent an unwanted tax in-

crease from occurring by preventing the shifting and shrinking of the

tax base'^^ that might occur if some employees received considerable

compensation in the form of unregulated non-cash fringe benefits. '^^

Congress was concerned that the tax burden might shift and fall unevenly

on employees in jobs not encouraging receipt of fringe benefits because

those in jobs with fringe benefits would receive more income in a non-

taxable form.'^<^

To be excluded under section 132, frequent flyer benefits must qualify
as one of the four excludible fringe benefits defined in the section. ^^'

First, an employee may exclude the value of an additional no-cost service
received from his employer. '^^ Generally, because airplanes usually fly

at only sixty percent of capacity, •^^ frequent flyer bonuses involve no

additional cost to the airlines. ^^'^ However, although the exemption seems

tailor-made for airlines, this benefit applies only to the employees of

'''See id.

'''See id.

''"See id.

"'Id.

'"Id. at 841.

"''See id.

'^Id.

'^'I.R.C. § 132(a) (Law. Co-op. 1986) states: "Gross income shall not include any

fringe benefit which qualifies as a—(1) no-additional cost service, (2) qualified employee
discount, (3) working condition fringe, or (4) de minimus fringe."

"^I.R.C. § 132(b) (Law. Co-op. 1986) states:

[T]he term 'no-additional cost service' means any service provided by an employer

to an employee for use by such employee if—(1) such service is offered for
sale to customers in the ordinary course of the Une of business of the employer

in which the employee is performing services, and (2) the employer incurs no

substantial additional cost (including forgone revenue) in providing such service

to the employee ....
'^^See Sherman, supra note 1, at 108.

'^'See New Deals, supra note 5, at 170-72.



1987] FREQUENT FLYER BENEFITS 845

the airlines,^^^ not to employees of other business; therefore, this ex-

emption cannot apply to frequent flyer bonus flights.

Second, the exemption for qualified employee discount fringe benefits

applies to employees who receive discounts on goods or services that
the employer sells. '^^ This exemption cannot apply to benefits received

by the general frequent flyer because the recipient must be an employee

of the airhne to qualify under this section. '^^ Furthermore, the temporary

regulations have plugged a potential loophole by stating that an exclusion

of income due to a quahfied employee discount does not apply to

reciprocal agreements between employers. '^^ Even if the airline receives

discounts for its employees from the employer whose employees receive

bonus flights, the goods and services exchanged will not be excludible

from gross income for the employees of either company. The temporary

regulation imposes affinal constraint on the exempt status of employee

discounts when it states that quantity (volume) discounts are not reflected
by this benefit unless the employee himself purchases the requisite quantity

of the product or service; '^^ therefore, because the employer paid for

the flights, the employee must include any bonus flights received in gross

income.

Third, an exemption from gross income is provided for a working

condition fringe benefit. This exemption applies to property awarded to

the employee which would have been deductible as a business expense,^^

or subject to capitaUzation and depreciation,^^^ if the employee had been

195QJ- Xemp. Treas. Reg. § 1.132-2T (1985). Subsection (b) provides that reciprocal

agreements between employers to provide no-additional cost service fringe benefits to each

other's employees are allowed if the services meet the requirements of I.R.C. § 132(b)(1)

& (2). Because this is the only way a no-additional cost service fringe benefit can be
made available to non-employees of the employer providing the service, frequent flyer

benefits made available to the public cannot qualify for exclusion under this section.

'^I.R.C. § 132(c)(1) (Law. Co-op. 1986) states:

The term 'quahfied employee discount' means any employee discount [on property

or services offered for sale in the employer's ordinary course of business] to

the extent the discount does not exceed—(A) in the case of property, the gross
profit percentage of the price at which the property is being offered by the

employer to customers, or (B) in the case of services, 20 percent of the price

at which services are being offered to customers.

'^'See id.

"«Temp. Treas. Reg. § 1.132-3T(a)(3) (1985).

'^emp. Treas. Reg. § 1.132-3T(b)2(ii) (1985) states: "The price . . . cannot reflect
any quantity discount unless the employee actually purchases the requisite quantity of the

property or service,"

^I.R.C. § 162(a) (Law. Co-op. 1986) states: "There shall be allowed as a deduction

all the ordinary and necessary expenses paid or incurred during the taxable year in carrying

on any trade or business . . . .'^

^'LR.C. § 167(a) (Law. Co-op. 1986) states: "There shall be allowed as a depreciation

deduction a reasonable allowance for the exhaustion, wear and tear ... (1) of property
used in a trade or business, or (2) of property held for the production of income." See

supra note 64 and accompanying text.



