Look at your tax situation
for the past few years. Do you notice
that your taxable income varies greatly from year to year? If so, it is likely
that your applicable tax rate may be varying from 0% to as much as 39.6%. Many
people are unaware that income averaging is available to farmers and fishermen.
The purpose of the income averaging rules is to alleviate the problem of your
paying more tax overall if a substantial portion of your income happens to be
bunched in one year.
As a farmer (or a
fisherman), you can elect to average all or part of your taxable "farming
income" or "fishing income" over three years. If you make the
election, your farming or fishing income subject to the election is treated as
if earned in the three previous years. Thus, the elected farm or fishing income
is allocated to the three previous years (base years) in equal amounts.
For this purpose,
farming (or fishing) income includes income from the trade or business of
farming or fishing; but, farming (or fishing) income does not include income,
gain, or loss from the sale of development rights, grazing rights, and other
similar rights. Although farming (or fishing) income does not generally include
compensation received as an employee, a shareholder of an S corporation (or a
partner in a partnership) engaged in a farming (or fishing) business may
generally treat compensation from the S corporation (or partnership) as income
from farming or fishing. It also includes income from certain crop-share
arrangements, certain vessel leasing arrangements, the sale or disposition of
property (other than land), regularly used for a substantial period in a
farming or fishing business. Thus, investment income is not eligible for income
averaging. A farming business includes operating a nursery or sod farm and
raising or harvesting ornamental trees or trees bearing fruit, nuts, or other
crops. A fishing business includes the conduct of commercial fishing (i.e.,
fishing in which all or part of the fish harvested are intended to enter
commerce).
Here's a simple
example of how averaging works. Assume that F, a single farmer, sold some of
his farm machinery and more corn than usual, and all of this happened in 2015.
F's 2015 taxable income is $50,000, of which $30,000 is from his farming
business. F had no taxable income in 2014, $5,000 of taxable income in 2013,
and $10,000 of taxable income in 2012. Since F's income is higher than in
previous years, F elects to average $30,000 of his 2015 income over the three
base years (2014, 2013, and 2012). F figures his 2015 tax in this manner:
- He subtracts the elected portion of his current year's taxable farm income ("elected farm income") from his total taxable income. Thus, in 2015, F subtracts the elected farm income ($30,000) from his taxable income of $50,000. F's remaining 2015 taxable income is $20,000.
- He figures the tax on the amount in (1) using the tax tables or tax rate schedules for the current year (in this case, 2015). Under the 2015 tax tables, the tax on $20,000 is $2,543.
- For each of the three base years (2014, 2013, and 2012), F adds one-third of the current year's (2015) elected farm income ($10,000 each year) to his taxable income for that year and figures the tax on that amount. Then, in each of the three base years (2014, 2013, and 2012), F subtracts his actual tax from the tax computed for the base year.
- Then, F adds the amounts computed for the three base years (2014, 2013, and 2012) to the amount of tax computed for the current year (2015) ($1,050 + $1,305 + $1,500 + $2,543) for a total tax of $6,398. If F had not elected to average his farm income, his 2015 tax (computed under the tax tables) would have been $8,300. Thus, by making the election, F saved $1,902.
With careful year-end
tax planning, we may be able to maximize the benefits of averaging for you.
Generally, you will benefit from the election if the income allocated to the
three previous years will be subject to a lower tax rate than it would be in
the current year. For example, it could be beneficial to accelerate income this
year (e.g., sell appreciated farm assets this year). This acceleration would
increase this year's farming or fishing income and the increase would receive
the benefits of averaging. However, we also need to keep in mind that any
amounts allocated to the three previous years as additional income will
continue to be allocated to those years should you elect to average your
farming or fishing income in future years. Thus, the allocated amounts will
increase your taxable income in those years and may reduce any benefits that
you might get from an election in later years.
Before making an
election, we will need to consider all of the tax implications of the election.
For example, we would need to determine the appropriate portion of your farm or
fishing income that should be subject to the election. Also keep in mind that this election can be
made on an amended return. So even if
you haven’t utilized farm income averaging in the past, a review of your last 6
years of tax returns could identify potential refunds.
Please contact us if
you have any questions concerning income averaging or if you would like to
discuss how income averaging could benefit you.
