For a lot of reasons, bartering between businesses makes sense. But how does the IRS view bartering? Is it possible to use bartering as a way to reduce your tax liability?

Small businesses barter goods and services on a daily basis. When one company agrees to provide something for another company in exchange for a similarly valued product or service, a bartering transaction has occurred. Since no cash changed hands at any point in the transaction, the transaction is 100% tax-free and immune from the auspices of the IRS, right? Not exactly.

Bartering & the IRS

As you might have guessed, the IRS isn't willing to let go of taxable income that easily. In fact, the IRS offers no loophole whatsoever for bartered transactions. According to the IRS code, the fair market value of bartered products and services must be included in income during the tax year it is received. On the other hand, the cost of producing the good or service given away in a bartered transaction can be included as an expense in the tax year it is incurred.

But even though you are required to report bartered goods as income, you can still use bartering as a way of reducing your tax liability since the fair market value of a good or service is often less than the amount that would actually be received at full markup. The result is less recorded profit and less taxable income at the end of the year. If you barter a couple of hundred dollars worth of services throughout the year, it's not going to have much of a tax impact. But if you barter several thousands of dollars in services, the tax benefits can begin to add up.

Non-tax Benefits of Bartering

Tax benefits aside, bartering is still a great idea for small businesses. In most cases, the non-tax benefits of bartering far outweigh the profit reduction bartering provides. For example, many small business owners find that bartering makes a nice starting point for strategic partnerships with other companies. The initial barter provides the impetus for a relationship of trust that ultimately springboards into a full-blown business partnership benefiting both companies.

Bartering also provides a perfect avenue to unload excess inventory or unused capacity. Instead of collecting dust in a warehouse, excess merchandise can be used to reduce your expenses through a barter arrangement. Likewise, instead of sitting around during your slow season, why not offer your services to another business in exchange for their services later in the year?

Once you begin to embrace bartering as a regular practice, you will quickly learn how to tell the difference between bartering relationships that advance your business and those that don't. The most important thing is to limit your barters to companies that have the ability to actually make good on their promises. If the company is going down the tubes, there's a good chance you'll never see the goods or services you've been promised.