846 INDIANA LA W REVIEW [Vol. 20:823

required to pay for the property or service. ^°^ Thus, according to the

wording of the statute, a flight appears to be deductible to the employee

so long as the employee uses it for business, anyone's business. ^^^ How-
ever, the Internal Revenue Service immediately plugged this loophole in

the law; a temporary Treasury regulation ensures that the exemption is

only available if the fringe benefit is used for the employer's business

and not for a side business belonging to the employee.^^'^ As the previous

discussion shows, although the name ''working condition fringe benefits"
seems to imply that flights earned by travel during working hours should

be exempt because the right conferred came about as a condition of

work, they cannot be excluded from gross income under this subsection.

Fourth, the final exemption, de minimus fringe benefits,^^^ excludes

the amount of fringe benefits received if the amount of the benefit is

small or the record-keeping required is so complex as to be burdensome. ^^^

In order to determine whether frequent flyer bonuses qualify for exclusion

under this provision, the methods of analysis suggested by the Treasury

regulations must be applied to frequent flyer bonuses and the intent of

Congress in passing the fringe benefit legislation must be re-examined.

The first method of analysis provided by the regulations is based

on three factors that are weighed to determine whether a fringe benefit

is impracticable to track, thus qualifying for exclusion as de minimus.
^^'^

The first factor is the value of the benefit: as it increases, the benefit

is more likely to be taxable. ^^^ Therefore, if the frequent flyer bonus is

a vacation worth thousands of dollars, ^°^ it does not appear to meet

the requirement of small value.

^°n.R.C. § 132(d) (Law. Co-op. 1986) states: "[T]he term 'working condition fringe'

means any property or services provided to an employee of the employer to the extent

that, if the employee paid for such property or services, such payment would be allowable

as a deduction under section 162 or 167."

^'''See id.

^°^Temp. Treas. Reg. § 1.132-5T(a)(2) (1985). The illustration in the regulation concerns

a payment by company A for an employee's airline ticket so that the employee, who is
a director of company B, can attend the board of director's meeting of company A. The

flight is not excludible from the employee's income as a working condition fringe.

^"'I.R.C. § 132(e)(1) (Law. Co-op. 1986) states: "The term 'de minimus fringe' means

any property or service the value of which is (after taking into account the frequency

with which similar fringes are provided by the employer to the employer's employees) so

small as to make accounting for it unreasonable or administratively impracticable."

^°*Temp. Treas. Reg. § 1.132-6T(a) (1985).

Gross income does not include the value of a de minimus fringe provided to

an employee. The term 'de minimus fringe' means any property or service the

value of which is (after taking into account the frequency with which similar

fringes are provided by the employer to the employer's employees) so small as

to make accounting for it unreasonable or administratively impracticable. Id.

^'''Id. at (b)-(c).

^°«5ee id. at (a)-(f).

^°^See id.



1987] FREQUENT FLYER BENEFITS 847

The second factor is the frequency of receipt: the more infrequently

the fringe benefit is suppHed, the more hkely it is to quahfy as de
minimus.^^° For example, the receipt of a daily free lunch by one employee

as compared to the receipt of a free lunch only once a month by another
employee may result in a de minimus fringe benefit to the occasional
recipient and gross income to the daily recipient.^" However, if each

employee's receipts under fringe benefit programs cannot be ascertained,

frequency of all similar fringes may be looked at together. ^'^ For instance,
employee use of a company Xerox machine may be very unequal, but
employers may ignore that inequality so long as the entire non-business
use does not exceed 15% of all of the machines. ^'^ Frequent flyer bonuses
are received infrequently because of the large amount of miles required
to be flown;^''^ therefore, the requirement of infrequent receipt has been

met.

The third factor is impracticality of administration: any benefit which
is not excluded by another section and is not unreasonable or admin-

istratively impracticable to account for must be included in the employee's

income. ^'^ For example, cash fringe benefits, regardless of size, are not

excludible.^'^ By comparison, however, any benefit that is unreasonable
or administratively impracticable to account for should not be included

in the employee's income. ^'^ Bonus flights definitely meet this requirement

because it is extremely difficult for employers to track frequent flyer

bonuses received by employees. Because the airlines have aimed the

bonus programs at individual business travelers^'^ and because the airlines

send the bonuses directly to those travelers,^^^ administration of the

awards by the employer is burdensome. ^^^ Therefore, the requirement

of administrative impracticality is met. However, because the outcome
of the value factor analysis conflicts with the outcome of the frequency

and practicality factors, further analysis is required.

