The value of frequent-flyer miles to passengers, airlines and other businesses.

Dear Globetrotter:

Welcome to the 443rd issue of your monthly foreign-travel magazine.

I’m about to take you on a long journey that touches on a few financial matters. While this article may be extensive, I suggest that you do not overlook the last few paragraphs or Uncle Sam may come calling.

If you fly often, it’s likely you’re a member of an airline’s frequent-flyer program. Each time you take a flight with the airline, you’re credited with “frequent-flyer miles,” the number depending on, among other things, how many miles the plane traveled. If you accumulate enough “miles,” you can redeem them for an “award,” such as an actual flight with that airline. The airline determines how many miles must be redeemed for any award.

When you redeem miles for a “free” flight, you have to pay government taxes on the value of the fare, of course; the airline isn’t going to cover those for you. You also might have to pay a small amount in mileage-redemption fees (“administrative costs”) and — especially with a non-US carrier — what can be a sizeable surcharge, usually for fuel, but your free points still will cover the bulk of the cost of the basic flight.

An airline often will offer its frequent-flyer program members reduced fares, reduced baggage fees, seat-class upgrades and perks such as airport lounge access and expedited check-in. All these are incentives to get members to choose that airline whenever they have choices of airlines.

So each time a program member takes a flight by turning in free miles, the airline loses money, right? Some of these flights would have cost the traveler thousands of dollars. How can an airline turn a profit with a program in which it gives away flights for free?

To carry passengers on a flight, an airline has lots of expenses to cover: fuel, food on the flight and the flight crew’s salaries, for starters, plus a proportional amount of the overhead (the cost of the planes, equipment, ground staff, property, etc.).

Even with all those expenses, when taking into account all of the domestic and international flights taken by frequent-flyer program members cashing in their award miles on airlines worldwide, the average cost to an airline for each award redeemed is actually only an estimated $10-$20.1

And sometimes flight awards are for seats that would have remained empty anyway, so it doesn’t cost the carrier much more to have program members sitting in them.1, 2

Of course, if a frequent-flyer program member does not redeem his accumulated miles, the airline has had that person’s repeat business without having to provide any award. Note: it’s estimated that, depending on the airline, 20 to 70 percent of all frequent-flyer miles earned go unredeemed.1

And there are a lot of “miles” out there. The magazine The Economist estimated that by the end of 2004, 14 trillion unused frequent-flyer miles had accumulated worldwide.3 In 2011, CNBC estimated that there were 15 trillion frequent-flyer miles outstanding.4 And the very next year, by August, The Economist and WebFlyer (a company that analyzes the “loyalty industry”) estimated that the number of unredeemed miles/points in travel-loyalty programs worldwide had jumped to 23.8 trillion.5

There are several ways in which it pays off for an airline to have “loyal” customers.

Just in getting a passenger on the plane, whether he’s a mileage program member or not, the airline can collect baggage fees, seat-assignment fees — all kinds of fees — and it also can charge for food and drinks on the flight.

Sometimes a passenger’s mileage account is just shy of the number of miles he needs to purchase a particular flight, in which case he forks over a certain amount of cash to make up the difference.

It’s also common for a member to redeem miles to book a flight in economy class and then pay cash to upgrade to business class.

Some airlines charge members fees for changing or canceling mileage-award flight reservations or returning miles to their mileage accounts.

And with certain airlines, frequent-flyer program members pay annual membership fees.

It used to be that the more miles a program member racked up, the higher his status and the more perks he received. Now many airlines allow any program member to have an elite-level membership simply by paying a higher annual fee. Among the perks that elite-status members get are free seat assignments, priority boarding, free food and drinks on the flight — a lot of things that other passengers now must pay extra for.

(In fact, now some airlines offer elite-member-level perks even to program nonmembers on an à la carte basis, selling a “perk package” for, say, $100 that provides expedited boarding and a lounge pass for just one flight.)6

So the airlines are, indeed, getting cold cash out of mileage members taking “free” flights. It was estimated that in 2009, a mere 1.25% of American Airlines’ more than 64 million frequent-flyer program members were responsible for 26% of the airline’s worldwide revenue.7 Advertising to such a captive group is also more efficient.

But there are other ways in which airlines profit from frequent-flyer programs.

Many banks pay cash to airlines for huge chunks of frequent-flyer miles to use as bonuses for their bank account holders and as rewards for their credit card holders. Car rental companies, hotels and other companies also purchase miles from airlines to give away.

