Mr. Charley owned slightly over half of his employer, Truesdail, a company that investigated accident sites. In his capacity as a company employee, he would travel on company business. Truesdail had an informal policy of making frequent flyer mileage earned while on company business the property of the employee.

The company used the following procedures for Mr. Charley's travel:

(1) A client would engage Truesdail and direct Mr. Charley to travel to an accident site.

(2) Truesdail would bill the client for round-trip air travel at first-class rates.

(3) Mr. Charley would instruct the travel agent to arrange for a coach-class ticket, but charge Truesdail for a first-class ticket.

(4) Mr. Charley would then use frequent flyer mileage to upgrade his coach ticket to a first-class ticket.

(5) Mr. Charley instructed the travel agent to credit his account with the difference between the amount they charged Truesdail for the first-class ticket and the amount they would have charged for a coach ticket.

The Tax Court held that the amounts deposited in Mr. Charley's travel account with the travel agent constituted taxable income and also imposed a negligence penalty. The taxpayer appealed to the Court of Appeals for the Ninth Circuit.

In the appellate court, the taxpayer argued that the question was whether frequent flyer miles are taxable and argued that they are not. The appellate disagreed with the taxpayer's identification of the issue in the case and did not address the issue of the taxability of frequent flyer mileage.

The appellate court agreed with the Tax Court that the transaction resulted in taxable income. The Tax Court noted that the transaction could be viewed in two ways. Either it constituted a transfer of travel credits to an employee and was simply compensation. Under this analysis, the fact frequent flyer miles were redeemed in the process was not relevant. In the alternative, the transaction could be seen as a transfer of Charley's frequent flyer mileage, an asset with zero basis, for the travel account, an asset with a fair market value.

The appellate court agreed with the Tax Court's analysis that the transaction resulted in taxable income to Mr. Charley. It disagreed with the imposition of a negligence penalty. Under the negligence penalty rules in place at the time of the transaction, negligence was "the lack of due care or the failure to do what a reasonable and prudent person would do under similar circumstances." In this case, the government itself did not know how to tax frequent flyer miles. There was nothing in the Tax Court's record to indicate that a reasonable and prudent person would have known that the use of frequent flyer mileage in the 1980s was a taxable event. *