The second method of analysis provided by the regulations is a Hst
of excludible and nonexcludible fringe benefits. ^^' Excludible benefits

listed are coffee and doughnuts, occasional typing of personal letters by

^'°Temp. Treas. Reg. § 1.132-6T(b) (1985).

^^*Who? supra note 38, at 77. "A huge amount of mileage is required to qualify
for a free ticket." Id.

^"Temp. Treas. Reg. § 1.132-6T(c) (1985).

^'''Id.

^^'^Cf. id. This premise is the converse of the one actually stated in the regulation.

^^^See supra notes 96-101 and accompanying text.

^''5ee supra notes 107-12 and accompanying text.

"^"^See Temp. Treas. Reg. § 1.132-6T(c) (1985).
^^'Temp. Treas. Reg. § 1.132-6T(0 (1985).



848 INDIANA LA W REVIEW [Vol. 20:823

a company secretary, occasional use of a copying machine, occasional
cocktail parties or picnics, occasional tickets to theater or sporting events,

and low cost holiday presents ;^^2 all of which have low market value.

By contrast, includible fringe benefits are more valuable—they include
season tickets for sporting events or the theater, athletic or country club

memberships, the commuter use of a company vehicle and use of an
employer-owned hunting lodge, apartment or boat for a weekend.^^^

Although one form of frequent flyer bonus, an upgrade to first class, ^^^^

resembles an excludible fringe benefit because of its low value, frequent

flyer bonus flights, because of their high value and usual personal use,

either as a vacation trip or as a commodity to be sold,^^^ resemble the

non-excludible types of benefits more than the excludible ones.
Finally, Congress' goals in passing the fringe benefit legislation must

be considered to determine if fringe benefits should be excludible as a

de minimus fringe benefit. Congress' first objective was to allow com-

pensation without taxation if there was a valid business purpose besides

compensation.22^ Most employers allow employees to keep the bonuses

for compensation and employee relations ;22^ thus, bonus flights do not

meet Congress' first objective for fringe benefit legislation. Congress'

second objective was to ensure that no shifting or shrinking of the tax

base could occur. ^^^ Allowing frequent flyer benefits to be excluded under

the de minimus fringe benefit exclusion shifts the tax base from those

whose jobs favor the earning of the flights to those whose jobs do not

because the frequent flyer is not taxed on an awarded two thousand

dollar vacation while a non-travelling co-worker is taxed on the two

thousand dollars he earned to pay for a similar vacation.229 Therefore,

bonus flights do not meet the second objective, either.

Thus, despite the infrequency of receipt and the difficulty of the

employer's record-keeping, frequent flyer bonuses do not qualify for

exclusion under section 132. Because of the high value of the bonuses,

their similarity to the examples of non-excludible fringe benefits listed

in the regulations and Congress' goals in passing the legislation, frequent

flyer bonuses will be includible in the employee's gross income.

V. The Amount of Income—What is the Bonus Worth?
After determining that a frequent flyer bonus constitutes income to

recipients, the dollar amount of income must be determined. The first

^^^Id. at (0(1).

^^'Id. at (0(2).

^See infra text accompanying notes 239-40.

^^^See supra text accompanying notes 22-28; see also supra notes 38-46 and accom-

panying text; see also supra notes 137-39 and accompanying text.

^^^ExPLANATiON, supro notc 168, at 840.

^^^See supra text accompanying notes 132-39.

^^Explanation, supra note 168, at 841.

"'See id.



1987] FREQUENT FLYER BENEFITS 849

Step in the analysis is the rule that the fair market value of the property

or service received must be included in income.^^^ In McCoy v. Com-
missioner, ^^^ fair market value was defined by the Tax Court as the

going rate at which the commodity can be purchased, not its retail

price. ^^^ In that case, the IRS claimed that the retail price of an automobile

given to an employee must be included in the employee's gross income.^"

The court held that fair market value is not necessarily retail price; it

is the market price. ^^"^ The court took judicial notice of the common
fact that an automobile, once sold, is worth less than retail even if it

has no miles on the odometer.^^^ Therefore, because the employer who
awarded the car was the original purchaser, the fair market value of

the car was not equal to retail price when received by the employee. ^^^

Thus, fair market value is the going rate at which the commodity can

be purchased, not its retail price. ^^^ As applied to frequent flyer bonuses,

McCoy suggests that an award recipient may be required to include only
the amount of income generated by using the price of a similar flight

on a less expensive airline because the lower price is the market price. ^^*

Furthermore, one tax commentator suggests that a different type of

frequent flyer bonus, an upgrade from coach class seating to first class

at no extra charge, should not be considered a taxable event because

it is minor, incidental, impossible to keep track of, and costs the airline

nothing extra. ^^^ By analogy, if the awarded bonus flight is a first class
flight, only the coach rate should be included in taxpayer's gross income.

