Advisory: Proper Reporting of Assets and Liabilities of the Managing Exchange vs. the Exchange Members and IRS 1099 Reporting Requirements Regarding Client/Member Bad Debt Trade Accounts
Published: February 7, 2017
When the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) classified barter exchanges as third-party record keepers it required barter exchanges to adhere to the same IRS 1099B reporting requirements that banks and investment firms follow. However, the fundamental legal debtor/creditor relationship in a barter exchange differs from what exists in the commercial banking and investment firm sector. These differences have caused confusion in the barter industry regarding two specific areas:
- The proper reporting of assets and liabilities of the managing exchange vs. the exchange members.
- IRS 1099 Reporting Requirements Regarding Exchange Members’ Bad Debt Trade Accounts.
This Advisory Memo will review the history and legal precedent of these issues and provide guidance for handling both. IRTA’s guidance on these topics is further substantiated by a December 2nd, 2016 professional opinion from the accounting firm of Manning Silverman & Company, (attached as Addendum “A”).
IRTA’s Historical Recommendations – The Managing Exchange’s Assets and Liabilities vs. The Exchange Members Assets and Liabilities
In October of 1989 IRTA issued guidance regarding asset and liability recognition of the managing exchange vs. the exchange members – with the release of a model managing exchange “Balance Sheet” and a model “Statement of Condition” of exchange members, (attached as Addendum “B & C”).
NOTE: The managing exchange, (i.e., the barter exchange), is typically an incorporated entity, be it a C-Corp, Limited Partnership or Sub-Chapter S Corporation. The managing exchange balance sheet reflects the company’s assets and liabilities. In most cases the members of the exchange are not a separate corporate entity, rather, the members have signed a membership agreement with the managing exchange that articulates their rights and obligations, and grants the managing exchange various third-party record keeping responsibilities. Although the exchange members are not an incorporated entity per se, the exchange members collectively have their own assets and liabilities. Because the exchange members typically are not an incorporated entity, their financial report for their assets and liabilities, (which resembles a balance sheet), is called a “Statement of Condition,” (Addendum “C).
The Statement of Condition of the exchange member system, (Addendum “C”) clearly categorizes the members’ negative trade balances as assets and the members’ positive trade balances as liabilities. The exchange members’ positive and negative trade balances ARE NOT recorded as assets or liabilities on the managing exchange’s balance sheet, (Addendum “B”). Furthermore, trade loans between the members are only listed on the exchange members’ Statement of Condition, and ARE NOT listed on the managing exchange’s balance sheet.
Relevant Legal Precedent that Recognizes the Separation between the Managing Exchange’s Balance Sheet vs. The Assets and Liabilities of the Exchange Members
The Exchange Enterprise v. Commissioner decision of 1987, (see Addendum “D”), further underscores the separation between the managing exchange’s books and the books of the exchange members themselves. Exchange Enterprises ruled that the managing could not take the bad debt write-offs of members’ accounts on the managing exchange’s tax return. The court ruled the managing exchange was not a guarantor of the members’ system and did not have any basis for the trade amount they attempted to write-off. The court went on to say, “The members’ trading accounts have no direct relationship to the Exchange’s books of accounts…the members’ accounts represent a separate system which reflect trade balances.”
The Exchange Enterprise decision recognized the lack of a “transactional relationship” between the managing exchange and the exchange members, and it noted the effect of closing negative trade balance accounts, when it said:
“Although Exchange was responsible for the overall management of the barter system, it was not a guarantor of the system. The act of closing out the debit and credit balances of members to Exchange’s books did not cause Exchange to have “paid or incurred” expenses in operating the barter exchange business. The lack of a transactional relationship between the members’ accounts and Exchange’s books of accounts renders meaningless the act of closing out the balances. Exchange, in its business capacity, is neither directly enriched by credit balances nor caused detriment by debit balance of other members’ trading accounts.”
IRTA’s 1989 model “Statement of Condition” of the exchange members’ system and the model managing exchange’s “Balance Sheet” were reviewed by Manning Silverman & Company on December 2, 2016 and were determined to be an accurate outline of the proper accounting for the assets and liabilities of both systems.
Background – 1099B Reporting of Bad Debt Accounts
The longstanding IRTA axiom that “the legal liability of redemption of goods and services of trade dollars in a (member) barter system lies with the debtor members collectively. A (managing) barter exchange does not extend credit, the client/members who accept trade dollars do,” (see Addendum “E” – IRTA’s Advisory Memo of March 3, 2014, titled “Legal Liability for Trade Dollars in a Barter Exchange”). This important axiom further supports IRTA’s position that the managing barter exchange “is not like a commercial bank, which makes loans and is liable for demand deposits,” and therefore managing exchanges are not subject to banking regulations.
Manning Silverman & Company’s December 2, 2016 opinion letter further supports IRTA’s axiom that trade dollar lending takes place collectively between the exchange members when it states:
“The legal liability of redemption of goods and services of trade dollars in a barter system lies with the debtor members collectively. The exchange has a managerial role in the extension of credit among members, verifying creditworthiness, collecting delinquencies, etc., but has no credit-extending power of its own.”
While TEFRA clearly recognized barter exchanges as third-party record-keepers and mandated exchanges provide IRS 1099B reporting for the barter sales of the exchange’s client/members, TEFRA did not address what a managing exchange’s reporting responsibilities are when the exchange members’ deficit trade accounts are deemed to be a bad debt.
Managing Exchange’s Approaches to Defaulted Negative Trade Accounts of Exchange Members – Manning Silverman and Company Recommendations
Typically, when a managing exchange determines a member’s negative trade balance is in default, the managing exchange will close-out the account by entering a “purchase” from its “Bad-Debt Reserve” trade account and a “sale” from the defaulted member’s trade account, so as to effectively zero-out the account, (assuming the managing exchange has created and funded a bad-debt reserve account). The bad-debt reserve account entry on the exchange’s computer software will normally automatically generate a 1099B for the defaulted exchange member company, (unless the exchange specifically set the software to not generate a 1099B).
Other managing exchanges have handled the matter differently, by going through a debt forgiveness process whereby the defaulted negative trade balance member is issued a 1099C. Alternatively, other managing exchanges do not issue 1099’s in defaulted negative trade balance situations at all.
Manning Silverman & Company’s, (see attached Addendum “A”) guidance recommends managing exchanges should send 1099B’s in defaulted negative trade balance situations.
Manning Silverman & Company was also asked whether the managing exchange’s issuance of a 1099B for a defaulted negative trade balance create a nexus between the managing exchange and the exchange members, sufficient to create a debtor-creditor relationship.
Manning Silverman & Company’s opinion states that the managing exchange’s issuance of the 1099B for a defaulted members’ negative trade balance DOES NOT “establish a creditor-debtor relationship between the client/members’ and the solo (managing) exchange, IRC Sec. 6045 (a); Reg. Secs 1.6045(c), 1.6045(e).
Manning Silverman & Company’s conclusions are consistent with IRTA’s emphasis that a managing exchange’s third-party record keeping role and tax compliance responsibilities are paramount, and that the trade dollar lending is done collectively between the members. Therefore no debtor-creditor nexus is inferred or created between the managing exchange and the exchange members.