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What are tax consequences of bartering?

barterCash is hard to come by these days. So it's not unusual to see barter arrangements between taxpayers.

You've probably even done a little of this yourself: You've designed someone's Web site in exchange for "free" handyman services, or you've done someone's taxes in exchange for a new Coach briefcase. In either case, whether it's the exchange of goods or services for other goods or services, it's a barter.

No money actually changes hands, so it's almost as if the transaction didn't happen, right? Not exactly. The fair market value of goods and services that you receive in exchange for goods or services you provide must be included as income on your tax return even though you don't receive payment in a traditional way.

Think of barter just like cash: If it would be taxable if paid in cash, it's taxable if paid in goods or services. If you receive value for goods or services that would normally be taxable to you personally but not as part of a trade or business (such as babysitting income), report it as "other income" on line 21 of your form 1040. If the exchange was part of your trade or business, report the transaction, including income and expenses, on a Schedule C on your form 1040.

The fair market value of goods and services can be subjective. A good rule of thumb: It's the price that a "willing buyer" would pay for the goods or services from a "willing seller." In other words, what would the cost of that Coach briefcase be on the open market? How much would you normally charge to do someone's taxes? Those answers determine the fair market value of the transaction.

It's not a one-sided transaction, though. You're not simply left with income to report and nothing to show for it. As with a more traditional, cash transaction, the cost of producing the good or service given away in a bartered transaction can be deducted as a business expense. The business-related expense is key to the deduction: You can deduct business expenses on your tax return, but not personal expenses (like the cost of mowing the lawn).

Similarly, if you use barter to provide bonuses, incentives, or other compensation to employees or other personnel, you would report it just as it if was paid in cash. You'll take the proper deductions as expenses to your business and include the associated income to your employees or contractors. Bartering to compensate an independent contractor would be included on the contractor's form 1099; for employees, use a form W-2 and withhold the appropriate payroll taxes.

The bottom line is that, whether or not cash changes hands, you'll treat a barter just as you would any other business transaction. That means that you need to keep good records of the transaction -- both what you bartered away and what you received. You may want to consult with a tax professional if you're not sure about reporting requirements or how to best value your services.

If you're not sure how to start bartering, or if the reporting requirements feel bit overwhelming, consider participating in a barter exchange company. A barter exchange is generally an organization with members that contract with each other to jointly trade or barter property or services for credits. Many of these barter exchanges are available on the Internet. The best part is that, since they are strictly regulated by the IRS, you'll receive a form 1099-B from the exchange indicating the amount of income to be reported. If you're skittish about valuing your services for purposes of income, a third party can offer additional perspective.

It's clear that you don't get any special tax benefits from bartering your services. But there are no tax penalties, either. In most cases, it's exactly like a traditional, cash transaction. So then, why bother?

The obvious answer is that bartering allows you to exchange your goods or services for something you need when you might not have the cash to otherwise pay for it. It also allows you to get rid of extra inventory or take advantage of "down time" in exchange for reducing your cash outlay for business expenses. In this economy, it can be a smart move.

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