In 2010, out of all of the frequent-flyer miles issued by the carrier American Airlines, almost a third were earned by program members taking flights and racking up miles, while 62% were issued by the airline and sold for cash to program partner firms (banks, car-rental companies, etc.) as well as individual program members.

From its SkyMiles program alone, Delta Air Lines brought in $1.6 billion in 2010, and most of that was due to American Express’ purchasing miles.7 Entering into an exclusive deal with a credit card company, an airline can also charge an annual fee for its cards to be co-branded.7

With bonus-points programs tied to credit cards, the card company awards the cardholder each time he uses his card. In some cases, airlines offer miles to members each time they shop online with participating retailers.

Loyalty programs are so popular now that more than half of all the purchases made in the US using credit cards are made with cards linked to loyalty programs.8

Airlines keep track of the millions of miles that they “owe” to their program members, of course, and since miles can be bought and sold in bulk, these miles have a certain value.

Most airlines’ annual and quarterly financial reports focus on revenue (current and future) coming in balanced against their liabilities, and the potential cost of honoring all of the awards currently owed is generally viewed as a liability.4, 9, 10, 11

After mileage programs had been around for a few years, airlines began “expiring” miles, deleting miles from program members’ accounts if they were not used within a set time limit (determined by each airline). When the miles time out and disappear, they are no longer a liability, in the accounting sense, to the airline.1, 4, 12 And if an airline declares that its miles will now expire in, say, two years instead of three, its bottom line all of a sudden looks far better.11, 12

Some airlines have benefited greatly by changing accounting methods. In what used to be the most prevalent method of accounting, an airline would define the amount of liability involved in its frequent-flyer program based on what it actually would cost it to honor the awards it expected to be collected by program members that year. (As I mentioned, it costs an airline about $10-$20 per award redeemed.) Previous years’ averages, among other factors, would help in estimating this cost.4, 13

An alternate accounting method (now widely used internationally in the airline industry) bases the liability on an estimated value of each mile and takes into account its outstanding miles.4, 9, 11

If an airline switches from a cost-based accounting method to one based on the value of its outstanding miles, it must count ALL of the unused miles that have accumulated (both those accrued by frequent flyers and those issued to banks, etc.), put a dollar figure on that total and add it to its balance sheet in one lump sum (a massive liability) at that time. Thus, this switch from a cost-based accounting method to one based on the value of its outstanding miles can be done only once. (Several US carriers have done this while in Chapter 11.)4, 11, 14

Thereafter, it will continue to categorize all newly generated miles as a liability based on their estimated “fair market” value, and each airline determines what that value is for its miles. While, under the first accounting method, the costs of fuel and food were outside of the control of airline management, under the second method the value of outstanding miles (an amount many times larger) can be effectively managed.7, 10

An airline can control the value of its miles, as perceived by its program members, by utilizing the principle of supply and demand in several ways: changing the number of miles required to redeem awards; raising or dropping the number of seats it makes available to mileage members on each flight, and increasing or decreasing the time limit in which miles expire.1, 11, 15, 17

Airlines can also flood the market with miles through co-branded credit card bonuses, reducing their value. And they can increase their value by lowering the number they sell to banks.15, 16, 18

So what is the value of a frequent-flyer mile?

If an airline is selling miles in bulk to another business, each could be worth about .01 cent. (In 2010, the preferential rate that banks paid was usually $0.01 to $0.015 per mile.)7

The value of each mile to a frequent-flyer program member (a consumer) when redeeming them for an award was about one to three cents in 2011.7

In “direct mile purchases” from an airline, as when paying cash for extra miles to reach a mileage requirement for an award, consumers paid three cents per mile in 2011.6, 7, 18

Some economists believe frequent-flyer miles have become a virtual currency. Miles are bought, sold, saved and traded. The values fluctuate, and each airline (along with its partners) functions like a central bank, controlling the rates by increasing or decreasing supplies.

Even back in 2005, The Economist estimated that the miles/points accumulated worldwide had a value of more than $700 billion, about equal to that of all of the printed US currency in circulation worldwide at that time.2

No longer an ethereal system of “bonus points” meant to be a lofty incentive, loyalty points constitute a separate, solid, rooted currency base. Naturally, the IRS has been taking note.19, 20

How is the IRS looking at your frequent-flyer mileage account?

Back in 2002, the IRS stated that, in general, the miles earned while on a business trip or on “official” travel are not taxable. That is, businesses are not taxed on the miles accumulated through the corporate travel of their executives and employees, and their employees are not taxed for using those miles.18

However, a consumer (a loyalty-points program member) who is given frequent-flyer miles as a bonus — such as those received when signing up for a credit card and outside of those accrued during actual travel — may be taxed if the fair market value of those miles exceeds $600.

