Tax Court rules reward program funds are income

The Tax Court has ruled in Hyatt Hotels Corporation & Subsidiaries v. Commissioner (T.C. Memo. 2023-122) that contributions Hyatt collected for a fund to redeem reward points should be included in income. This case could have implications for other taxpayers with similar reward program structures.

The case addressed a customer rewards program (Program) operated by Hyatt that provided customers staying at Hyatt hotels with reward points redeemable for free future stays. Hyatt-branded hotels comprise both Hyatt-owned hotels and locations operated by Third Party Hotel Operators (THPOs). Under the program, Hyatt required hotel owners to make payments into an operating fund (Fund) whenever customers received rewards points for a stay at a Hyatt hotel. When a customer redeemed rewards points for a stay, Hyatt compensated the hotel owner out of the Fund.

The Fund was held by Hyatt. Portions of the Fund's unused balance were invested by Hyatt in marketable securities.  Hyatt also used the Fund to pay administrative and advertising expenses that it determined were related to the Program.

For federal income tax purposes, Hyatt ignored the amounts paid into the Fund, specifically excluding the revenue from its gross income and claiming no deductions for expenses paid, in accordance with its belief that it was merely a trustee, agent, or conduit for the hotel owners instead of a true owner of the Fund.

The Tax Court considered several issues related to the structure and held the following:

• The amounts received related to the customer reward program are revenue includible in gross income
• The treatment of the revenue was not a method of accounting subject to a Section 481 adjustment
• Hyatt could not adopt the trading stamp method

Gross income

Section 61 broadly defines gross income as all income from whatever source derived. However, several exclusions exist, including the trust fund doctrine, which Hyatt asserted as a justification for the exclusion of the Fund from federal income tax. The trust fund doctrine established in Seven-Up Co. v. Commissioner (14 T.C. 965 (1950)) allows a taxpayer to exclude trust funds from gross income when a taxpayer (1) receives funds in trust, subject to a legally enforceable restriction that they be spent in their entirety for a specific purpose and (2) does not profit, gain, or benefit from spending the funds for that purpose.

The Tax Court noted that the taxpayer payments in Seven-Up were not includible in gross income because of the fully offsetting restriction on Seven-Up’s ability to use the funds and the fact that the benefit flowed directly to third parties and only indirectly to Seven-Up. The Tax Court distinguished Hyatt’s situation because Hyatt, without oversight of input from the TPSOs:

• Mandated that the TPHOs participate in the Program and pay into the Fund
• Controlled the amounts of Program payments in and compensation payments out of the Fund
• Decided how to invest the Fund
• Accrued interest and realized investment gains from holding the Fund
• Determined whether particular advertising or administrative costs would be paid for by the Fund

The Tax Court held that the Hyatt’s significant control indicated a beneficial interest instead of a legally enforceable restriction. The Tax Court also found that Hyatt directly benefited from the Fund because the Fund benefited Hyatt-owned hotels, compensated Hyatt for advertising costs and ultimately generated goodwill among customers leading to increased bookings, as well as increases in royalties and other fees that TPHOs would provide to Hyatt as a result of the increased goodwill and bookings. As such, the Tax Court concluded that the trust fund doctrine exception was inapplicable to Hyatt’s situation and the Fund revenue was includible in gross income. 

Method of accounting

The second item of contention between Hyatt and the Commissioner was whether Hyatt’s treatment of Fund revenue and expense was a method of accounting subject to a Section 481(a) adjustment. Under the regulations, a “change in method of accounting” includes a change in the over-all method of accounting for gross income or deductions, or change in the treatment of material item, which is any item that involves the proper time for the inclusion of the income or the taking of a deduction. Hyatt asserted that the treatment of the Fund did not involve material items since the Fund’s revenue and expenses were permanently excluded on prior returns. In an attempt to reach the revenue by the Fund received in closed years, the IRS took a more results-based view whereby both Hyatt’s prior and current treatment of the Fund as a whole (revenue and expense) results in zero aggregate lifetime taxable income to petitioner, thus implicating questions of timing. The Tax Court concluded that Hyatt’s approach was correct because the taxpayer’s consistent, total exclusion of both Program revenue and expenses did not involve timing. Therefore, there was no method of accounting and the revenue was not subject to a Section 481(a) adjustment. 

Trading stamp method

The last issue focused on an exception to the all-events test. Pursuant to the all-events test, a liability is incurred for the taxable year when (1) “all the events have occurred that establish the fact of the liability"; (2) "the amount of the liability can be determined with reasonable accuracy"; and (3) "economic performance has occurred with respect to the liability.” Hyatt attempted to assert the trading stamp method, under Treas. Reg. Sec. 1.451-4, as an exception to the all-events test applicable to their fact pattern. The trading stamp method allows taxpayers to accelerate deductions to the point in time when trading stamps or premium coupons are dispensed, instead of when they are redeemed for merchandise, cash or other property in a future period. For Hyatt, the trading stamp method would allow Fund gross receipts to be offset by both the current year reward redemptions and the estimated cost of future tax year reward redemptions. However, the Tax Court denied this argument on the grounds that a hotel stay, which is either characterized as a license or a leasehold, would not qualify as merchandise, cash or other property as required under the trading stamp method. The Tax Court clarified that “other property” should be construed only as property similar to merchandise or cash. 

Consideration of these holdings are essential when evaluating tax planning opportunities associated with the administration of loyalty programs among multiple taxpayers. Taxpayers relying on the trust fund doctrine will want to ensure that their fact pattern more closely aligns with Seven-Up rather than Hyatt when attempting to establish the taxpayer as an agent or conduit.