An airline's willingness to upgrade seating^'*^ demonstrates that coach
fare is the market value of an airline trip; subjectively, the taxpayer

should not be charged more.

Finally, in Turner v. Commissioner,^^ the Tax Court held that

because a trip to South America could not be transferred to a third

"°Treas. Reg. § 1.61-2(d)(l) (as amended in 1979). "[I]f services are paid for in

property, the fair market value of the property taken in payment must be included in

income as compensation."

"'38 T.C. 841 (1962).

"Vfi?. at 844.

^"M at 843.
"VoT. at 844.

^''See id.

"^Cf. id. Fair market value is a price at which a commodity is available in the

marketplace; therefore, the lower priced airfare reflects fair market value. See id.\ see

also supra notes 38-46 and accompanying text,

"^Aidinoff, supra note 74, at 1348.

^The six major frequent flyer programs, American, Delta, Eastern, Pan Am, TWA
and United, all offer an upgrade to first class at 10,000 miles. This upgrade is the first

award available and 10,000 miles is the lowest number of miles that will win any award

in all of the programs. New Deals, supra note 5, at 170.
^'13 T.C.M. (CCH) 462 (1954).



850 INDIANA LAW REVIEW [Vol. 20:823

party, it was income only to the extent of its subjective worth to the

recipient. ^"^^ Because the taxpayers could prove the subjective worth of

the trip was very small and because they could not sell it, the court

held that an amount less than the fair market value of the trip should

be includible in the taxpayer's gross income.^^^ Similarly, if a frequent

flyer bonus flight is not readily transferable^"^"* and a traveler is being

issued a bonus of small subjective worth, ^"^^ receipt of the bonus should

only shghtly increase the recipient's gross income. However, this rule

will not reduce the employee's income recognition below the amount

for which the traveler could sell the bonus. 2"*^

VI. Wages or Not?—The Withholding Dilemma
If a bonus flight is included in the gross income of the employee

because it passes from the employer to the employee and cannot be

excluded under any of the previously discussed exclusionary sections,

the next question for consideration is whether or not the flights are to

be considered ''wages" under the Code. Generally, if any payment from

the employer to the employee is considered wages, the employer must

withhold social security and federal income tax on the payment. ^"^^ The

Code states that wages includes all remuneration, including non-cash
remuneration, ''for services performed by an employee for his em-

ployer.''^'^^ Case law helps delineate the difference between wages and

other types of income. ^"^^ In Royster v. United States,^^^ the Fourth

Circuit Court of Appeals rejected as overbroad the Internal Revenue

Service's contention that the primary question in determining whether

^^Id. at 463.

^'Id.

^'^See supra notes 44-46 and accompanying text. The fair market value of frequent

flyer bonuses upon their sale is somewhat constrained by the limits on their marketability,

such as airhnes that permit only same surname transfers. Toy, supra note 38, at 88.

^'Sherman, supra note 1, at 106. A travel agent states, "Many of our customers
tell us the last thing they want is more flying." Id.

^*^See supra notes 38-46 and accompanying text.

^l.R.C. § 3402(a) (Law. Co-op. 1986) states: "[EJvery employer making payment

of wages shall deduct and withhold a tax . . . ,"

^«I.R.C. § 3401(a) (Law. Co-op. 1986) (emphasis added). "For the purposes of this

chapter, the term 'wages' means all remuneration performed by an employee for his

employer, including the cash value of all remuneration (including benefits) paid in any

medium other than cash . . . .''Id.
^'Central 111. Pub. Serv. v. United States, 435 U.S. 21 (1978) (lunch reimbursements

not wages for withholding purposes); Allstate Ins. Co. v. United States, 530 F.2d 378

(Ct. CI. 1976) (indirect moving expenses not wages for withholding purposes); Royster

Co. V. United States, 479 F.2d 387 (4th Cir. 1973) (meal reimbursements not wages for

withholding purposes); Acacia Mut. Life Ins. Co. v. United States, 272 F. Supp. 188 (D.

