Bartering is the exchange of goods without money. The words “without money” might make you believe that barter transactions aren’t taxed. But in reality, barter transactions are taxed.
During the 1970s, bartering started to become popular among businesses. It wasn’t just limited to the exchange of goods and services; saving businesses had started making a lot of profit and saved a lot of working capital as a result of the barter system. Even though businesses didn’t earn any US dollars with these barter deals, they generated significant revenue. As a result, the Internal Revenue Service (IRS) took action and created legislation governing barter income. This post will cover everything you need to know about the tax implications of a barter transaction.
What is Barter?
Before moving on, it is essential to understand what the term “barter” means. Barter is essentially an equal trade of goods and services. Simply put, we will have to exchange equal-value goods and services in place of paying money to complete the deal.
This exchange can happen in three ways-
Goods for Goods: both parties exchange goods
Goods for Services: one party gives some goods to receive a service
Services for Services: both parties exchange services
Barter transactions can happen between two individuals or two companies. The latter is referred to as corporate barter. Let us look at an example to understand corporate barter better. Suppose there are two companies: one is an ad agency, and the other is an event management company. The advertising agency is holding a huge celebration for its 25th anniversary. The agency can ask the event management company to manage this event for them. In return, the ad agency will help them with advertising their company. The amount of money needed to pay the event management firm will equal the amount the ad agency will use for marketing and promoting the event management company. Hence, achieving an equivalent exchange of services.
But are all exchanges of goods and services taxed? If you exchange some veggies with your neighbor, will that be taxed? We know it doesn’t work that way.
A barter tax is imposed on exchanges that benefit businesses. The tax kicks in if the individuals trading vegetables are firms looking to obtain raw materials or for any other use that might have required them to pay the cost had they not bartered them. As long as you are mere neighbors exchanging veggies, you won’t have to pay taxes for them.
What is barter income?
There are two ways in which you can barter-
1. Direct barter
When the two parties mutually decide on the barter exchange without third-party interference, we call it a “direct barter.” Usually, businesses that rely on each other’s services or goods would continuously engage in direct barter transactions to save their working capital.
2. Using trade credits
The modern barter system has a concept of trade credits or trade dollars or barter dollars.
Barter exchanges are networks where businesses can find each other businesses interested in bartering. Barter exchanges have rules, and equal exchange happens using barter dollars. You can earn barter dollars if you are bartering office stationery from your inventory. Later, you can use these barter dollars to buy things you need.
Barter income is the income you generate from direct barter and barter exchanges. Your barter income is taxable. Trade dollars are now treated as equal to US dollars. The trade dollars obtained in the barter exchange network and the fair market value of the product you obtain via direct barter comprise your total barter income. You can expect to present reports of all these formal and informal deals which contributed to your business.
How is the tax on barter transactions applied?
Tax on barter transactions is levied in many different ways based on the commodity you exchange and the purpose of its use.
The following are the three most common ways tax is applied on direct-barter or barter exchange transactions.
As Income Tax
A tax placed on people or organizations on their income or earnings is known as an income tax. If the barter transaction helped increase your overall revenue, you would be liable to pay income tax. If you think about this, you would be earning US dollars instead of trade dollars if you skipped bartering. Hence, the income tax on barter transactions.
For example, you are a manufacturing company that manufactures sewing machines. I am a designer who has a boutique and wants to buy two new sewing machines. I propose a barter offer to you. You give me a couple of sewing machines, and I will sew aprons or uniforms with your brand logo on them for your employees. The value of the sewing machines equals the cost of sewing uniforms for all employees. Hence, it is an equal exchange without any involvement of money.
The IRS, however, views this scenario differently. According to the IRS, both used the barter deal for their business and earned an income of a certain amount. So you and I are expected to report the fair market value of our goods and services.
As Capital Gains Tax
As the name suggests, capital gain tax refers to the tax levied on your profit. Your profit is the difference between the price you paid to buy or make a product and the price you charged for selling it. A percentage of that profit is the amount you would be paying as capital gain tax.
In the previous example, you spent $55 manufacturing the sewing machine. However, our barter deal was worth $100. Which means you were successful in selling it for $100. The remaining $45 represents your capital gain.
As self-employment tax
Self-employed individuals and small business owners must pay self-employment taxes to cover the cost of Medicare and Social Security. When your annual net income exceeds $400, you must pay self-employment tax. It is comparable to the Federal Insurance Contributions Act tax; a federal payroll tax levied against employees and employers.
In the initial stages, many businesses consider bartering to increase their overall profit. Barter exchanges are also open to individuals. Hence, if you are self-employed and can generate a profit with the help of the barter system, then you are expected to pay self-employment tax for the same.
Barter Tax deductions
Like other taxes, barter taxes are also deductible. You can reduce a certain amount as business expenses. However, to accurately minimize your tax liability, you will need to contact a professional accountant. For example, registration fees for a barter exchange can be considered a business expense, so you can deduct some of the tax amounts. Finding such gaps where tax amounts can be reduced is a skilled person’s job. So it is always a better idea to seek a professional accountant. You can even barter this service.
How to report bartering income?
Reporting bartering income for the tax year is necessary for all businesses. Here is how you can do it.
We learned that there are two ways of bartering. Trading goods and services directly with another business and trading via barter exchanges using trade dollars. Tax forms are different for both transactions.
Reporting is not necessary if
- Less than 100 barter transactions occur in a year, which is not enough to be flagged by the tax authorities.
- If the value of every transaction is less than 1$, you are exempted from paying tax.
The following are some of the most important forms you are expected to fill out to report your barter income.
- Form 1099 B is to be submitted by businesses that are part of a barter exchange.
- Form 1099-MISC is to be submitted by businesses that are not part of any barter exchange but still trade goods and services.
- Form 1065 needs to be submitted by every domestic and international partnership conducting business in the United States to report their income.
- Form 1120 must be submitted by all domestic corporations, even those without taxable income. This form must also be filed by corporations filing for bankruptcy. Corporations exempt from taxation under Section 501, such as NGOs and charitable organizations, are not required to submit form 1120.
- Tax deduction forms: If you are filing for any tax deductions, you are also expected to submit the respective forms.
Determine the value of the barter transaction
To fill out the above forms, you need to find the value of the barter. Now, what do we mean by the value of the barter transaction?
You know the trade dollars you earn are your taxable barter income. If you have been conducting barter business without trade credits, in that case, the fair market value of the product you received from bartering is considered the value of the barter transaction. This value should be reported in the forms mentioned above.
For example, if a computer retailer barters a few units worth $1000 (fair market value) with a graphic design firm and, in return, asks for some posters and banners for their store, the fee that the graphic design firm charges for this service is also approximately $1000. So, in this case, the value of the barter transaction is $1000.
To calculate the fair market value, you can use historical pricing patterns or the carrying cost to determine the correct value.
My last piece of advice would be to gain as much knowledge as you can before entering the world of trading. Although barter transactions are moneyless, you still have to pay taxes to the federal government. Make sure you file your income tax return on time with the help of an accountant. Make sure you have proof of all the barter transactions you’ve ever made, whether directly or via a barter exchange. Such documents are necessary to prove the occurrence of a transaction.