I'm looking to start a business which deals in customer reward points, redeemable for giftcards/coupons/special offers, or at partner businesses. The reward point becomes a sort of currency which we are backing with a pile of cash taken from advertiser fees. This way we should always have more cash on hand than point redemption liabilities.
What I need to know is how to account for the points, and how to hold the 'funds for redemption' in a way that it is not taxed (Oregon, USA) until the expense of redemption is realized, possibly multiple years. Ideally, I'd like to hold these funds in an interest-bearing account or liquid investments so we can get some output from the parked capital.
Is this too complicated already?
Thanks for your considerate reply!
Pete
Hi, I'm not in Oregon so you'll need to speak to a local tax expert to verify the details but here is how it works:
When you issue points you're creating a liability. You owe something to someone. It's like a gym which sells a one-year membership, they're only supposed to recognize 1/12 of the sale in the month it was sold. 11/12 of the money actually is a liability called 'deferred revenue.' As each month goes by, they reduce their liability by 1/12 and credit that money to income because now it is 'earned.'
In your case you sell points to merchants (who give them to consumers) but most of the money collected is now owed to consumers to redeem their points. This is not income, you're just holding money owed to someone else. A small portion of the money, your gross margin on points sales, would be recognized as revenue and would have to cover your overheads and give you your profit, if any.
So your balance sheet will keep growing in cash and an offsetting liability. Your income statement will only recognize the small margin which is your profit from selling the points to the merchants.
I hope this helps make it more clear.
With this type of business you may wish to investigate whether it makes sense from a liability point of view to hold the funds owed to consumers in a trust account rather than just 'floating' the points. I could see problems arising if you ever dipped into this cash pool to cover your own expenses while trying to argue to tax authorities that you're holding the cash for someone else.
If you'd like to learn more about how merchants account for their own proprietary point systems, just book a call with me. I worked in the loyalty field for a few years.
Cheers
Dave
Hi, I worked for a business that does exactly what you described. I believe the answer is - you can't "park" the funds and avoid taxation of revenues you earmark for rewards cost. Rewards cost is just another cost of doing business for you.
I think the key here is that the income you recognize is not tied to points that are being redeemed. On one hand, you generate revenues from advertisers, that is your revenue, you will be taxed on the profit (in some states on revenue post some adjustments) that remains after you take out expenses (most start-ups pay state/federal minimum taxes, if any, because they are not profitable). On the other hand, every time a user earns a point, you have to book a liability on the balance sheet showing the value of the points earned but not yet redeemed. Every month, you will have to recognize an expense for Cost of Rewards, which decreases the liability. That expense hits your P&L and reduces your revenues. That is the process by which the cost of points hits the income statement, you can only recognize as an expense the cost of points that have been redeemed.
Please consider that you can institute a rule (in your T&C) that says any unused points in accounts that have been inactive for 6 months expire. Once points expire, you can reduce your liability. After approximately, 2 years, you will have enough history to also calculate breakage and reduce the points liability by a % of points that historically have not been redeemed.
I am happy to walk you through our points cost calculations. They do tend to get a little complicated.
Regards,
Olga
