I have been audited twice by the I.R.S. during the past 5 years. During both of these audits the I.R.S. agent asked how many "inventory items did I withhdraw for personal use?" This is a potential trap, so avoid this practice if you can!
A letter from the I.R.S. Information Document required:
"Documentation and computation of the cost of inventory items withdrawn for personal use. Include gifts to family members and friends, items for personal consumption, etc. A logbook, written record, or any documentation you have that shows what you used for business and what was given as gifts to family, friends or personal consumption. We need to see how you separated what was used for business and what was used for personal consumption."
Just to clarify here, I am not talking about taking an item from your inventory to display in your studio or wearing a pair of earrings to an opening for promotion. These are two examples of a legitimate way to promote your work. You still own the item and you are actively offering them for sale. What should be a concern is the common practice of "trading work with other artists."
Recently I read an online art/craft busines newsletter discussing how much fun it is to trade work! Trading work is NOT a business like behavior. Sorry if I sound like a fuss budget, but there are many facets of behaving "like a business." If you want to deduct your legitimate art or craft business expenses (whether you make money or not), you need to be able to prove that you are "acting like a business."
The whole point is that the I.R.S. wants to determine if you fit their definition of a "hobby" or a "business." If you want the I.R.S. to perceive your entrepreneurial efforts as a business, then you must show them that you act like a business. A business needs to account for every item in their inventory.
The I.R.S. has rules regarding giving your work away or trading from business inventory. It is called "barter." If you want more information on barter, see the information below my signature (copied directly from the I.R.S. web site).
On the other hand, if you are happy being deemed a "hobby" by the IRS, then no inventory management is required. You may give away or trade your work as an informal exchange anytime on a noncommercial basis.
What disturbs me is to see public discussion about bartering work on an art business web site, at craft shows, or other requests to trade work with so little awareness of the consequences. If you feel you must give gifts or barter, you could make such work on your own personal time not using your business inventory or materials or employees. That is what gifts are for.
Topic 420 - Bartering Income (from the I.R.S. web site)
Bartering occurs when you exchange goods or services without exchanging money. An example of bartering is a plumber doing repair
work for a dentist in exchange for dental services. The fair market value of goods and services received in exchange for goods or services you provide must be included in income in the year received.
Generally, you report this income on Form 1040, Schedule C (PDF), Profit or Loss from Business. If you failed to report this income, correct your return by filing a Form 1040X. Refer to Topic 308 for Amended Return information.
The Internet has provided a medium for new growth in the bartering exchange industry. This growth prompts the following reminder: Barter exchanges are required to file Form 1099-B for all transactions unless certain exceptions are met. Refer to Barter Exchanges for additional information on this subject. If you are in a business or trade, you may be able to deduct certain costs you incurred to perform the work that was bartered. If you exchanged property or services through a barter exchange, you should receive a Form 1099-B (PDF), Proceeds From Broker and Barter Exchange Transactions. The IRS also will receive the same information.
Please refer to the I.R.S. Bartering page for more information on bartering income and bartering exchanges.
Direct Barter Transactions (from the I.R.S. web site.)
If you engage in the direct barter of products or services with an individual or a business you will generally not receive a Form 1099-B, but the transaction must be accounted for in your books and records just the same. Think of a barter transaction as just another sales transaction of your business goods or services you must include in your income at the time received. Accurate accounting and record keeping can help you manage barter transactions.
For example, if a doctor agrees to give an accountant a personal medical exam in exchange for personal tax return preparation, the fair market value of the medical exam is taxable to the accountant, and the fair market value of the tax return preparation is taxable to the doctor.
For simplicity sake, let’s assume the fair market value of both services is equal to say, $200. Note that all pieces of the transaction should be clearly marked as a bartering transaction in the books and records of both the doctor and the accountant. With the fair market value of both services being equal, both the doctor and the accountant must include $200 in their income as a result of the bartering transaction.