Md. 1967) (convention trips not wages for withholding purposes).
"0479 F.2d 387 (4th Cir. 1973).



1987] FREQUENT FLYER BENEFITS 851

amounts were wages was to determine if amounts paid were "due to

the employment relationship."^^' The court held that not all payments

from employer to employee were necessarily wages subject to with-

holding.^" In another case, Acacia Mutual Life Insurance Co. v. United

States,^^^ the U.S. District Court for the District of Maryland stated

that it is the purpose of the employer that controls in determining

whether payments are wages. ^^^^ Therefore, if frequent flyer bonuses are

given as remuneration, they should be considered wages.

Furthermore, in Central Illinois Public Service v. United States,^^^

the Supreme Court held that withholding is a narrow concept and is

definitely not required unless a payment constitutes wages. ^^^ The Internal

Revenue Service wanted to enforce withholding on taxable lunch reim-

bursements paid to employees by their employer;^^^ although taxable to

the employees, the amounts were not wages because they were not

remuneration for services. ^^^ The Court conceded that if a payment was

considered to be wages the employer would be obligated to withhold, ^^^

but reasoned that there was a large gap between the premise that income

was taxable and the conclusion that the employer was therefore re-

sponsible for withholding simply because he made the payment.^^° There-
fore, if frequent flyer bonuses are wages in remuneration for services

rendered, the employer will be required to withhold on them; in contrast,

if the bonuses are by way of expense reimbursement or some other
payment not recognizable as wages, then the employer need not with-

hold. ^^^ Because the employer is usually allowing the employee to keep

the bonus flight as an incentive to produce,^^^ it is remuneration for

services performed. Thus, despite the employer's difficulty in tracking

the employee's receipt of frequent flyer bonus income, the bonus con-

^^'/c?. at 390. The court stated, "We are of the opinion that the term wages is
narrower than the term income as used in the provisions relating to how an individual
must treat payments to him. Wages are merely one form of income." Id. The court

continued, "We believe that the question here is whether the payments at issue were made
to the employees of Royster as remuneration for services performed." Id. The court held

that the lunch reimbursements were not attributable to the service of the employee because

the salesmen were not on call during lunch and received the lunch reimbursement whether

or not they made sales on that day. Id. at 391-92.

''^Id. Sit 390.

2^^272 F. Supp. 188 (D. Md. 1967).
^'^Id. at 195.

^"435 U.S. 21 (1978).

^'^Id. at 29.

^'Ud. at 23.

^''Id. at 28.

''^Id. at 25.

^"^Id. at 29.

^^'See id.

^^^See supra text accompanying notes 132-39.



852 INDIANA LAW REVIEW [Vol. 20:823

stitutes wages and it appears that the employer is required to withhold

on it.

However, although frequent flyer bonuses are wages because they

are remuneration for services performed for the employer, they are not

wages for the employer's withholding purposes because of a statutory

exception to the definition of the word "employer. "^63 Section 3401(d)

of the Code states that if the employer for whom the services were
performed does not have control of the payment of the wages, the payor

of the wages becomes the employer for the purposes of withholding. ^^^

Although redefining the word ^'employer" solves the employer's with-

holding difficulty, it appears to shift the burden of withholding to the

airlines, which are statutorily considered to be the "employer" because

they made the payments.^^^ Unfortunately, the airlines have an even
greater burden in withholding than the employer because the airline has

no information about the frequent flyer's status as an employee and

has none of the traveler's funds from which to withhold.

However, two 1970 Revenue Rulings discuss situations that are anal-

ogous to the frequent flyer bonus situation. In one ruling,^^^ the IRS

held that a distributor's award of "prize points" to its dealer's salesmen,

under a system that allowed salesmen to earn points toward cataloged

merchandise prizes to be sent directly to the salesmen, was income to

the recipient. 2^^ However, the IRS also held that the value of the points

awarded was not "wages" for withholding purposes. ^^^ In the second

ruling, ^^^ a manufacturer paid sales volume bonuses to its dealer's sales-

men even though it did not have control over the salesmen or a common
law employment relationship with them. The IRS held that section 3401(d)

did not require the manufacturer to withhold because the bonuses "are

^"I.R.C. § 3401(d) (Law. Co-op. 1986) states:

For purposes of this chapter, the term 'employer' means the person for whom
an individual performs or performed any service, of whatever nature, as the

employee of such person, except that—(1) if the person for whom the individual
performs or performed the services does not have control of the payment of

the wages for such services, the term 'employer' means the person having control

of the payment of such wages. . . .

