Seventh Circuit vacates Hyatt loyalty program decision

The Seventh Circuit vacated the Tax Court’s holding that amounts paid into a Hyatt Hotel Corp. customer loyalty program fund from third–party hotel owners, direct point sales, and the fund’s investments were income to Hyatt.

Background

Hyatt operated a loyalty program that allowed program members to earn points by spending money at Hyatt–branded hotels. The program’s expenses were paid out of a centralized fund, which Hyatt managed and to which all Hyatt–branded hotels — including those owned by third parties in management or franchise agreements with Hyatt — were required to contribute. The fund also derived some income from investing in securities and selling rewards points directly to customers. Members could redeem their points for hotel stays, airline miles, and other perks.

For federal income tax purposes, Hyatt essentially ignored the fund. It did not include any of the fund’s revenue in gross income and claimed no deductions for its expenses paid. The IRS audited Hyatt’s returns and issued a notice of deficiency in which it determined that Hyatt should have reported the fund’s net income as its own.

Hyatt challenged the IRS’s determination in Tax Court (Hyatt Hotels Corp., T.C. Memo. 2023–122). Hyatt contended that the disputed payments into the fund (i.e., payments from third–party–owned hotels, direct–point sales, and the fund’s investments) were properly excluded from its income under the claim–of–right doctrine. The Supreme Court has described income included under the doctrine as “earnings [received] under a claim of right and without restriction as to its disposition” (Healy, 345 U.S. 278, 281 (1953) (citation modified)). Hyatt also argued the income should be excluded under the trust–fund doctrine, which excludes from income trust funds that the taxpayer must spend “for a specified purpose,” receiving, at most, an “incidental and secondary” benefit in return (Affiliated Foods, Inc., 154 F.3d 527, 531, 533 (5th Cir. 1998) (citation modified)).

In the alternative, Hyatt argued that if the fund was Hyatt’s property and the fund’s income was its income, then it was entitled to use the trading–stamp method authorized by Regs. Sec. 1.451–4(a)(1). This method applies to accrual–method taxpayers that issue “trading stamps or premium coupons with sales” which “are redeemable by [a] taxpayer in merchandise, cash, or other property.” The court observed that loyalty programs are the modern analog of the physical trading stamps that retailers once issued as promotions with sales of their products, and if the trading–stamp method applied to Hyatt, it would be permitted to deduct its estimated cost of members’ redeeming their loyalty program points when those points were initially issued. Hyatt contended that the perks for which the loyalty program points could be redeemed were “other property” within the meaning of Regs. Sec. 1.451–4(a)(1) and thus that it was eligible to use the trading–stamp method.

The Tax Court rejected both of Hyatt’s arguments. With respect to the claim–of–right argument, the court found that the doctrine didn’t provide a basis for excluding income under the circumstances. Instead, the court applied the trust–fund doctrine, assuming, without deciding, that income received by the fund was received in trust subject to a legally enforceable restriction. The court addressed only the benefit prong of the doctrine: Because Hyatt profited from loyalty program advertising through increased hotel stays and brand goodwill, the court determined that Hyatt “had a sufficient beneficial economic interest in the Fund” for the fund’s income to constitute Hyatt’s income.

The Tax Court also held that Hyatt wasn’t eligible to use the trading–stamp method based on the canon of ejusdem generis, which uses a common element among preceding terms to narrow a catch–all term. The court reasoned that because the words “merchandise” and “cash” were listed before the catch–all term “other property” in Regs. Sec. 1.451–4(a)(1), and merchandise and cash are tangible property, “other property” must also be tangible property for purposes of the regulation. Since the perks for which members could redeem loyalty program points (e.g., hotel stays and airlines miles) aren’t tangible property, the court held that Hyatt was not permitted to use the trading–stamp method.

Hyatt appealed the Tax Court’s decision to the Seventh Circuit. On appeal, Hyatt renewed its arguments that the payments into the fund weren’t its income, and if it was held that they were, the company should be able to use the trading–stamp method of tax accounting, which would offset that income by associated costs.

The Seventh Circuit’s decision

Because the Seventh Circuit found that the Tax Court’s analysis was incomplete when it considered whether the payments into the fund were Hyatt’s income, it refrained from deciding either of the issues Hyatt raised. Instead, it reversed the Tax Court’s decision and remanded the case for further proceedings consistent with its opinion.

The Seventh Circuit agreed with Hyatt’s argument that the Tax Court should have considered whether exclusion from income was appropriate under the claim–of–right doctrine. The court noted that the Tax Court disregarded Hyatt’s claim–of–right arguments because it didn’t believe that the claim–of–right doctrine provided a basis to exclude income in the circumstances presented. Instead, the court considered Hyatt’s arguments only under the trust–fund doctrine. Thus, the Seventh Circuit determined that the issue before it was whether the claim–of–right doctrine operates as an independent basis to exclude income and, if so, how that doctrine interacts with the trust–fund doctrine.

