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In today's competitive market, retailers have had to find new ways to recruit and maintain a stable customer base. Many have turned to offering various types of rewards to their customers that can be accumulated and cashed in after a certain amount of goods or services have been purchased. For example, many major restaurant chains offer rewards cards or other programs providing free meals, drinks or appetizers after a certain amount of money has been spent.
Credit card companies also offer a variety of rewards, such as discounts for certain types of purchases like hotel rentals and travel, or reward with big-ticket items, such as plasma TVs, cash back and airline miles. But does this type of benefit count as income or compensation in the eyes of the IRS? The answer is fairly straightforward in most cases.

Nontaxable Rewards
For the most part, taxpayers do not need to report perks such as discounts, cash back or airline miles as income. The IRS classifies this type of perk as a reduction in the purchase price of an item, instead of income, which means that they view it as a type of sale or promotion. The only stipulation here is that if a discount from a rewards program is applied to an item that is later sold in a taxable transaction, then the discounted price must be used for the item's cost basis.

Another instance where the use of reward cards or other perks may become taxable is when an employee or owner uses a personal card or program for business expenses, in order to personally accumulate the miles or other perks of the program. If the IRS perceives that the taxpayer does this habitually, then they will most likely demand payment for the amount of rewards or cash received as a result of those purchases. Owners of small businesses and self-employed taxpayers need to be certain to add this income to their tax forms, in order to ensure compliance on this issue.

Airline miles are also usually tax-free, except when they are given by a company in conjunction with another type of account. For example, if a credit card company promises free airline miles to any customer who opens a bank, investment or other type of account with a partner company, then the IRS views the free miles as a form of taxable income. However, they do not tax frequent flier miles, and the IRS admitted several years ago that complications in how this perk is awarded have made it difficult for them to provide much material guidance on how they should be taxed or reported.

Other Types of Rewards
Unlike consumer rewards, rewards that are paid or earned elsewhere are generally taxable. If you win the lottery or cash or other prizes on a game show, then you will have to report the value of your winnings as taxable income. In most cases, this will be taxed as ordinary income.

Money that a taxpayer receives from a lawsuit or court settlement may or may not be taxable, depending upon the nature of the award. Money or other benefits that are paid or given to indemnify the recipient are generally not taxable. For example, if someone vandalizes a car and the owner wins a lawsuit against the vandal or the vandal's parents to cover the cost of repairs, then this type of award will generally be nontaxable to the extent that it is used to repair the car.

Court judgments for lost wages or other types of earned compensation must be reported as ordinary income, because the income that was sued for would have been taxable to begin with. Punitive damages that are awarded as a form of punishment for the payee are also taxable, and awards for violations such as breach of contract are also taxable.

The Bottom Line
As you can see, there are many different ways to earn rewards, but whether a reward is taxable or not will depend on the situation at hand. For more information on the taxation of rewards, perks and court judgments, visit the IRS website at www.irs.gov or consult your tax advisor.  

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