Seventh Circuit Opens the Door on Loyalty Program Tax Exclusions

INTRODUCTION

The U.S. Court of Appeals for the Seventh Circuit recently vacated the U.S. Tax Court’s decision in Hyatt Hotels v. Commissioner, a case concerning the taxation of loyalty programs. The Seventh Circuit remanded the case to the Tax Court for further review.

BACKGROUND

Hyatt is an international hospitality company that owns, manages, and franchises hotels. While Hyatt owns some hotels, most are owned by third parties in management or franchise agreements with Hyatt.

Like many hospitality chains, Hyatt has a loyalty program (the Program). Through the Program, members earned rewards points by spending money at Hyatt-branded hotels, which could later be redeemed for hotel stays and perks or travel miles. All Hyatt-branded hotels were required to participate in the Program.

To cover the Program expenses, Hyatt operated the Gold Passport Fund (the Fund). All Hyatt-branded hotels were required to pay 4% of loyalty-point-earned purchases into the Fund at the time the points were issued; if a member chose to earn travel miles instead of points, hotel owners paid the actual cost of the miles into the Fund. The Fund also derived income from investing its assets in securities and from directly selling points to customers. When members redeemed points, Hyatt compensated the hotel owner out of the Fund, which also covered the Program’s administrative and advertising expenses.

Although Hyatt established the Fund in 1987, it never reported or paid income tax relating to the Fund. Instead, the hotels Hyatt owned paid income tax on their contributions to the Program because those amounts were not deducted from the hotels’ income.

The IRS disagreed with Hyatt’s tax treatment of the Fund and issued a notice of deficiency for the years 2009 through 2011, contending that Hyatt should have reported income to the Fund as income to Hyatt.

TAX COURT

Hyatt’s Arguments

In Tax Court, Hyatt advanced two main arguments.

First, Hyatt contended that payments into the Fund from third-party hotel owners, direct point sales, and Fund investment income were not its income. Hyatt argued for exclusion on two independent doctrinal grounds:

• Claim of right doctrine: The classic formulation of the claim of right doctrine regards as income “earnings [received] under a claim of right and without restriction as to its disposition.” Hyatt argued it lacked a claim of right to the Fund because the funds were collectively owned by the hotel owners and could only be used for Program purposes, meaning Hyatt could not treat them as “belonging to” it.  
• Trust fund doctrine: The trust fund doctrine holds that trust funds are excludable from income when two requirements are met: first, the taxpayer must be obligated to spend the money for a specified purpose; and second, the taxpayer may not receive any profit, gain, or other benefit in return, unless it is merely incidental and secondary. Hyatt maintained that the Fund satisfied both prongs.

Second, in the alternative, Hyatt argued that if Fund income was its income, it was entitled to use the trading stamp method, which applies to accrual-method taxpayers issuing trading stamps redeemable for “merchandise, cash, or other property.” If applicable, the trading stamp method would permit Hyatt to deduct the estimated cost of members redeeming their points at the time those points were initially issued, rather than waiting until redemption.

Tax Court Ruling

The Tax Court ruled against Hyatt on both issues.

On the income question, the Tax Court disregarded Hyatt’s claim of right argument, finding that the doctrine did not provide a basis for excluding income under the circumstances. The court treated the trust fund doctrine as a more tailored application of claim of right principles and reasoned that if Fund income was not excludable under the trust fund doctrine, it must be income to Hyatt. Addressing only the trust fund doctrine’s benefit prong, the Tax Court determined that because Hyatt profited from Program advertising through increased hotel stays and brand goodwill, it had sufficient beneficial economic interest in the Fund for Fund income to constitute taxable income.

On the trading stamp method, the Tax Court applied the canon of ejusdem generis and reasoned that the “other property” catch-all term was limited to tangible property. Since hotel stays and airline miles are intangible, the court concluded that Hyatt was not permitted to use the trading stamp method.

SEVENTH CIRCUIT HOLDING

The Seventh Circuit vacated the Tax Court’s decision in its entirety and remanded for further proceedings.