The Supreme Court has stated that a taxpayer has a claim of right to funds when they “are received and treated … as belonging to him” (Healy, 345 U.S. at 282). Hyatt and the IRS agreed that the claim–of–right doctrine operates as one of income inclusion, i.e., that funds satisfying the claim–of–right doctrine are income. But they disagreed as to whether the doctrine also operates as one of income exclusion — in other words, whether failure to satisfy the claim–of–right doctrine means that the funds at issue may be excluded from income.

In Indianapolis Power & Light Company, 493 U.S. 203 (1990), the Supreme Court found that the claim–of–right doctrine is an independent basis to exclude income. Even before that decision, tax courts regarded use of the doctrine to exclude funds as “sound law” (Diamond, 56 T.C. 530, 541 (1971), aff’d, 492 F.2d 286 (7th Cir. 1974)). Therefore, the Seventh Circuit determined that income could be excluded based on the claim–of–right doctrine.

The Seventh Circuit also determined, as had the Tax Court, that the trust–fund doctrine is a more tailored application of claim–of–right principles. Thus, funds excludable from income under the trust–fund doctrine are also excludable under the claim–of–right doctrine. However, according to the Seventh Circuit, the opposite isn’t true; funds that aren’t eligible for exclusion under the trust–fund doctrine may still be excludable under the claim–of–right doctrine. Consequently, it found the claim–of–right doctrine provides a broader basis for exclusion than the trust–fund doctrine.

Based on this conclusion, the Seventh Circuit found that the Tax Court had erred. As the court stated, “the trust fund doctrine is one (but not the only) way to show that a taxpayer lacks a claim of right to the funds at issue, and thus that they are not his income. It was therefore error for the [Tax Court] to treat the [fund’s] income as income to Hyatt based only on Hyatt’s failure to satisfy the trust fund doctrine, without considering Hyatt’s arguments under the claim of right doctrine.”

Hyatt urged the Seventh Circuit to find that the fund’s income wasn’t its income under the claim–of–right doctrine and reverse the Tax Court. The court declined to do this because “the [Tax Court] never applied the claim of right test and, in fact, explicitly declined to resolve issues relevant to that analysis, such as whether the [f]und was subject to a legally enforceable use restriction.”

Hyatt also urged the Seventh Circuit to reverse the Tax Court’s decision because the IRS failed to argue in the alternative about the outcome under the claim–of–right test. The court, citing Pasha v. Gonzales, 433 F.3d 530, 535 (7th Cir. 2005), declined to reverse for this reason because “an appellee’s failure to brief an alternative ground for affirmance does not entitle the appellant to an automatic reversal.” Finding that the appropriate course of action was for the Tax Court to conduct the claim–of–right analysis, it vacated the Tax Court’s decision and remanded it with instructions for that court to determine whether the fund’s income was Hyatt’s income under the claim–of–right doctrine.

Trading-stamp method

Because the trading–stamp method would be an issue only if the fund’s income was Hyatt’s income and the Seventh Circuit had already remanded that issue to the Tax Court to decide, the court was not required to reach the issue of whether Hyatt could use the trading–stamp method. It nevertheless addressed the issue in its opinion in the event that the issue arose again on remand. The Seventh Circuit found that the Tax Court had erred in its interpretation of “other property” when it determined that the trading–stamp method did not apply.

The Seventh Circuit first observed that ejusdem generis would apply in interpreting “other property” only if the phrase were ambiguous. Assuming, without deciding, that phrase was ambiguous, the court concluded that “the [Tax Court’s] chosen theme — tangibility — doesn’t work.” The Seventh Circuit found that cash is not always tangible, based on current dictionary definitions of the word and dictionary definitions contemporaneous with the promulgation of Regs. Sec. 1.451–4(a)(1).

Thus, the Seventh Circuit held that tangibility is not a common trait of cash and merchandise that can narrow the meaning of “other property” in the interpretation of Regs. Sec. 1.451–4(a)(1). Consequently, the court concluded that, on remand, the Tax Court had the flexibility to consider Hyatt’s eligibility to use the trading–stamp method if the issue arises.

Reflections

The trading–stamp method effectively accelerates what otherwise would have been future–year deductions and serves as an exception to the general rule that reserves for contingent liabilities are not deductible. If the method applies to Hyatt’s loyalty program, Hyatt would be allowed to deduct its estimated costs of loyalty program members redeeming their points for free hotel stays and airline miles when the points are issued instead of when they actually redeem the points.

Hyatt Hotels Corp., No. 24–3239 (7th Cir. 4/22/26)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.