You met today with your client, Sam Spader, who described the following situation and asked for your advice.

Sam is the vice-president of Eyewitness Inc., a private investigation firm. He also owns 45 percent of its voting stock. The other 55 percent of the stock is owned by Phillip Marloan, the firm’s president and principal investigator. Recently, it has come to Sam’s attention that Phillip has been “cashing in” frequent flyer miles which he earned in connection with his business travel for Eyewitness. Sam not only questions the ethics of what Phillip is doing, but also the tax consequences.

Phillip, as the principal investigator, is frequently required to travel to distant cities in order to gather information relevant to a case. Eyewitness has a policy of billing clients for all direct investigation expenses, including first class air travel, plus a fixed hourly amount. Clients sign a contract with Eyewitness agreeing to the billing rates and estimated direct expenses before an investigation begins.

Eyewitness has an unwritten policy that frequent flyer miles earned during an employee’s business travel are the sole property of the employee. In connection with his employment, Phillip earns a significant number of frequent flyer miles. Instead of using these frequent flyer miles for personal travel, however, Phillip engages in the following procedure: (1) after determining that travel is required, he instructs the travel agent for Eyewitness to arrange for round-trip coach service to and from the necessary city, but requests that the agent charge Eyewitness for first class travel; (2) he uses his frequent flyer miles to upgrade the coach ticket to a first class ticket; (3) he instructs the travel agent to transfer cash into his personal travel account for the difference between the price of the first class ticket and that of the coach ticket; and (4) he later uses the coach ticket, albeit upgraded, to travel to and from the distance city.

Sam is troubled by the arrangement between Phillip and the travel agent because he believes it may be both unethical and taxable. You tell Sam that as a tax practitioner you are unable to advise him regarding the ethical aspects of the arrangement, but that you will be able to inform him about the tax consequences. Sam agrees and engages you on behalf of Eyewitness to determine whether Phillip’s conversion of frequent flyer miles to cash results in any tax consequences to him.

Assignment:

Using your textbook and tax websites, prepare a file memo indicating whether the conversion of frequent flyer miles to cash credited to a personal travel account results in any tax consequences to Phillip.