^^Id.

^^'Notice that for gross income inclusionary purposes, the employer awards the bonus

when he allows the employee to keep a benefit that is an accession to the employee's

wealth and gross income because the employee did not pay for the underlying tickets and

so cannot treat the bonus as a volume discount. See supra text accompanying notes 122-

39. However, for employment tax purposes, the airline is considered to have awarded the

bonus because the Code redefines the word "employer" as being the person who controls
the payments. I.R.C. § 3401(d) (Law Co-op. 1986).

^^Rev. Rul. 70-331, 1970-1 C.B. 14.

^^'Id. at 15.

^^'Id.

^^^Rev. Rul. 70-337, 1970-1 C.B. 191.



1987] FREQUENT FLYER BENEFITS 853

not remuneration for services performed for the dealer who employs the
salesmen, but are remuneration for services rendered to the [manufac-

turer] and as such are not wages subject to withholding. "^^^

Similarly, for withholding purposes, the award of a bonus flight by

the airlines is not remuneration for services performed for the employer

who paid for the flights even though the employer's reason for allowing
the employee to keep the bonus may be remunerative.^^' Instead, by
awarding the bonus, the airline, with no right to exercise control over

the employee, is rewarding that employee for brand loyalty. ^'^^ Thus, it

appears that neither the airline nor the employer is required to withhold

on a frequent flyer bonus award.

VII. The Reporting Burden—Employee, Employer or Airline?
The final issue for consideration is who should be required to report

the gross income generated by the issuance and receipt of a frequent

flyer bonus to the Internal Revenue Service. Three possibilities exist: the

employee, the employer, or the airline could be required to report. First,

the employee could be responsible for the reporting function. Despite

the fact that it would be least burdensome for all parties to require the

employee to report, past experience shows that the individual is least

likely to comply with reporting requirements. ^^^ Therefore, the frequent

flyer should not be responsible for the reporting function.

^™Rev. Rul. 70-331, supra note 266, at 15 (interpreting Rev. Rul. 70-337, supra note

269). Rev. Rul. 70-337, supra note 269, explained the reasoning of the IRS as follows:

Section 3401(d)(1) of the Code provides in part, that if the person for

whom the individual performs or performed the services does not have control
of the payment of the wages for such services, the term "employer" . . . means

the person having control of the payment of such wages.

Under the fact presented, the [manufacturer] is not the employer of the

salesmen within the meaning of section 3401(d)(1) of the Code.

The "bonuses" paid to the salesmen by the [manufacturer] whether directly

or through an agent (the dealer), are not remuneration for services performed

for the dealer who employs the salesmen, but are remuneration for services
rendered to the [manufacturer]. Under the facts presented, the salesmen are not

employees of the [manufacturer] under the usual common law rule and, therefore,
the "bonuses" paid by it to the salesmen employed by the dealers are not wages

for the purposes of [withholding]

Id. at 192.

^^^See supra text accompanying notes 1312-39.

^^^Richer Rewards, supra note 1, at 89.

^^Tor example. Congress has found it necessary to implement many penalties for
individuals' failure to report and pay tax. E.g., I.R.C. § 6651 (Law. Co-op. 1986) (penalty

for failure to file return or pay tax); I.R.C. § 6653(a)(1) (Law. Co-op. 1986) (penalty

for neghgence or intentional disregard of the rules and regulations); I.R.C. § 6653(b)

(Law. Co-op. 1986) (penalty for fraud); I.R.C. § 6654 (Law. Co-op. 1986) (penalty for

underpayment of estimated tax); I.R.C. § 6661 (Law. Co-op. 1986) (penalty for substantial



854 INDIANA LAW REVIEW [Vol. 20:823

The second option is to require employers to report, however, em-

ployers are not required to withhold because the payment is received

from a third party. ^^'^ Similarly, the employer should not be required to

report because the payment is received from a third party. ^''^ Because

employers cannot track the employee's use of frequent flyer bonuses

without excessive cost in order to reclaim the bonuses from the em-

ployees,^"^^ it would be impossible to require an employer to track the

bonuses for reporting purposes. Therefore, the employer should not be

required to report the frequent flyer bonuses awarded by airUnes.