In January/February 2012, Citi-bank sent out 1099 tax forms to its customers who had received 30,000 or more bonus frequent-flyer miles for opening bank accounts in 2011. Previously, this had not been done by other financial institutions that had loyalty-points programs, and it caused quite a flap. The bank valued the miles at $.02 each; that is, an award of 30,000 miles would have been valued at $600.20, 21, 22

Currently, the IRS considers mileage awards to be taxable under the following circumstances:

• You receive, from a financial institution, a 1099 form listing the value of the miles as taxable income for “prizes and awards” that were not the result of a purchase.

• The miles given to you went into a personal account and were not awarded for business travel or business expenses.

• The value of the miles was over $600.

Bottom line — as of April 2012, if you receive a 1099 form listing the income value of your frequent-flyer miles, pay the tax on it. Then, if you wish, challenge it, but don’t ignore it. The IRS pursues nonpayment of taxes aggressively.21, 22

Senator Sherrod Brown (D., Ohio) said in January 2012 that he will pursue a clarification of the rules from the IRS, but that may take a while. The IRS is reluctant to set rules for fear of raising complex new issues.17, 22

Though reading all of this might not give you any additional influence with the airlines regarding mileage awards, I hope you found the ins and outs of this complex reward system as interesting as I did. ITN’s Mary Beltran researched and compiled this information. I just worded it so that I could understand it. Thank you, Mary.

I’ll be back next month with new topics.

Information sources:

1. Smartertravel.com article “Frequent Flyer Program Myths and Realities” by Tim Winship, June 21, 2005
2. Frequentflyerservices.com article “Press Room — Frequent Flyer Facts,” 2006, and the article “The Truth About Frequent Travel Programs” by Randy Petersen, editor of Inside Flyer magazine, 1990, reprinted March 6, 2009
3. The Economist magazine, “Frequent-flyer miles — In terminal decline?,” Jan. 6, 2005
4. The report “Accounting for Airline Frequent Flyer Programs” [PDF link] by Brian J. Franklin, College of Business & Public Policy, University of Alaska, May 2012
5. Choosedigital.com “What is the World’s Leading Currency?… would you like to guess again?” by John Dunaj, Aug. 14
6. “Your Choice” program, American Airlines’ website
7. Ideaworks’ white paper “Loyalty By the Billions,” [PDF link] Loyalty Marketing Report Series for 2011
8. Inside Flyer article “The New Number One” by Randy Petersen, editor, 2011
9. Price Waterhouse Coopers’ report “IFRIC 13, Accounting for customer loyalty programmes” (no date given)
10. MERCER “Case Study: Building Customer Loyalty with Actuarial Analysis,” Sept. 25, 2008
11. MERCER report “Customer Loyalty Programs: The New International Accounting Interpretation IFRIC 13,” Jan. 22, 2009
12. BoardingArea.com article “Not Using Your Frequent Flyers Miles is Like Giving Airlines Free Money” by Steven Frischling, April 29, 2010
13. United Airlines’ Annual Report for 2010, “United States Securities And Exchange Commission Form 1 0-K”… and UA News Release “United Announces Third-Quarter 2012 Profit,” Oct. 25, 2012
14. CFO.com article “Miles to Go: UAL Sale Boosts Liquidity” by Stephen Taub, Sept. 18, 2008
15. The New York Times article “Have Elite Fliers Been Downgraded?” by Michelle Higgins. June 8, 2012
16. ChooseDigital.com article “Making Loyalty Program Awards More Difficult to Attain May Turn Loyalty into Antipathy,” Sept. 14, 2012
17. Airlineinformation.org article “Credit Cards, Co-Branding, and the Mega Event,” Aug. 17, 2010
18. Taxanalysts.com article “What Is a Frequent Flier Mile Worth” by Marie Sapirie
19. Internal Revenue Service Industries webpage “LB&I Tier III Issue: Loyalty Programs in Service Industries” (irs.gov), Aug. 3, 2012
20. Forbes article “Citibank Issues Forms 1099 for Frequent Flyer Miles, Surprising Customers and IRS,” March 1, 2012
21. Newsweek article “Take Flight” by Christopher Elliot, “Personal Finance” column, March 2012
22. Dow Jones Newswires article “Lawmaker to Revisit Taxing Of Frequent Flier Miles” by Kristina Peterson, Jan. 31, 2012