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Tax
Deductions of Barter Exchanges
Barterer Beware of IRS's Posture on Barter Tax Deductions by William Brighenti, Certified Public Accountant, Certified QuickBooks ProAdvisor  Have you been considering bartering lately
because of the tightness of money? If so, have you given any
thought to the correct tax treatment of bartered transactions?
Although the Internal Revenue Service has a “Bartering Tax Center” on
its website, after a cursory reading of the half dozen webpages devoted
to its tax treatment, you may feel more confused than clarified about
the tax treatment of bartered transactions.What is clear is that bartered services or products generate income that needs to be included in gross income on your business tax return. Typically services and products provided in a direct exchange between companies or individuals for other services and products are reported at their fair market value on Form 1099-MISC. These barterers are required to include in gross income the fair market value of the products or services received. On the other hand, swaps conducted through a barter exchange are reported by the exchange on Form 1099-B to its members, who are required to include in gross income the fair market value of the products or services provided. A barter exchange is an organization of traders who use a third-party record keeper to effect and record the trades. Less clear is the deductibility of expenses involved in a barter transaction. The Internal Revenue Service’s Publication 535 Business Expenses states the following about payments in kind, i.e., barter: If you provide services to
pay a business expense, the amount you can deduct is limited to your
out-of-pocket costs. You cannot deduct the cost of your own labor.
Similarly, if you pay a business expense in goods or other property, you can deduct only what the property costs you. If these costs are included in the cost of goods sold, do not deduct them as a business expense. After reading this passage, you might ask yourself the following question: does this statement mean that if you exchange business services or products with another business to pay a business expense, you can only deduct your actual incurred costs and not deduct the associated business expense? For instance, assume you sell computers and agree to sell a laptop, which cost you $500, for its fair market value of $1,000 to an attorney in exchange for $1,000 of legal services. Although you would record $1,000 in gross income for the receipt of legal fees if such constituted their fair market value, would you only be able to deduct $500, the cost of the computer, for this transaction? Does the above statement suggest that you could not also deduct the $1,000 fair market value of legal services as a business expense as well as the cost of the computer? The tax treatment is crystal clear if the transaction were entirely a cash transaction. If you sold a computer that cost you $500 to the attorney for $1,000, and then paid $1,000 for legal services, unquestionably you could deduct both the $500 cost of the computer as well as the legal fees of $1,000. Memorandum Number 200147032 issued by the Internal Revenue Service’s National Office of Technical Advice on August 14, 2001 contradicts the above-quoted seeming denial of the tax deductibility of services received through an exchange or barter transaction: When a taxpayer engages in
a barter transaction, the transaction should be treated as
if the taxpayer sold its own product or services at fair market value and then paid fair market value for the product or services of the other party… …Thus, the recognition of income gives the taxpayer a cost basis in the services or product received equal to the amount of income recognized. The memo cites several court cases in support of its position, including the landmark tax court case, United States v. General Shoe Corp., 282 F.2d 9, 12 (6th Cir. 1960), cert. denied 365 U.S. 843 (1961). Similarly, in Memorandum Number 200411042 published on March 12, 2004 by the Office of Chief Counsel of the Internal Revenue Service, the IRS recognizes the deductibility of bartered services in exchange for bartered services: The payment of cash in
exchange for property and services generally constitutes an
expense paid or incurred during the taxable year. Amounts also may be treated as paid or incurred during the taxable year if the taxpayer provides property or services (rather than cash) in exchange for property or services (a bartering transaction). Taxpayers that engage in bartering transactions are treated as if they had received cash for their goods or services in an amount equal to the value of goods or services received and then used that cash to purchase goods or services from the other party to the exchange. Again, the memo cites the same landmark court case, United States v. General Shoe Corp., 282 F.2d 9, 12 (6th Cir. 1960). Consequently, in accordance
with this memo, the computer retailer in the above example would also
be able to deduct the cost of the legal fees against the income
recognized from the receipt of legal services in exchange for a
computer in addition to the cost of the computer.
