The tax consequences of point-based employee reward programs.

• Author: Takacs, Natalie Bell

The incentive merchandise and travel industry has experienced rapid growth in recent years. According to a study released by the Incentive Federation in 2007, the amount spent on incentive merchandise and travel in 2006 was $46.1 billion--almost double the $26.9 billion spent in 2000. (1) The study found that more than one in three U.S. companies used incentive travel or merchandise to recognize or motivate employees and that one of the biggest trends in the incentive industry was the popularity of incentive programs for nonsales employees. In 2000, nonsales employee programs accounted for just 13% of incentive spending, but by 2006 such programs accounted for nearly one-third of all incentive spending. One of the fastest-growing formats for incentive spending is point-based employee recognition programs.

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Modeled on the affinity programs sponsored by airlines, credit card companies, and banks, an effective point-based employee recognition program is highly visible and can help create a culture of reward and recognition, even on a lean budget. In a typical program, managers are allocated a certain number of points on a monthly basis that can be awarded to employees for accomplishments that help meet the employer's business objectives. Employees accumulate points, which they can redeem for merchandise in an incentive catalog. Common rewards include gift certificates, merchandise, and travel awards. Because they can spontaneously award points, supervisors are able to recognize even small acts, which helps to foster a culture of recognition.

As Michael Levy, president of Online Rewards, a Dallas-based incentive solutions provider, explained, "The constraints of general remuneration and compensation plans make it difficult for companies to develop innovative employee rewards programs for the mainstream. Noncash (i.e. travel or merchandise rewards) provides significantly greater flexibility and the option for creativity as it applies to developing performance-based employee rewards programs." (2) Levy has also observed that "even with the downturn in the economy, top executives at many of the Fortune 500 companies are recognizing the opportunity of investing valuable resources into creating a culture of reward and recognition in their organizations. Managers are realizing that it is important to engage their existing workforce now, so that when the economy does improve, their employees choose to stay because they feel valued." (3)

Incentive solutions providers can not only assist employers in designing and implementing recognition programs but can also administer programs for them. Providers can customize programs for the employer, and employees are often provided internet access to their accounts, where they can review available rewards and redeem points. The incentive solutions providers generally give employers a summary of the rewards that have been redeemed by their employees and will invoice employers for the cost of such rewards. It is the employer, however, who is responsible for the payroll tax consequences associated with the programs.

The specific provisions of a reward program will determine its tax consequences. Some programs may be structured to provide nontaxable benefits in the form of employee achievement awards under Sec. 74(c), which permits an employee to exclude from gross income the value of tangible personal property awarded for length of service or safety if the cost to the employer of the award does not exceed $400. A trucking company, for example, may find a program designed on the safety criteria of Sec. 74 to be highly effective in motivating its drivers.

Other programs may be structured to provide nontaxable fringe benefits under Sec. 132 (e.g., no-additional-cost services, qualified employee discounts, working condition fringe benefits, de minimis fringe benefits, qualified transportation fringe benefits, qualified moving expense reimbursements, qualified retirement planning services, and on-premise gyms and athletic facilities). For example, a hotel chain might design a program that awards free lodging (a no-additional-cost service) to employees on a nontaxable basis. (It should be noted, however, that some nontaxable fringe benefits are subject to nondiscrimination requirements, which if not satisfied will cause benefits provided to highly compensated employees to become taxable. A failure of the nondiscrimination requirements, however, does not affect the non-highly compensated employees who receive benefits or the employer's deduction for the cost of the benefits.) Most employers, however, will find that the narrow benefits permitted under Sees. 74 and 132 cannot effectively achieve their goals and therefore will opt for an alternative plan design, even if it causes the benefits offered under the plan to be taxable. This article explores the tax consequences of such taxable programs.

