The Rocket Scientist and the Tax Court Exemption

SMITH BRAIN TRUST – It’s not rocket science, says Maryland Smith’s Samuel Handwerger, but it may be “a rather clever scheme to make a living and beat the IRS to boot.”

The scheme, involving a doctorate of physics from MIT as revealed in a recently published tax court case (Anikeev v. Commr, 2021), has been holding Handwerger’s attention, even amid the busy tax-filing season.

Here’s how it works, according to Handwerger, a CPA and accounting lecturer at the University of Maryland’s Robert H. Smith School of Business.

First, you get a credit card yielding effectively 3% with a rewards system on purchases. Then, you buy a $500 gift card with that credit card, which will cost you a $7 transaction fee. But with the 3% from the credit card, a $15 credit resulting from your $500 purchase, you are now in the black. “Ahead of the game by $8 – a pretty good profit on for a one-day $500 investment,” Handwerger notes.

How do you pay off the $500 credit card debt?

“Simple: Use the gift card cash value, $500, to buy a money order and pay off the credit card. A trick in forensic accounting we call ‘making the round trip,’” he says.

“Now imagine you get upgraded to an Amex’s 5% rewards card and you follow the steps for that $500 round-trip transaction many times – like to the tune of $6.4 million churned in a two-year period. Add a few extra-good deals on the fees to purchase the gift cards, and you, like the rocket scientist in 2013 and 2014 before the credit card companies closed his accounts, may have yielded a tidy profit of over $300,000.”

The scheme came to light when the IRS came looking for its share, in income tax. Those profits are taxable income, right?

“To the beginning accounting student it certainly would seem to be,” says Handwerger. But years ago the IRS analyzed these kinds of transactions in a different way.

Say you go into a store and buy a $10 item. Your credit card company gives you 20 cents cash back or an air-miles allowance equivalent to that in cash value. Did you just earn 20 cents or did you just get a discount on your purchase so that it cost you only $9.80 instead of $10?

“The IRS ruled years ago that it is not an accretion of wealth since you are only wealthier when compared to the person who purchases without getting the ‘discount’ and, therefore, it is not income subject to tax,” Handwerger explains. “Clearly a ruling that made the giant credit card companies happy.”

However, in the case of the physicist, the IRS felt that the discount analogy didn't apply, since the gift cards were used as cash. So they tried to tax the credit card “cash” rewards.

“But the tax court didn’t ‘buy’ this argument,” Handwerger says. “It is still a discount on the initial gift card purchase and gift cards are not directly redeemable as cash. Therefore, the rocket scientist got a boost on his scheme in that it is indeed not taxable.”

In case you’re already Googling where to buy gift cards (‘everywhere’ is essentially the answer, btw), Handwerger says you can rest assured that your normal credit card rewards program is not yielding any current taxable income. Although based on this loss for the IRS, he adds, it is likely that there will be some change in the near future. “In the meantime,” he jokes, “consider how valuable an advanced degree in physics might truly be to your future.”