So how can you explain this apparent inconsistency of tax treatments of deductions of business expenses settled by barter? It appears that the Internal Revenue Service fails in Publication 535 in its own imitable fashion to clarify explicitly the full tax treatment of a barter transaction in accordance to tax law, including case law. Although the IRS has reiterated on numerous occasions the requirement to include in income the receipt of services or products received in an exchange of products or services, it typically fails to make equally, unequivocally, and unambiguously as clear that in addition to the actual costs incurred in the provision of services or products, the barterer is also entitled to deduct the business expense of the services and goods received in the exchange. The statement in Publication 535—“if you pay a business expense in goods or other property, you can deduct only what the property costs you [my emphasis]”—suggests that you cannot in addition deduct the business expense settled by those goods or other property, since the word only can be interpreted to exclude it. Because there was no payment of cash here, the question that naturally comes to mind when reading the IRS’s policy on the tax treatment of payments in kind to settle a business expense is whether such services constitute economic performance, which is ordinarily required in order to deduct a business expense. Consequently, you may be left with the impression that you can only deduct the costs of your products or services, and not the business expense settled with the payment in kind. Because I was troubled with the above passage and its tax implications, and because I wished to have the Internal Revenue Service clarify its position on the tax deductibility of business services provided in exchanged for other services, I submitted an inquiry to its Tax Law Assistance service asking whether or not you can deduct the services provided in a barter exchange. Not at all surprising is the noncommittal response that I received from the Tax Law Assistance department: If you are operating a
viable bartering business, you may be entitled
to deduct business expenses. If you have an established business and
are augmenting your sales with barter transactions, include the sales
from bartering in your business income.
Business expenses are the cost of carrying on a trade or business. These expenses are usually deductible if the business is operated to make a profit. Business expenses are the cost of carrying on a trade or business. These expenses are usually deductible if the business is operated to make a profit. Please review the general information below on bartering. Bartering is the trading of one product or service for another. Usually there is no exchange of cash. It is the most ancient form of commerce. Any business owner or professional who has a product or service to offer can barter. The fair market value of the goods and services exchanged must be reported as income by both parties. To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary. If you barter your products or services through a barter exchange, you should receive a Form 1099-B, Proceeds from Broker and Barter Exchange Transactions. The amount shown in 1099-B Box 3 Bartering is your barter transactions proceeds and is generally reportable as income and must be included on your tax return. Barter exchanges have an annual obligation to report your bartering proceeds to the IRS. If a business makes payments of bartered services to another business (except a corporation) of $600 or more in the course of the year, these payments are reported on Form 1099-MISC. Nevertheless, even if no Forms 1099-B or 1099-MISC are filed, bartering is generally taxable to the extent of the fair market value of the products or services bartered under Internal Revenue Code Section 61. For more information, you may access Publication 525, Taxable and Nontaxable Income, on the internet at www.irs.gov or may be ordered by calling 1-800-829-3676. Observe that the Internal Revenue agent failed specifically to address my question: if you swap business services for other business services, may you deduct those business services provided? The reply—"If you are operating a viable bartering business, you may be entitled to deduct business expenses—completely begs my specific question of whether or not the business services provided in the exchange are deductible. It fails to specify what kinds (i.e., cash versus exchanged services) of business expenses are deductible, and even qualifies the deductibility of these unspecified business expenses in its the use of the modal verb, "may". Note that this kind of noncommittal statement on the tax deductibility of bartered services provided contrasts sharply with its unequivocal statement in the use of the auxiliary verb, "must", that bartered services received are taxable: "your barter transactions proceeds...must be included on your tax return". In addition to the passage in Publication 535 on payments in kind, there are other instances of failures on the part of the Internal Revenue Service to clarify the full and complete tax consequences of a barter transaction in its publications, where it repeatedly makes perfectly clear the taxable income to be recognized from bartered transactions while it muddles the corresponding tax deductions from them. In fact, some ironically appear in the Bartering Tax Center section on the IRS website. However, if you read these passages with the carefully, close scrutiny of a biblical exegesis scholar, you can discern an acknowledgment by the IRS on the deductibility of business services and products received through bartering. For example, under “Tax Responsibilities of Bartering Participants”, the IRS states that “Barter dollars or trade dollars are identical to real dollars for tax reporting”. Although this suggests that bartered transactions are treated tax-wise like cash transactions, when you consider that barter dollars or trade dollars are terms normally restricted to barters conducted through a barter exchange and are not applied to direct trades, you might wonder whether the statement may only be a confirmation on the part of the IRS of the deductibility of business services or products traded just on a barter exchange, since an acceptable medium of exchange for barter transactions is available only on an exchange, and the recognition of tax liabilities for a business expense require economic performance. Further down that same web page, the IRS illustrates with an example the different reporting requirements for services and products provided as payments in kind to settle business expenses as opposed to personal expenses. There it explains that an attorney is required to issue Form 1099-MISC to a painter for painting his or her office, but that the painter is not obligated, in turn, to issue the attorney a Form 1099-MISC since the attorney represented the painter on a personal matter. Although the IRS observes in this passage that “painting the office is a business expense for the attorney”, it fails to state outright that the business expense is deductible for the attorney, since not all business expenses are deductible. The passage’s context and intent, clearly, is to clarify who is required to issue Form 1099-MISC. Obviously, the issuance of Form 1099-MISC is to document the payment of non-employee compensation arising in business transactions. But the fact that the painter does receive Form 1099-MISC, and that the attorney does not, is evidence, however indirectly stated, that the IRS does indeed concede the deductibility of business expenses settled through bartering. In the case of the attorney, it is documentation attesting to the “payment” of non-employee compensation to, as well as its receipt by, the painter: i.e., it is prima facie evidence supporting the tax deduction by the attorney for the business expense of having his or her office painted. The fact that the painter is not required to issue Form 1099-MISC to the attorney, in turn, is due to his services not being regarded as “payment” of non-employee compensation to the attorney: the painter cannot deduct a personal expense on his or her business tax return. Again, the IRS passes up another opportunity to fully clarify the full tax ramifications of the barter transaction to its participants with its reluctance to include the word “deduction” in the passage. There is further evidence supporting the deductibility of services received in a barter transaction, appearing on the IRS web page, “Tax Responsibilities of Bartering Participants”: A business can pay bartered
goods or services as a bonus or as part of a compensation package to
employees, partners and contractors…. Just as cash business expenses
associated with bartering are deductible, barter used as compensation
is deductible and subject to employment taxes and information
reporting. Barter used as a bonus or compensation for an independent
contractor must be included on the contractor’s Form 1099-MISC,
Miscellaneous Income, as non-employee compensation, and all barter
compensation for employees must be taken into account on their Forms
W-2. Barter compensation is subject to FICA, FUTA, and federal income
tax withholding.
Although the thrust of the passage is, again, to emphasize the necessity of reporting all bartering for services on Form 1099-MISC and Forms W-2, and the withholding and payment of taxes on such, it clearly states that services obtained from independent contractors in exchange for services and products are “deductible”. But since the wording of the passage includes the bartered services of the independent contractor with those of employees and partners, uses the term compensation as opposed to purchases, and emphasizes the payment and withholding of employment taxes, you might overlook its inclusion here as a legitimate deduction in a barter transaction. As mentioned previously, the IRS does state that “barter dollars or trade dollars are identical to real dollars for tax reporting”. Moreover, the IRS devotes two WebPages on its website to barter exchanges: “Barter Exchanges” and “Tax Requirements for Barter Exchanges”. Yet in spite of this coverage of barter exchanges, its discussion of barter dollars fails to declare explicitly that purchases made with trade dollars are deductible, even though it says unequivocally that sales paid for with trade dollars are taxable, perhaps leaving you with the interpretation that trade dollars may only be an acceptable equivalent to regular dollars in the measurement of sales but not purchases. For instance, in its discussion of trade dollars, the IRS makes perfectly clear the necessity of including trade dollars in gross income upon their crediting to a member’s account of a barter exchange: Barter exchanges have their
own unit of exchange, usually known as barter or trade dollars.
Trade dollars or barter dollars are valued in U.S. currency for the
purposes of information returns. Trade dollars allow barter
to take place between parties when one party may not have a
simultaneous need or desire for the goods or services of the other
members. Barter exchanges act as the bookkeeper for keeping track
of trade dollars that participants accumulate. Earning trade or barter
dollars through a barter exchange is considered taxable income, just as
if your product or service was sold for cash.