The third option, requiring the airlines to report, is the most practical

in terms of accessibility of information. The airlines already possess the

centralized records that would yield most of the information necessary. ^^^

Because the airlines send monthly statements to program participants'

homes showing the balance of miles flown and bonuses available,^^^ the

airlines must have the participants' names and addresses. Similarly, the

airlines must keep track of the amount and nature of bonuses awarded

to maintain the participants' mileage balances.^^^ Therefore, the only

additional information the airlines need to enable them to report is the

social security number of the recipient. ^^^

understatement of liability). Moreover, Congress has also implemented a multitude of

reporting and withholding requirements by payors of income. E.g., I.R.C. § 6041 (Law.

Co-op. 1986) (reporting of information at source); I.R.C. § 6042 (Law. Co-op. 1986)

(reporting of dividends); LR.C. § 6044 (Law. Co-op. 1986) (reporting of patronage

dividends); I.R.C. § 6045 (Law. Co-op. 1986) (reporting of broker and barter transactions);

I.R.C. § 6049 (Law. Co-op. 1986) (reporting of interest); I.R.C. § 6050E (Law. Co-op.

1986) (reporting of state and local income tax refunds); I.R.C. § 3402(o) (Law. Co-op.

1986) (withholding on supplemental unemployment compensation, annuities and sick pay);

I.R.C. § 3402(q) (Law. Co-op. 1986) (withholding on gambUng winnings).

^^'•I.R.C. § 3401(d) (Law. Co-op. 1986); see supra note 263 and accompanying text.

^''^See id. If an employer is not required to withhold because the payment is made

by a third party, then the employer should not be required to report because the payment

is made by a third party. See also infra note 263 and accompanying text.

^'^^E.g., Who?, supra note 38, at 77; Sherman, supra note 1 at 108. Travel agencies

have created services to track the number of bonus miles flown by getting information

from the airlines and matching it to employer's employee hstings. There has been little

demand for the services, apparently because of high cost and employee relations aspects.

See also supra text accompanying notes 132-39.

^'^^E.g., United Airlines, Inc., Mileage Plus Program Guide 6 (1987). United sends
a monthly statement if activity is recorded in a frequent flyer's account. Included is a

detailed listing of mileage activity and Bonus Bank activity.

'''Id.

'^^Id. For discussion of problems related to fair market value of the bonus, see supra

text accompanying notes 241-46; see also infra text accompanying notes 281-87.

^«°C/. I.R.C. § 6042 (Law. Co-op. 1986) (reporting of dividends); I.R.C. § 6044

(Law. Co-op. 1986) (reporting of patronage dividends); I.R.C. § 6045 (Law. Co-op. 1986)

(reporting of broker and barter transactions); I.R.C. § 6049 (Law. Co-op. 1986) (reporting

of interest). Reporting requirements for all of these payments consist of name, address,

social security number, and amount.



1987] FREQUENT FLYER BENEFITS 855

Furthermore, there is precedent for requiring the airhnes to report

the total amount of bonus awarded, regardless of taxability, by com-
parison with the reporting requirements for patronage dividends. A
member of a farmer's cooperative earns monetary patronage dividends
due to purchases and sales entered into by the cooperative. ^^^ State statute

requires that the cooperative, a non-profit organization, share its profit

with its members through patronage dividends. ^^^ Dividends paid because
of the member's purchase of personal or depreciable assets are not gross

income to the recipient.^^^ Other dividends earned on the member's sales

through the cooperative and by sales the cooperative makes to non-

members are treated as gross income by the recipient. ^^^^ However, for
reporting purposes, the cooperative is not required to determine which

amounts are income to the member.^^^ Instead, the cooperative is required

to report the amounts to its members and the IRS.^^^ The members are
responsible for allocating the dividends into taxable and non-taxable

portions. ^^^ A similar system should be adopted for the reporting of
frequent flyer bonuses because the airline would not be responsible for

deciding who received income. Instead, it would only be responsible for
preparing a statement for everyone who received a frequent flyer benefit.

Finally, if the airUne reports the fair market value of frequent flyer

bonuses awarded, the treatment of frequent flyer bonus income will be

consistent with the *' Information at Source" reporting requirements of

the Code.^^^ Under these requirements, payments of $600 in any year

2*'Internal Revenue Service, Department of the Treasury, Pub. No. 225, Farm-

er's Tax Guide 10 (1983) [hereinafter Farmer's Tax Guide].
^'^Ind. Code § 15-7-l-13(f) (1982). This section provides that all net earning or savings

in excess of amount needed to restore a deficit, pay stock dividends and maintain reserves

shall be distributed on a patronage basis, either to members and non-members or to

members only.

