Court Clarifies Tax Treatment of Loyalty Programs

Programs involving third-party vendors providing rewards, like hotels, airlines, and fuel companies, can amass substantial value over time. The term “substantial” is an understatement. “Massive” is more fitting.

The tax law for these arrangements is not clear as it touches on concepts like trust funds, accounting methods, and redemption deductions. Given the size of the amounts involved and the uncertainty of the tax laws in this area, court cases that touch on these issues warrant close attention.

The recent Hyatt Hotels Corporation v. Commissioner, T.C. Memo. 2023-122 case is an example. Hyatt narrowly avoided a massive tax adjustment, and, in doing so, it has created an unfavorable legal precedent that alters the tax landscape for most large loyalty programs. The case is one that those who have loyalty programs will have to address and those planning loyalty programs will have to consider when planning their programs.

Facts & Procedural History

Hyatt operated a customer loyalty program. Its guests could participate and be members of the program. The program allowed guests who stayed at Hyatt’s owned and branded hotels to earn reward points based on their spending. Members could later redeem accrued points for free nights or other benefits at Hyatt participating hotels and other contractually-bound vendors.

When guest members earned points for a stay, Hyatt required the hotel owner, which was often not Hyatt, to pay 4% of the member’s hotel spending into a fund. When members redeemed points, Hyatt would pay compensation to the hotel owner out of this fund. Hyatt controlled the fund amounts, investing portions and using the balance to pay for advertising and administrative costs related to the program.

For income tax purposes, Hyatt treated the fund as not taxable on the basis that it was merely holding the amounts on behalf of hotel owners.

On audit by the IRS for the 2009 through 2011 years, the IRS disagreed with Hyatt and asserted the amounts paid to the fund were taxable income to Hyatt. Litigation ensued–and culminated in this decision in 2023.

The Trust Fund Doctrine

The first question for the court was whether revenue paid to Hyatt’s customer loyalty program fund was taxable income to Hyatt.

The court started with the “trust fund doctrine.” This is a concept found in the Seven-Up Co. v. Commissioner, 14 T.C. 965, 979 (1950) court case.

The trust fund doctrine is an exception to the general rule that all gross receipts are taxable income. Under this doctrine, if certain criteria are met, a taxpayer may exclude funds received in trust from gross income.

The key elements of the trust fund doctrine are:

• The taxpayer receives funds in trust that are subject to a legally enforceable restriction requiring them to be used for a specific purpose.
• The taxpayer does not profit, gain, or benefit from spending the funds for that purpose (beyond an incidental benefit).
• The taxpayer is merely a conduit or custodian holding the funds for the benefit of others.

If these elements are met, the taxpayer is not considered the beneficial owner of the funds for tax purposes. The funds are excluded from the taxpayer’s income as if it were holding them in trust for another party.

In the Seven-Up case, the taxpayer sold extract to third-party bottlers, who did not own the Seven-Up brand. The bottlers sold the finished soda to end users. So the advertising fund in Seven-Up directly benefited those third-party bottlers first by increasing bottler revenue. Any benefit to the taxpayer was secondary, through increased sales of extract to the bottlers.

The facts were different in Hyatt. During the years at issue, Hyatt owned 20-25% of the hotels itself, unlike the taxpayer in Seven-Up. So when Hyatt used the loyalty program funds for advertising, it directly benefited itself as an owner by generating more revenue at its owned hotels. This differentiated Hyatt from a mere secondary beneficiary.

Because Hyatt owned a significant number of hotels and directly benefited from using the funds for advertising, the court found the amounts paid into the program were taxable income to Hyatt. This direct benefit to Hyatt as a hotel owner was a key factual difference from Seven-Up that led the court to find that the amounts paid to the fund were taxable for Hyatt.

Not an Accounting Method

While the IRS won on this first issue of taxability of the amounts paid in, its victory may be somewhat limited as Hyatt got away with a “windfall” according to the IRS.

The IRS argued that Hyatt’s failure to report the income was an accounting method change and, as a result, the IRS could adjust all later years by making a catch-up adjustment in the current year. The court did not agree with the IRS on this.

This is a timing concern that goes to what years the IRS can go back and tax this income. Hyatt’s rewards program was started by Hyatt in 1987. The IRS only proposed this tax adjustment in three years–2009 through 2011. The IRS did not even propose an adjustment for the post-2011 tax years, apparently.

So consider this example, a hotel made payments to Hyatt back in the late 1980s and Hyatt did not report that income. The statute of limitations has passed for the IRS to impose tax on that old income. Now, years later, Hyatt pays out an expense funded by that old untaxed income. Even though the income was never taxed, Hyatt can take a full deduction for the payout. And one wonders if the third parties may also take a deduction for the same expense.

This results in Hyatt permanently avoiding tax on the income that funded the deductible expense. The IRS is prevented from fixing this mismatch because the statute of limitations has passed on the original unreported income.

Trading Stamp Companies

While the IRS did not fully prevail in the Hyatt case itself, the court’s denial of the trading stamp method could have wide-ranging implications. This method allows taxpayers like hotel and airline loyalty programs to immediately deduct estimated future redemptions–a huge tax benefit.

By holding that hotel stays do not qualify as “property,” the court potentially jeopardized this treatment for hospitality and travel industry loyalty programs. The IRS will likely use this ruling to challenge other major hotel and airline companies that currently rely on the trading stamp method.

The tax revenue at stake is massive given the size of today’s loyalty programs. For instance, Marriott’s Bonvoy program or American Airlines’ AAdvantage program has hundreds of billions of outstanding points. Disallowing the trading stamp method would significantly reduce their tax deductions.

So while a mixed result for the IRS here, the court’s strict interpretation of the trading stamp method could ultimately let the IRS score a very large tax victory against the largest loyalty programs. Hyatt likely opened the door for the IRS to challenge this longstanding tax provision.

The Takeaway

This court case highlights how to structure a loyalty program to take advantage of the trust fund doctrine. This is a narrow exception that can allow companies holding customer funds in loyalty programs and similar arrangements to avoid paying taxes. This is even more important for those who provide services, such as hotels, given the court’s holding on trading stamp company method. Programs that cannot use the trading stamp method must consider these rules or they could trigger significant tax liabilities.