Competition for new banking customers, where larger and more enticing rewards are dangled to lure new clients, has added a new player in the rewards game -- the IRS.
Depending on how you obtain them, rewards may be taxable as income, according to tax experts and the Internal Revenue Service. People who covet and collect rewards can rest easy. The traditional rewards points earned when making purchases with credit cards or debit cards are still tax-free.
Rewards that are given away as part of new banking account recruitment drives are considered income and can be taxed. If the value of those taxable rewards is more than $600, banks are required to send 1099 tax notices to both the IRS and the rewards recipient. Depending on the taxpayer's deductions, tax bracket and other income, the rewards bonus could turn into a tax bite.
"The game changer on all of this in my opinion is the scope, the size, the simple magnitude of the gifts is all increasing," says Mark Steber, chief tax officer for Jackson Hewitt, the nationwide tax preparation service.
Reeling from lost revenues, banks offer bigger rewards
U.S. banks are desperate for new business to shore up revenues lost in a series of blows over the past two years from federal regulators. Gone are billions in revenues from checking account overdraft fees, late payment fees, over-limit credit card fees and fees collected from merchants whenever cardholders swiped their debit cards.
Offering juicy rewards packages has become a popular way to recoup lost revenues. The most tempting offers dangle 25,000 to 40,000 or more in rewards miles or points to new customers.
"Competition for customers, their services, their deposits or their purchases on their credit cards" is driving the rewards escalation, Steber says. "It's garnering more attention because they are becoming larger. People are trying to outdo one another."
Two kinds of rewards treated differently
Taxations of rewards points hasn't been an issue before now for two reasons. First, the type of rewards considered income rarely came close to the IRS's mandatory $600 reporting threshold. Second, the type of rewards most people receive -- and hoard to redeem for big trips or merchandise -- have been earned as the result of the consumer making purchases with a credit or debit card.
"Rewards and airline miles that are provided in connection with a purchase on a credit card are routinely not subject to individual income tax reporting," Citi spokeswoman Emily Collins, said in an e-mailed statement.
On the other hand, "When a customer receives a gift for opening a bank account -- whether cash, a toaster or airline miles -- the value of that gift is generally treated as income and subject to tax reporting. This is separate and distinct from miles or points earned by our credit card customers for their purchases," Collins says.
Citi sends out 1099s
Citi drew attention to the issue last week because it is sending out 1099-MISC notices to customers who took advantage of a 2011 Citi promotion that offered 25,000 American Airlines frequent flier miles to anyone who opened a new bank account.
One of the customers who signed up reportedly got a 1099 notice showing $645 in "income" from the frequent flier miles. The customer claimed it was a surprise, but Citi's standard disclosure found in the terms and conditions of its promotions and on its ThankYou rewards program website has this nugget:
"In accordance with U.S. tax law, Citibank may be required to send to you and file with the IRS a Form 1099-MISC (Miscellaneous Income) for the year in which a reward is issued to you. The valuation of ThankYou Point redemptions for Form 1099-MISC tax reporting purposes will be at Citibank's sole discretion. You are solely responsible for any personal tax liability arising out of the redemption of ThankYou Points."
The IRS confirmed that Citi was correct in sending out the 1099 for giving away miles as a sign-up bonus.
"When frequent flier miles are provided as a premium for opening a financial account, it can be a taxable situation subject to reporting under current law," IRS spokeswoman Michelle Eldridge said in a statement e-mailed to CreditCards.com. "If taxpayers have questions about the information they receive on a Form 1099, they should follow up with the issuer or their tax professional to resolve any questions about valuation, timing or other issues regarding the income reported."
Customers who have more than one account with a bank or who received multiple rewards for different promotions would receive a 1099 for the total amount received during the tax year. As Eldridge points out: "The IRS also notes that information on a particular Form 1099 may include various different sources of income from the issuer."
Tax experts said 1099s for rewards points are rare. Citi's 1099s likely impacted a very small percentage of its total customers.