^"Farmer's Tax Guide, at 10.
^^*See id. See generally The Indiana Farm Bureau Cooperative Association Inc.,

Cooperatives The American Way \\ 8-10; The Indiana Farm Bureau Cooperative
Association Inc., Facts 11 8, 12-15.

285Xreas. Reg. § 1.6044-5(b)(l) (as amended in 1977). The statement shall "[s]how

the aggregate amount of payments shown on the return as having been made to such
persons. ..."

286Treas. Reg. § 1.6044-3 (1962) (lists amounts required to be reported to the IRS

by cooperative organizations).

"^'See Treas. Reg. § 1.6044-5 (b)(1) (as amended in 1977).

^««I.R.C. § 6041(a) (1986) states:

All persons engaged in a trade or business and making payment in the course

of such trade or business to another person, of rent, salaries, wages, premiums,

annuities, compensations, remunerations, emoluments, or other fixed or deter-

minable gains, profits and income ... of $600 or more in any taxable year

. . . shall render a true and accurate return . . . setting for the amount . . .

and the name and address of the recipient of such payment.



856 INDIANA LAW REVIEW [Vol. 20:823

must be reported at the source of the payment by the payor. ^^^ When
it awards a bonus, the airUne is the preUminary source of the bonus

and is making a payment in connection with its trade or business because

the bonuses are paid and deducted by the airhne as a promotional

expense. ^^° Thus, the aidine should be required to send information

statements to the recipient and to the Internal Revenue Service in order

to be consistent with other information at source requirements. Also,

the airline is in a better position to report than the employer because

the airline is reporting information already collected in the course of

everyday transactions.

VIII. Conclusion

Frequent flyer bonus awards are not income to a person who pur-
chases the underlying flights because the bonus should be considered to

be a rebate or volume discount taken over time. Therefore, no income

is realized by frequent flyers who buy their own tickets to earn flights.
Furthermore, generally, if the purchaser of the underlying flights transfers

an earned bonus to a third party, the purchaser of the underlying flights

will recognize income only to the extent of any compensation received

for the bonus given up.

If, however, the
*

'purchaser" of the underlying flights is an employer,

and if the employee who earned the mileage credit is allowed to retain
the bonus, the employer should properly be considered the purchaser

because without the employer's payment for the underlying tickets, the

bonus could not have been earned. Therefore, the employer has "trans-

ferred" the bonus to the employee even if the employee receives it

directly from the airline. Furthermore, the employment relationship re-

quires that the employee recognize gross income to the extent of the

fair market value of the bonus received as adjusted by the subjective

worth of the bonus to the employee. Because the courts have consistently

been reluctant to infer gratuitous motives to the employment relationship,

the bonus has been transferred to the employee as a form of remuneration

and not as a gift.

The income thus allocated to an employee by the receipt of a bonus
flight for personal use cannot be excluded under the gift or prize and

award exclusionary sections of the Code. Furthermore, despite the fact

that a literal reading of the de minimus fringe benefit rules implies

exclusion, Congress' intent when they promulgated the rules indicates
that the inclusive gross income concept requires the recognition of the

bonuses as income.

'''Id.

'"^See supra notes 16-21 and accompanying text.



1987] FREQUENT FLYER BENEFITS 857

If bonus flights are transferred to the employee for the purpose of

"remuneration for services performed" instead of for some other business

purpose, frequent flyer bonuses are not simply income; they are also

"wages." However, because of the statutory exception that an employer

who is not in control of the payment of the wages cannot be an employer
for the purposes of withholding on those wages, the employer is not

required to withhold on the income generated. The airline is not required

to withhold, either; it does not meet the common law definition of
employer because it has no control over frequently flying business trav-

elers. Thus, neither the employer nor the employee is required to withhold

on the amount received as a frequent flyer bonus.

Finally, the recipient should not be required to report the income

received. Past experience shows that irregularities in tax treatment would

result as income recipients often do not properly report income received.

Similarly, the employer should not be required to report because acquiring

the necessary information would be too burdensome. Therefore, because

most of the information required for reporting has been accumulated

by the airlines, it is logical to put the burden of reporting the amount

of income due to the awarding of frequent flyer benefits on the airlines.

Kathryn Symmes Hall