Avoiding Pitfalls When Combining Business and Personal Travel

By George G. Jones and George L. Yaksick Jr.

The recent news that the Internal Revenue Service will not treat frequent flyer miles as taxable income may spur a lot of people to redeem their miles and take a vacation or use the miles to bring spouses, significant others, children or friends along on business trips.

But travel expenses are more complicated than that. Not only are they held to the usual standards set forth for business expense deductions under Internal Revenue Code section 162, but many of these expenses are held to an even higher standard of necessity and proof, which is spelled out in a separate Code provision—section 274(d). A lot of people want to combine business and personal travel and do not understand why a “business” trip isn’t automatically fully deductible.

When spouses, significant others, children and friends travel too, the dynamics of a trip can change and the tax treatment correspondingly can change. So before continuing to rack up those miles and fly the friendly skies, it’s a good time to take stock of the general rules about travel expenses. Otherwise, your client may end up paying for some of those miles in the form of increased compensation income or lower allowable travel expense deductions.

Frequent Flyer Miles

Over the past few years, there was a great deal of speculation that the IRS would tax frequent flyer miles. However, skeptics pointed to the potential administrative nightmare and predicted the IRS would not act on them, as miles earned from business travel but used for personal travel would have to be valued and separated from miles earned from personal travel.

Approximately six years ago, the IRS determined that frequent flyer miles, converted to cash, constitute taxable income, and the Tax Court and the Ninth Circuit Court of Appeals agreed. In Charley v. Commr., 91 F3rd 72 (1996), the taxpayer bought tickets for coach travel but charged his employer for first class tickets. He used his frequent flyer miles to upgrade from coach to first class. His travel agent credited the difference between the prices of the coach and first class tickets, and the “sale” of his miles earned him about $3,000. His “earnings” were taxable as income.

New Treatment

Many thought Charley was a prelude to a more aggressive posture by the IRS on taxing frequent flyer miles, but not much happened afterwards. Unofficially, the IRS took a hands-off approach and never gave a definite answer until now.

The new rule is simple and a continuation of the unofficial policy. The IRS will not assert that an individual owes tax because of the receipt of frequent flyer miles earned from business travel. That includes official government travel.

However, the IRS did not surrender any ground from its win in Charley. Individuals who convert frequent flyer miles to cash must include the amounts in their income. The same rule applies to compensation paid in the form of travel. Because of Charley, therefore, there can continue to be a different tax result based simply on how frequent flyer miles are handled between an employer and an employee.

Letting an employee keep his or her miles for personal travel will be tax free to the employee and without a tax cost to the employer. Requiring the same employee to use them for his next business flight in return for his employer paying his airfare later in the year for a vacation flight produces a different result. The employer gets a deduction either way: as an additional travel expense or as additional payroll. The employee, however, only realizes income if the employer pays directly for his vacation flight instead of allowing him to keep his miles.

Primary Purpose Must Be Business

Now that your clients can use their business miles for personal trips, they may want to combine their pleasure trips with business. While this sounds tempting, the combination is a red flag for the IRS. Nevertheless, having an employee give up some of his personal time on a “free” miles trip to conduct business could prove to be enough of a win-win situation to make sense to some clients.

Travel expenses of a trip (e.g., transportation, lodging and meals) that is primarily personal in nature are not deductible, even though the taxpayer engages in some business activities while at the destination. However, expenses incurred while at the destination that are properly allocable to the taxpayer’s trade or business are deductible. Therefore, if, during a vacation in which frequent flyer miles are used, the employee meets with a business prospect over lunch, the direct cost will be deductible by the business and tax free under proper reimbursement procedures to the employee. Unfortunately, however, the rules won’t allow a business expense deduction to cover more than that (e.g, one day of lodging or meals) even if one or two full days is spent on business. The trip must be considered “substantially for business” for those expenses to be deductible.

First class and educational trips also generate confusion:

• The cost of first class travel can be deductible if it is reasonable. Reasonableness is measured by custom in the industry as well as by the potential that a particular trip has for profit. Generally, however, the IRS will not question the cost of first class airfare as long as the business’s revenues are substantial.
  
• Travel merely for the sake of education is not deductible, but if the educational activity enhances an individual’s employment skills, the costs may be deductible. Generally, there must be evidence of a direct relationship between the educational activity and the skills required in an individual’s employment.
  

Taxpayers should not take the IRS’ recent concession on frequent-flyer miles as a signal that the general rules for travel expenses have been relaxed. Whether done on flyer miles or on the business’s expense account, travel and entertainment expenses will continue to be held to a standard of proof and relevance higher than “ordinary” business expenses and the IRS will continue to see this area as one to harvest in any tax examination.