"I have yet to see anyone get a 1099 for a rewards program," says Eric L. Green, a tax attorney with the Convicer & Percy law firm in Connecticut. "Effectively, they've given you something of value. That, in theory, would be income."
Anyone who receives a 1099 from their lender for rewards should not ignore the notices. As Steber points out, the IRS is much more sophisticated today at tracking income. If the 1099 income is not reported on a tax return, that can trigger an IRS letter and the potential for a penalty.
Traditional rewards still tax-free
Traditional rewards that many rewards card users have come to love are still safe and tax free because they are tied to purchasing something with a payment card. Many of the promotions currently on the market offer rewards points to sign up for credit cards with a caveat that the applicant must make a minimum amount of purchases within the first few months of opening an account. Those rewards are contingent upon spending.
Says Steber: "It's considered a reimbursement of the fees that you're paying in association with being a member. It's a rebate of your fees. That's the way a great many rewards programs are set up."
If, however, the reward isn't tied to purchases, it is in the same category as a car you might get from TV talk show host Oprah Winfrey or your winnings from the church raffle. If more than $600, those "gifts" must be reported by the givers to the IRS on a 1099 tax form.
When Winfrey famously gave her entire studio audience new cars in 2004, it caused tax angst for some recipients. "The IRS said those are taxable property windfalls," Steber says. "That's what this [rewards gift] falls into."
"Who would have thought that winning a car on 'The Price is Right' or "Oprah" would be taxable?" Steber says. "But if you win a car, then you could owe $7,000" -- a rough estimate on taxes for an average new car.
Many banks don't bother with 1099s for rewards
Several major banks contacted by CreditCards.com said they let the customer figure out the tax implications of their rewards.
Wells Fargo doesn't offer rewards points for signing on for new credit cards, says spokeswoman Lisa B. Westermann. "Our giveaway for opening a checking account is usually a plush pony, which wouldn't require a 1099," she says.
Wells Fargo's disclosure reads: "Any tax liability, including applicable state sales tax and state and federal disclosures, connected with the receipt or use of a reward is your or the reward recipient's responsibility."
At Discover Financial Services, customers earn cash back bonuses when they use their Discover More and Open Road cards. The bonus points can be redeemed for statement credits, gift cards, merchandise or to donate to a charity.
"With our Discover Miles Card, you earn mileage points," says spokesman Matthew Towson. "Every 10,000 miles you earn can be redeemed for $100 off an airline ticket or miles can be redeemed for gift cards." He added: "The cash back bonus a card member receives is not taxable according to the tax code. It is, in effect, considered a rebate, so there are no tax implications."
Another sticky point about taxable rewards is how they are valued. How much does 25,000 in airlines miles equate to in dollars? Citi's policy says: "The valuation of ThankYou Point redemptions for Form 1099-MISC tax reporting purposes will be at Citibank's sole discretion."
Steber from Jackson Hewitt says the valuation is "complicated on a good day ... You value it when you have the unrestricted right to it or when you have unrestricted use of it. What are miles worth? They may not have any readily ascertainable value."
Americans underreporting income
Steber says the rewards income issue is part of a larger problem with Americans underreporting their sources of income. The only reason many people report income such as winnings or prizes or rewards is because a 1099 is sent to the IRS documenting the gift. If the $600 threshold for required reporting isn't met, the IRS is in the dark about how much taxpayers receive in this manner.
However, taxpayers should report any income they receive. Many don't. According to a study released Jan. 6, 2012, by the IRS, underreporting of income was the biggest contributor to the tax gap in 2006. That gap is defined as the difference between what Americans owe in taxes and how much they actually pay. In 2006, the most recent year available from the IRS, that gap stood at $450 billion. Of that, $68 billion was from underreported personal income.
"If you receive income from your eBay job or your bank or your employers, that's generally taxable," Steber says.
See related: 1099-C surprise: IRS tax follows canceled debt
- Reward point 'gifts' are taxable, says the IRS
- 6 reasons card rewards go unredeemed -- and how to change that
- 8 wise ways to rack up rewards while holiday shopping
- credit cards