Exchanging goods and services with another business owner – bartering – is a common practice, and can make excellent sense in today's economy, but the IRS is warning that "barter dollars" are equal to "real dollars" for tax purposes.
Warning. The IRS is not the only taxing authority that considers barter dollars to be real dollars. Many states impose sales tax, as well as income tax on barter transactions. With states increasingly strapped for cash, many are stepping up their vigilance in searching out unreported transactions.
Income Tax and Self-Employment Tax. Because "barter dollars," the fair market value of the goods and services you received, are taxed as if they are cash, you can owe income tax, self-employment tax, employment tax, or even excise tax on your bartering income – even if you don't actually receive a penny in cash.
If you have bartering income as part of your business, the IRS expects you to report it on Form 1040, Schedule C, Profit or Loss from Business, or other business returns such as Form 1065 for partnerships, Form 1120 for corporations, or Form 1120-S for small business corporations. If the income isn't related to a trade or business, then it should be reported as "Other Income" on your Form 1040.
Example. Ray, an accountant, agrees to prepare a tax return for his friend, Karl. In exchange for the tax prep work, Karl agrees to replace the alternator in Ray's car, which he uses solely for business. Normally, each would charge $100 for the service they provided, but because this was a barter transaction, no money changes hands.
In the eyes of the IRS, both Ray and Karl have to include the $100 on their tax returns as taxable income. However, Karl will also be able to claim a deduction on his Form 1040, Schedule C, for professional services.
Also, if they would have to include the amount for self-employment tax if they had been paid in cash, they will need to include the $100 in their self-employment tax computation.
Capital Gains and Losses. Bartering activities can do more than create ordinary income. This can happen if you are exchanging products or tangible assets, rather than services. Exchanges of property can result in a capital gain or loss or in a nondeductible personal loss. If you barter business assets or close your business, you may have capital gains, ordinary gains and depreciation recapture to report. If you have barter property and the fair market value is more than your cost or other basis, you usually will have a reportable gain. Depending on how long you held the property, the gain could be ordinary income or capital gain.
Reporting requirements. Bartering can also create additional reporting requirements. If you would have to issue a Form 1099 to report cash payments for goods or services, then you will be required to issue a Form 1099 to report bartering income.
Example. Instead of simply preparing a tax return, Ray agrees to represent Karl in an IRS audit of his business. And, Karl agrees to rebuild the engine on Ray's car. Ray never uses this car in his business. Normally, Ray would charge $1,000 for audit representation. Karl normally charges $1,000 for an engine re-build.
Karl is required to provide Ray with a Form 1099-MISC, but Ray does not need to provide one to Karl because the car repair is a personal expense, not a deductible business expense. (Ray does need to report the income on his Form 1040 as "Other Income," even though he can't claim a deduction for the expense.)
If Karl had paid Ray $1,000 in cash for audit representation, he would have to provide Ray with a Form 1099-MISC. The fact that he paid by exchanging services does not eliminate his obligation to provide the Form 1099. However, a Form 1099 must be provided only for payments that are made in the course of a trade or business. Because Ray doesn't use his car for business, the repair is a personal expense.
There are special rules that apply if you are use a bartering exchange or if your trade or business consists of bartering activities. You can learn more about this by visiting the Bartering Tax Center.