Court reopens question of income inclusion for reward funds

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The U.S. Court of Appeals for the Seventh Circuit has vacated the Tax Court’s decision in Hyatt Hotels Corporation & Subsidiaries v. Commissioner (see our prior story) and remanded the case for further consideration as to whether cash contributions Hyatt collected from hotel operators to fund the redemption of customer reward points should be included in income under the claim-of-right doctrine.

Hyatt operated a customer rewards program under which customers staying at Hyatt hotels earned reward points that could be redeemed for free future stays and perks or travel miles. Both Hyatt-owned hotels and hotels operated by third-party operators participated in the program. Hotel owners funded the program by making payments into an operating fund when customers earned reward points. When customers redeemed points at a participating hotel, Hyatt compensated the hotel owner for the stay from the fund.

Hyatt held the fund, invested portions of the fund’s unused balance in marketable securities, and used the fund to pay administrative and advertising costs related to the program. For federal income tax purposes, Hyatt did not include amounts paid into the fund in its gross income and did not claim deductions for expenses paid out of the fund.

The Tax Court considered several issues related to the fund and held that:

• The amounts received related to the program are includible in gross income,
• The treatment of the revenue was not a method of accounting,
• Hyatt could not adopt the trading stamp method.

On appeal, Hyatt argued that contributions to the fund were not includible in its gross income and that the Tax Court should have considered whether the contributions were excludible under the claim-of-right doctrine. In general, the claim of right doctrine treats as income amounts received under a claim of right and without restriction as to their disposition.

The Seventh Circuit agreed with Hyatt, ruling that the Tax Court erred by finding that fund contributions were includible in Hyatt’s income based on the trust fund doctrine without independently considering whether the amounts were excludible under the claim of right doctrine.

The Seventh Circuit first considered whether the claim-of-right doctrine operates as an independent basis to exclude amounts from income. The court cited Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990), in which the Supreme Court ruled that customer deposits held by a utility company were not income to the company due to an express obligation to repay.

The Seventh Circuit reasoned that Indianapolis Power & Light demonstrates that the claim-of-right doctrine is an independent basis to exclude income and further stated that this conclusion is consistent with the Tax Court’s prior recognition of the use of the doctrine to exclude funds as “sound law.”

Next, the Seventh Circuit assessed the relationship between the trust fund doctrine and the claim-of-right doctrine. The trust fund doctrine excludes from income trust funds that the taxpayer must spend for a specified purpose, receiving, at most, an incidental and secondary benefit in return. Acknowledging that the trust fund doctrine is also a basis for excluding amounts from income, the court agreed with the Tax Court that the trust fund doctrine represents a tailored application of principles found in the claim-of-right doctrine.

However, the Seventh Circuit rejected the Tax Court’s conclusion that contributions to the fund were income to Hyatt solely because Hyatt failed to satisfy the trust fund doctrine due to the direct benefits Hyatt received from the fund. Using commercial loans as an illustrative example, the court explained that although commercial loans are excluded from income, they do not satisfy the trust fund doctrine because they confer economic benefit on the recipient. The court reasoned that this contrast shows that the claim-of-right doctrine provides a broader basis than the trust fund doctrine for excluding amounts from income.

The Seventh Circuit explained that the trust fund doctrine is one way — but not the only way — to show a taxpayer lacks a claim of right to funds and, therefore, that such amounts may not be includible in income.

Since the Seventh Circuit Court is a court of review, it returned the case to the Tax Court for application of the correct legal test.