Tax Question: What are the tax laws on bartering? How do you determine when something is a barter that should be taxed?
Answer: Services provided in exchange for goods or services is considered taxable income to both parties.
Follow-up Tax Question: What if the same value of billable services are traded. The net effect is the same. Would it be better to go through the actual cash transaction even though it is a wash? for example if I provide a service for someone and the value is $500 and they provide a service for me and the value is $500 would it be illegal to do this as a barter vs writing a check claiming the income and the expense?
Answer: You would think this would be an easy answer. It is not. The IRS has clearly stated that bartering is considered taxable income to both parties. However, the IRS does not clearly state how to treat expenses.
The following example is from the IRS website.
Example 3
You are a self-employed house painter. In return for painting his personal residence, your attorney agrees to perform personal legal services. If you would normally paint such a residence for $3,000 you would report the $3,000 in your gross receipts and you would be able to deduct the ordinary and necessary business expenses associated with painting the residence (such as paint, brushes and equipment rentals) on Schedule C or Schedule C-EZ of Form 1040. The attorney must also report the fair market value of the services in gross income on Schedule C or Schedule C-EZ of Form 1040, and deduct his ordinary and necessary business expenses associated with the legal services.
This implies the following. Both the painter and the attorney report $3,000 of income. This is clear. But want is not clear are the expenses. The IRS is implying that the painter and attorney can only deduct the out-of-pocket cost for providing the services. This means the painter and the attorney are unable to deduct the cost of services provided. This does not make since. Take a look at the numbers.
The painter used $500 of supplies and the attorney had $100 of out-of-pocket costs to provide the service.
IRS Scenario 1 – Bartering
Painter Income – $3,000
Painter Expenses – $500
Net Profit for Painter – $2,500
Attorney Income – $3,000
Attorney Expenses – $100
Net Profit for Attorney – $2,900
Scenario 2 – Bartering was not done
The painter and attorney are not bartering. The painter and attorney exchanged cash for services.
Painter Income – $3,000
Painter Expenses – $500
Painter cost for legal fees – $3,000
Net Loss for Painter – ($500)
Attorney Income – $3,000
Attorney Expenses – $100
Attorney cost for painting – $3,000
Net Loss for Attorney – ($100)
Why would the accounting be any different? It should not be. The IRS should clarify this but they don’t.
Thankfully there are tax court cases and memorandums that support deducting the value of services provided. This would line up with scenario 2. Accounting for bartering services is the same as if cash was exchanged.
Overall, we recommend you exchange cash for services if possible. You will not have to worry about this. But if exchanging cash is not possible, then the transaction needs to be clearly recorded in the books.
IRS Circular 230 Disclosure: To the extent this writing contains advice on a federal tax issue, the advice is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed in this communication.