Updated: Mar 28, 2021
Written by Attorney Margrit Parker and CPA Michael Pharris
Why do people trade services rather than exchange money for them? If one reason is that the parties to the trade believe that the absence of cash in the deal exempts them from issues relating to taxes and employment laws, then, unfortunately, they are mistaken. Bartering or exchanging services in lieu of cash carries with it all the same obligations related to income tax as well as employment laws.
Let’s say that a horse-riding student spends four hours cleaning stalls in exchange for a riding lesson. Assume that the fair market value of stall cleaning is $15 per hour, so $60 total here, and the riding instructor charges $60 for a lesson. A clean swap, and no bookkeeping or reporting needed, right? Wrong.
If the goal of trading services instead of money was to avoid dealing with taxable income and employment law issues, they are out of luck.
First, the instructor still has to properly classify the student as an employee or independent contractor. Beware, people often misclassify workers as independent contractors thinking they can avoid the costs and legal obligations that come with having employees. For a discussion of several reasons why it is important to get the classification right, see this previous blog post. In this post, we’ll focus on income taxes.
If the student is an employee, then the non-cash compensation (i.e. the riding lesson) is treated the same as if it had been paid in cash, valued at the fair market value of the lesson. It’s subject to the same payroll withholding as any other compensation. This raises an obvious practical application problem – where does the cash come from to fund the withholding? Some employers would require the employee to contribute cash equal to the withholding, but more commonly, the employer ‘grosses up’ the reported wages to account for the tax which is also funded by the employer. This raises the costs for all parties incrementally – more taxable income to the employee and increased compensation and tax expense to the employer.
Let’s modify the example for a moment. What if the riding instructor paid the student in cash instead of a lesson, but failed to do the required income tax withholdings? When the employer avoids withholding they expose themselves to potentially costly penalties. The IRS has the ability to hold the employer accountable for the payroll tax and the income tax that should have been withheld from the employees pay. This, combined with the applicable penalties and interest can make a small error quite costly.
On the other hand, if the student is an independent contractor and not an employee, then the exchange of services in our original example is taxable income to both parties. The value of the services that each party “paid” to the other is reportable income. The student paid in services valued at $60, and the instructor likewise paid in services valued at $60. The value of the transaction does not change even if cash is not used. Any person who exchanges property or services through a barter exchange will have to file either Form 1099-B or FORM 1099-NEC with the IRS.
All of this is to say that whether you exchange cash or goods and services as payment, the fair market value of what is given must still be accounted for, reported, and appropriate taxes paid by both parties to the transaction. The absence of cash doesn’t create an exemption. In fact, it can make compliance with tax and employment laws more complicated and create more opportunities for errors.
There may be good reasons to trade or barter services. But before you do, it is wise to consult your tax and legal advisors to ensure you are setting things up correctly.
Michael Pharris of Michael F. Pharris CPA, LLC, is a CPA advisor with years of experience assisting clients with financial reporting, tax planning, sale or purchase of a business, IRS audit representation, negotiation with banks or vendors, staffing issues, accounting department design and function, and overall business strategic planning.
Margrit Parker and Lent Parker Law LLC provide business legal services and estate planning services. Equine clients include businesses, nonprofits, associations, and professionals. The firm also serves licensed professionals, including health care professionals and lawyers, in business matters and license defense.
Legal disclaimer: Individual circumstances and state laws vary. This post is not intended and should not be relied on as legal or tax advice for your particular circumstance. Contact an attorney or a CPA advisor if you are in need of legal or tax assistance.
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