Hyatt Tax Case Sets the Stage to Change Loyalty Reward Programs

An appeals court last week said a case involving the IRS and Hyatt Hotels Corp.’s customer loyalty reward program should go back to the US Tax Court, whose eventual final ruling could have significant effects on how these programs are structured. Sponsors of loyalty programs should ensure their obligation to repay prepayments of loyalty rewards are clearly documented in agreements with their counterparties.

When customers patronize a business offering loyalty rewards, they prepay for the rewards that they may later claim. The prepayments are typically collected in a fund and then disbursed to pay for rewards when customers claim them.

In one of the tax years at issue in Hyatt Hotels Corp. v. Commissioner, $118 million of prepayments flowed into the fund. The provision for future award redemptions amounted to $72 million that year. Hyatt didn’t include the inflows as income or deduct the outflows as an expense. Its theory was that it didn’t have a claim of right to the fund.

The claim of right doctrine provides that a taxpayer must include in income an amount that the taxpayer isn’t obligated to repay. The reverse is also true, which was the point in Hyatt: A taxpayer need not include in income an amount that the taxpayer is required to repay. It’s analogous to a loan, and loan proceeds aren’t income as long as the obligation to repay persists. The case’s central argument involved the intersection of the claim of right doctrine and the trust fund doctrine.

The US Court of Appeals for the Seventh Circuit ruled that the claim of right doctrine is a rule of income inclusion as well as a rule of income exclusion. If a taxpayer has an obligation to repay, the taxpayer has no claim of right to the item and may exclude it from income. The Hyatt case resolves any ambiguity about whether the claim of right doctrine operates as an exclusionary rule.

The trust fund doctrine denies exclusion if the taxpayer benefits from funds deemed held in trust. But the claim of right doctrine permits taxpayers to exclude an item from income even if they benefit from the funds they hold if they are obligated to repay those funds.

That is a significant clarification: Exclusion under the claim of right doctrine trumps what would be inclusion under the trust fund doctrine.

The Seventh Circuit ruled in Hyatt that even if a taxpayer fails the exclusionary test of the trust fund doctrine for an item of income, the taxpayer may exclude the item from income if the taxpayer has no claim of right. The trust fund doctrine holds that trust funds are excludable from income when two requirements are met:

• The taxpayer must be obligated to spend the money for a specified purpose.
• The taxpayer may not receive any profit, gain, or other benefit in return unless it is incidental and secondary.

The Seventh Circuit opinion thus provides sponsors of loyalty reward programs with flexibility in use of funds remitted to pay loyalty program rewards. Hyatt made expenditures from the fund for advertising, which Hyatt asserted focused on the loyalty program.

The tax court previously ruled that the advertising expenditure benefited Hyatt directly. But the Seventh Circuit opinion avoids that issue by observing that a borrower generally can use borrowed funds for any purpose and doesn’t have to include the funds in income if the borrower has an obligation to repay the funds.

The Seventh Circuit remanded the case to determine if the claim of right doctrine applies. The tax court earlier decided only that Hyatt failed the trust fund doctrine because of the advertising and other benefits that it derived from the funds.

The central question now is whether the agreements between Hyatt, its franchisees, and the loyalty reward members require Hyatt to repay the amounts that are remitted to it as prepayments.

Even if the exclusionary feature of the claim of right doctrine doesn’t apply, Hyatt may decrease the amount of its inclusion if the trading stamp exception applies.

If a taxpayer issues trading stamps (or premium coupons) with sales, and if they’re redeemable in merchandise, cash, or other property, the taxpayer may offset against sales revenue the cost of redemptions in the taxable year, plus an addition in the taxable year for the cost of future redemptions. This exception accelerates what essentially is a deduction for an economic performance—payment of the loyalty reward—that won’t yet have occurred.

The tax court denied this accelerated deduction in its earlier ruling because it perceived the reward—providing a hotel room—as an intangible that is outside the scope of rewards permitted by the trading stamp exception. The Seventh Circuit rejected that “other property” couldn’t include intangible property.

The tax court hasn’t yet evaluated Hyatt’s calculation, but there are indications that the IRS believes Hyatt didn’t calculate the cost of current and future redemptions correctly. A taxpayer who is relying on the trading stamp exception should be prepared to prove that the calculation precisely tracks the guidance in the regulation.

Other circuits might not follow the Hyatt opinion. The tax court’s adverse opinion isn’t to be disregarded. Another court may find that the trust fund doctrine is controlling, and that the taxpayer’s method reporting income and expense is a method of accounting, with the conclusion that the full amount of the contingency reserve for the rewards must be included in income.

That would be a devastating conclusion for the taxpayer. A way to avoid such a conclusion is to disburse the funds to the parties that contributed to it in case the program is terminated.

Also, focus advertising on the program and not on the sponsor. In Hyatt, there was testimony that the advertising favored the Hyatt brand and not the hotel. Perhaps having franchisees participate in the advertising selection aids in a factual finding that fund expenditures don’t benefit the sponsor. This is an important finding if a court outside the Seventh Circuit treats the trust fund doctrine as controlling.

Finally, a court is unlikely to agree to a calculation of the trading stamp exception different from the regulatory calculation. The IRS commissioner used his broad authority to promulgate accounting methods to formulate the trading stamp exception. There is no statute on which a taxpayer may rely to show that the regulation fails to express congressional intent.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Loren M. Opper is of counsel and Christie R. Galinski is a principal at Miller Canfield.

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