As some say, there's always a catch. And frequent flyer programs aren't immune to that theory. There are some not-so-free aspects of this "free money."
Keep in mind that as a frequent flyer member, you do not truly "own" your miles. Many of the frequent flyer program terms and conditions state clearly that passing along mileage in the event of an account holder's death or divorce is NOT part of the program. However, airlines DO have policies that allow division and/or transfer of mileage to occur. What happens to the miles seems to depend on the situation.
A financial ruling by the IRS (PLR9746048), as summarized by Ernst & Young, states that "frequent flyer miles awarded to an investor will be treated as an 'adjustment' to the purchase price of the fund shares and results in a reduction in the basis of those shares." This is an interesting point to ponder if you are considering using stock trades to gain mileage points.
Moreover, as a frequent flyer member, you may pay fees when redeeming miles for tickets. The Taxpayer Relief Act was passed quietly in 1997. As part of this act, when an airline partner gives miles to the program member, the airline must purchase the miles from the sponsoring airline with the 7.5% tax placed on top of the purchase. For example, if Hilton Hotels rewards you with miles for staying with them, they must buy those miles from the airline (in order to give them to you) and pay the 7.5% on top of the purchase price.
What does the tax mean to you, the frequent flyer? In all probability, the cost of the tax is passed on to the consumer/frequent flyer in the form of miscellaneous fees. According to the travel industry, the profit margin for these "partners" is so slim the cost would wipe them out. Still, they need to partner with the airlines to keep their market share (remember what happened to Hertz). So, the partners remain in the frequent flyer program, and the costs are passed on to you the consumer.
One thing that you as a customer can be sure of is that frequent flyer programs will continue to evolve.
For more information on frequent flyer programs and related topics, check out the links below.