Claim of Right Doctrine

The Seventh Circuit agreed with Hyatt and held that the claim of right doctrine provides a basis for income exclusion that is independent from and broader than the trust fund doctrine. The court therefore held that the Tax Court erred when it concluded that Fund income was Hyatt’s income based solely on the trust fund doctrine, without considering Hyatt’s arguments under the claim of right doctrine.

Hyatt and the government agreed that the claim of right doctrine works to the inclusion of income but disagreed on whether the doctrine can be used to exclude income where a taxpayer could not satisfy the claim of right doctrine.

Relying on Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990), the Seventh Circuit answered in the affirmative and held that the claim of right doctrine operates as a basis for exclusion. In that case, the U.S. Supreme Court found that customer deposits acquired subject to an express obligation to repay were not income to the company, and that “whether these payments constitute income when received … depends upon the parties’ rights and obligations at the time the payments are made.”

The Seventh Circuit agreed with the Tax Court that the trust fund doctrine is a more tailored application of claim of right principles and is one way of showing a taxpayer lacks a claim of right to funds. However, the Seventh Circuit held that the opposite is not true: funds that are ineligible for exclusion under the trust fund doctrine may still be excludable under the claim of right doctrine, which provides a broader basis for exclusion.

Critically, the Seventh Circuit rejected the Tax Court’s reliance on Angelus Funeral Home v. Commissioner, 407 F.2d 210 (9th Cir. 1969), clarifying that economic benefit alone is not sufficient to make funds taxable income. Rather, the correct analysis focuses on the “parties’ rights and obligations at the time the payments are made,” not merely incidental benefit. Having found that the Tax Court never applied the claim of right test and explicitly declined to resolve issues relevant to that analysis, the Seventh Circuit vacated and remanded to the Tax Court with instructions to determine whether Fund income constituted income to Hyatt under the claim of right doctrine.

Trading Stamp Method

Although the Seventh Circuit did not need to resolve the trading stamp issue given its remand on the income question, it nonetheless addressed the Tax Court’s interpretation of “other property” under 26 C.F.R. § 1.451-4(a)(1). The Tax Court applied the cannon of ejusdem generis to limit “other property” to tangible property. The Seventh Circuit assumed, without explicitly deciding, that ejusdem generis applied and concluded that tangibility is not a common trait of cash and merchandise and was therefore the wrong unifying trait. Cash, for instance, refers to money or its equivalent, including bank account balances, and is not necessarily tangible.

The Seventh Circuit therefore held that the Tax Court erred in concluding that Hyatt could not use the trading stamp method because “other property” must be tangible. On remand, the Tax Court retains flexibility to consider other arguments regarding Hyatt’s eligibility to use the method, should that issue arise.

PRACTICAL TAKEAWAYS

The Seventh Circuit’s decision in Hyatt carries several practical implications for businesses operating loyalty programs.

• While the Seventh Circuit vacated and remanded the Tax Court's decision, it did not reverse it. The Tax Court will have the opportunity to apply the claim of right doctrine and may still conclude that contributions to the Fund constitute taxable income. Accordingly, the decision should not be treated as a definitive victory for taxpayers.
• Companies operating loyalty programs — particularly those with centralized funds financed by mandatory contributions — should evaluate whether their current income treatment is defensible under the claim of right doctrine. The Seventh Circuit’s decision clarifies that the trust fund doctrine is not the exclusive means of establishing that a taxpayer lacks a claim of right to funds received subject to obligations, potentially opening additional avenues for exclusion arguments.
• The Seventh Circuit resolved only the threshold question of whether “other property” is limited to tangible property. On remand, the Tax Court will have the opportunity to address other aspects of eligibility under 26 C.F.R. § 1.451-4(a)(1). Businesses that may benefit from the trading stamp method should monitor the remand proceedings for further guidance on the method’s applicability to modern loyalty and rewards programs.
• The Seventh Circuit’s holdings are binding only within that circuit. Taxpayers in other jurisdictions should assess how their respective circuits have treated the claim of right doctrine and the scope of “other property” under the trading stamp method, and whether the reasoning in Hyatt may serve as persuasive authority.

Crowell & Moring lawyers are available to assist clients in assessing the implications of this ruling and traversing the changing legal field surrounding loyalty program taxation.