Existing Revenue Rulings

The IRS has issued at least two rulings on the compensatory use of items redeemable for noncash rewards of the employee's choosing. In Rev. Rul. 68-365, (4) a corporation adopted a stamp plan and began giving stamps, instead of money, to its employees in payment of commissions. The stamps, commonly referred to as trading stamps, had a distinctive printing and color, were the same as stamps distributed by local merchants when making retail sales, and were redeemable for merchandise at designated redemption centers established by the supplier of the stamps. The question presented in the ruling was whether commissions paid in trading stamps are within the definition of "wages."

The revenue ruling noted that the term "wages" means all remuneration for employment, including the cash value of all remuneration paid in any medium other than cash, with certain exceptions not here material. It went on to note that "the applicable Employment Tax Regulations [Regs. Sees. 31.3121(a)-1(e), 31.3306(b)-1(e), and 31.3401(a)-1(a)(4)] provide, in part, that when remuneration is paid in items other than cash, the remuneration is computed on the basis of the fair value of the items at the time of payment."

Accordingly, Rev. Rul. 68-365 concludes that the fair value of trading stamps distributed by the corporation to its employees in payment of the commissions is includible in wages for purposes of the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, and the Collection of Income Tax at Source on Wages.

In the facts of Rev. Rul. 70-331, (5) a distributor issued "prize point checks" redeemable for merchandise to salesmen-employees of his dealers. Each salesman-employee selected the merchandise award he desired and sent an order form together with sufficient prize point checks to cover the order to the distributor. The merchandise award was sent directly to the salesman. The ruling held that the fair market value (FMV) of the prize points was includible in the employees' gross income at the time the prize points were paid or otherwise made available to them, whichever was earlier.

Observation: Although it does not appear that the prize points in Rev. Rul. 70-331 were transferable, the IRS failed to distinguish them from the trading stamps in Rev. Rul. 68-365. While the trading stamps in Rev. Rid. 68-365 were "the same as stamps distributed by local merchants when making retail sales, and ... redeemable for merchandise at designated redemption centers established by the supplier of the stamps," and the IRS appears to have viewed them as cash equivalents (e.g., taxable upon receipt), it is the author's opinion that the prize points in Rev. Rul. 70-331 were not cash equivalents, and therefore Rev. Rul. 70-331 should have contained a thorough analysis of the time at which income should be recognized (e.g., whether the points were taxable at grant or whether the merchandise was taxable when received) and the related issue of valuation.

Years ago, the IRS faced similar timing and valuation issues in attempting to tax the personal use of frequent flyer miles attributable to business travel. Not surprisingly, in its initial guidance regarding frequent flyer miles in a business context, (6) the IRS ruled that frequent flyer awards earned on business trips should be treated as taxable income. Critical commentary followed the issuance of this guidance, and seven years later, while not conceding that frequent flyer miles are not income, the IRS issued Announcement 2002-18, (7) which stated that it would not impose understatement liabilities on taxpayers on account of the receipt or personal use of frequent flyer miles or other in-kind promotional incentive attributable to a taxpayer's business or official travel.

In issuing this moratorium on the taxation of frequent flyer miles, the IRS acknowledged the "numerous technical and administrative issues relating to these benefits on which no official guidance has been provided, including issues relating to the timing and valuation of income inclusions and the basis for identifying personal use benefits attributable to business (or official) expenditures versus those attributable to personal expenditures." The IRS did state, however, that this moratorium is to be narrowly construed and does not apply to travel or other promotional benefits that are converted to cash, compensation that is paid in the form of travel or other promotional benefits, or other circumstances where these benefits are used for tax avoidance purposes.

As provided in Rev. Proc. 89-14, (8) published revenue rulings do not have the force and effect of IRS regulations. In Mead Corp., (9) the Supreme Court held that an administrative agency's interpretation of a statute contained in an informal rulemaking must be accorded the level of deference set forth in Skid-more v. Swift & Co. (10) In the Skidmore case, the Court held that the deference required depends on the "thoroughness evident in [the agency's] consideration, the validity of its...