But once again the IRS fails here as elsewhere to mention the tax deductibility of products or services purchased with trade or barter dollars. Although declaring that earning trade or barter dollars is taxable income, the IRS fails to state explicitly its corollary: that paying for goods and services with trade or barter dollars is a tax deduction. A pattern appears to exist on the IRS’s part of not emphasizing the tax deduction but only the taxable income of a barter transaction. There is, however, an important distinction between the tax treatments of direct barter trades and those conducted on exchanges. The differences stem from TEFRA, the Tax Equity and Fiscal Responsibility Act of 1982, which recognized barter exchanges as brokers, as third-party record keepers, and bestowed upon them a stature similar to that of other financial institutions, such as brokerage houses and credit card companies. The basic distinction of trades on a barter exchange as opposed to those conducted off an exchange privately and directly between parties is that the presence of the barter exchange monetarizes the barter transactions by quantifying them in terms of barter or trade dollars and recording those monetary valuations in the members accounts. Since a bartered transaction is essentially two transactions—the provision of a service and product in exchange for another service or product—the barter exchange underscores this distinction by providing a market place for the two transactions to be consummated independently of each other, as opposed to what typically occurs in a direct trade, where—because of the dependency of the transaction on two specific and immediate parties, along with the proximity in time and place—the two transactions appear as one, as implied in Publication 535: e.g., the provision of services to settle a business expense. On an exchange a member may provide a service or a product to another member at one point in time, and then much later this same member may purchase a service or a product from an entirely different member. The barter exchange effectively accomplishes a complete separation of the two transactions, that often have the appearance of one in a direct trade, by providing a marketplace for many members to trade their services and products at any time or place, by recording all of the barter transactions and keeping an account of the trades, and by assigning fair market values to the trades in terms of trade or barter dollars, a medium of exchange: that is, it monetarizes the trade. In essence the barter exchange decomposes a combined set of dependent transactions into two independent transactions. As a result of this decomposition provided by the barter exchange, when a member performs a bartered service or provides a product, its fair market value is recorded by the exchange in the member’s account in terms of barter or trade dollars and taxable income is recognized, as in a normal sale. Since the transaction is completely independent of a reciprocal exchange transaction, there is no necessity to wait until the exchanged products and services are received to determine and recognize the gross income and record it, as is required in a direct trade. Trade or barter dollars are credited to one’s barter account upon the provision of the services or products, independent of whether or not the member has purchased any services or products with those dollars. Similarly, again due to the use of trade or barter dollars, the presence of a third-party record keeper, and the existence of a marketplace, exchange bartering recognizes the deduction of the fair market value of the services or products received when purchased, whereas direct bartering recognizes the deduction of the fair market value of the services or products purchased when provided. It follows then that direct bartering requires the issuance of Form 1099-MISC to each recipient of the barterer’s services and products at their fair market value, whereas exchange bartering requires the issuance by the barter exchange of Form 1099-B to all active members, showing the fair market values of all of their individual services and products provided to other members. These significant differences between barters conducted on exchanges and those conducted off exchanges are all a result of the monetarization of the transaction by the use of a third-party record keeper, trade or barter dollars, and a marketplace provided by the broker exchange. The Bartering Tax Center features a five-minute video explaining the tax treatment of barter transactions. Unfortunately, but now not surprisingly, not one second is devoted to discussing the tax deductions available to the taxpayer, but only the tax liabilities from the generation of taxable income. It appears that the posture of the IRS is “we against you”: we will fully disclose to you when to report income; it is up to you, however, to discover your deductions. The purpose of this article is to clarify the deductions available to you in a barter transaction and the difference in the recognition of income and deductions of trades conducted directly and privately between businesses from those conducted on a barter exchange. This article is provided for informational purposes and is not intended to be construed as legal, accounting, or other professional advice. For further information, please consult appropriate professional advice from your attorney and certified public accountant. Have a tax, a QuickBooks, or an accounting question? Please feel free to submit it under "Comments" on our blog, Accounting, QuickBooks, and Taxes by William Brighenti, Certified Public Accountant, Accountants CPA Hartford, LLC. For information and assistance on any tax, QuickBooks, or accounting issue, please visit our website: Accountants CPA Hartford, LLC. If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. The above tax advice was written to support the promotion or marketing of the accounting practice of the publisher and any transaction described herein. The taxpayer recipients of this offering memorandum should seek tax advice based on their particular circumstances from an independent tax advisor. |
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