Finding clarity in the IRS's position on barter transactions.
The deductibility of expenses involved in a barter transaction is more difficult to understand. IRS 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.
This passage raises the following question: If a company exchanges business services or products with another business to pay a business expense, can the company only deduct its actual incurred costs and not the associated business expense? For example, assume a computer retailer agrees to sell a laptop, which cost it $500, for its fair market value of $1,000 to an attorney, in exchange for $1,000 of legal services. Although the business would record $1,000 in gross income for the receipt of legal fees, if such constituted their fair market value, would it only be able to deduct $500, the cost of the computer, for this transaction? Does IRS guidance suggest that it could not also deduct the $1,000 fair market value of legal services as a business expense as well as cost of the computer?
The tax treatment is clear if the transaction is entirely a cash transaction. If a business took a computer that cost $500 and sold it to the attorney for $1,000, and then paid $1,000 for legal services, unquestionably it could deduct both the $500 cost of the computer as well as the legal fees of $1,000.
Memorandum 200147032, issued by the IRS'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 decisions 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 ).
Similarly, in Memorandum 200411042--published on March 12, 2004, by the IRS's Office of Chief Counsel--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.
The memo also cites United States v. General Shoe Corp.
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 the computer), in addition to the cost of the computer.
So how to explain this apparent inconsistency of tax treatments of deductions of business expenses settled by barter?
It appears that the IRS failed in Publication 535 to explicitly clarify the full tax treatment of a barter transaction in accordance with tax law, including case law. Although the IRS has reiterated on numerous occasions the requirement to include in income the receipt of products or services received in an exchange of products or services, it does not state as unambiguously 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" [emphasis added]--suggests that an individual or business cannot additionally deduct the business expense settled by those goods or other property, because the word "only" can be interpreted to exclude it. Because there was no payment of cash in this example, 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, it may seem that one can only deduct the costs of one's products or services, and not the business expense settled with the payment in kind.
An Example of Deductibility
In the Bartering Tax Center section of the IRS website, there is an acknowledgment of 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" (www.irs.gov/businesses/small/article/0,,id=188095,00.html). Although this suggests that bartered transactions are treated like cash transactions for tax purposes, when considering that barter dollars or trade dollars are terms normally restricted to barters conducted through a barter exchange and are not applied to direct trades, it is ambiguous whether the statement is only a confirmation of the deductibility of business products or services traded on a barter exchange. This is because an acceptable medium of exchange for barter transactions is available only on an exchange, and the recognition of tax liabilities for a business expense requires economic performance.
Also on that webpage, the IRS uses an example to illustrate the different reporting requirements for services and products provided as payments in kind to settle business expenses, as opposed to personal expenses. It explains that an attorney is required to issue Form 1099-MISC to a painter for painting his office, but the painter is not obligated, in turn, to issue the attorney a Form 1099-MISC because the attorney represented the painter on a personal matter. Although the IRS observes that "painting the office is a business expense for the attorney," it does not state outright that the business expense is deductible for the attorney, because not all business expenses are deductible. The passage's context and intent is to clarify who is required to issue a Form 1099-MISC. The issuance of a Form 1099-MISC is to document the payment of nonemployee compensation arising in business transactions. But the fact that the painter receives Form 1099-MISC and 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 nonemployee compensation to, as well as its receipt by, the painter--that is, it is prima facie evidence supporting the tax deduction by the attorney for the business expense of having his office painted. The fact that the painter is not required to issue a Form 1099-MISC to the attorney, in turn, is due to his services not being regarded as "payment" of nonemployee compensation to the attorney--the painter cannot deduct a personal expense on his business tax return.
Untangling the IRS Guidance
There is further evidence supporting the deductibility of services received in a barter transaction on the IRS webpage, "Record Keeping for Business Barter Transactions":
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. (www.irs.gov/businesses/small/article/0,,id=215975,00.html)
Although emphasis of the passage is on the necessity of reporting all bartering for services on Form 1099-MISC and Form W-2, and the withholding and payment of taxes on such, it states that services obtained from independent contractors in exchange for services and products are "deductible." But because 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, it is easy to 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 pages on its website to barter exchanges: "Barter Exchanges" and "Tax Requirements for Barter Exchanges." Despite this coverage, its discussion of baiter dollars fails to explicitly declare that purchases made with trade dollars are deductible, even though it says unequivocally that sales paid for with trade dollars are taxable. This might lead to the interpretation that trade dollars are an acceptable equivalent to regular dollars in the measurement of sales but not purchases. For example, the IRS makes apparent 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. ("Barter Exchanges," www.irs.gov/businesses/small/article/0,,id=113437,00.html)
But the IRS does not mention here the tax deductibility of products or services purchased with trade or barter dollars. Although it declares that earning trade or barter dollars is taxable income, the IRS does not explicitly state its corollary: Paying for goods and services with trade or barter dollars is a tax deduction. This appears to be part of a pattern wherein the IRS does not emphasize the tax deduction but only the taxable income of a barter transaction.
Direct Trades Versus Exchanges
There is, however, an important distinction between the tax treatments of direct barter trades and those conducted on exchanges. The differences stem from the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which recognized baiter exchanges as brokers and third-party record keepers, and bestowed upon them a stature similar to that of 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.
Because a bartered transaction is essentially two transactions--the provision of a product or service in exchange for another product or service--the barter exchange underscores this distinction by providing a marketplace for the two transactions to be consummated independently of each other. This is different from 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 product or service from an entirely different member. The barter exchange effectively accomplishes a complete separation of the two transactions, which often have the appearance of one in a direct trade, by serving as a marketplace for many members to trade their services and products at any time or place, by recording all 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 separates a combined set of dependent transactions into two independent transactions.
As a result of this division provided by the barter exchange, when a member provides a bartered product or performs a bartered service, 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. Because the transaction is completely independent of a reciprocal exchange transaction, there is no necessity to wait until the exchanged products or 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 the member has purchased any products or services with those dollars.
Similarly--due again 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 products or services received when purchased, whereas direct bartering recognizes the deduction of the fair market value of the products or services 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.
It's Up to the Taxpayer
The Bartering Tax Center features a five-minute video explaining the tax treatment of barter transactions. It does not discuss the tax deductions available to the taxpayer, but only the tax liabilities from the generation of taxable income. It appears that the IRS's position is that it will fully disclose when to report income; it is up to the individual or business, however, to discover its deductions. The purpose of this article is to explicate the deductions available 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.
William Brighenti is the director of Accountants CPA, Hartford, Conn.
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|Title Annotation:||federal taxation; Internal Revenue Service|
|Publication:||The CPA Journal|
|Date:||Jan 1, 2011|
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