Farmers and ranchers have a unique opportunity to lower their tax liability during a year in which they earn a significantly higher income than the previous three years, bumping them into a higher tax bracket.
For example, a farmer, who sold a large portion of property used to grow crops and has now been pushed into the higher tax bracket, may choose to average this income over three years to avoid being taxed at a higher rate. Consider these questions to determine if farm income averaging is right for you:
What is farm income averaging?
Federal statutes allow farmers to spread a portion of their current year farming income equally over the three previous tax years. By averaging an income tax burden over several years, you can reduce the effects of both lean and bounty years. This can be done using IRS form 1040 Schedule J, which can be found on the IRS website here.
Why is farm income averaging beneficial?
Using Schedule J to spread out your income allows you to average your current tax bracket with previous years to avoid being taxed at a significantly higher rate this year. This treatment can make sense for any of the following reasons:
- Your current year taxable income places you in a higher marginal tax bracket than prior years. Income earned at the higher rate can be applied retroactively to prior years with lower rates.
- The farm income averaging election has not been utilized in earlier years. The IRS will let you amend prior years’ filings to capture those benefits.
- You anticipate higher income or higher tax rates in future. Applying income averaging for 2013-2016 sets you up for profitable use of this treatment in future years.
Am I eligible?
The IRS defines a farming business as one involved in the trade or business of cultivating land or raising or harvesting any agricultural or horticultural commodity. In addition to most farming, ranching, and nursery operations, this also includes those that lease land to a tenant engaged in a farm business, as long as the lease payments are based on a share of the tenant’s production rather than a fixed fee.
A farming business does not include the contract harvesting of crops grown by someone else or the selling of plants or animals grown or raised by someone else. In addition, you must be filing as an individual, co-owner in a partnership or a shareholder in an S Corporation.
Is there anything else I should know?
Income from the three previous years – referred to as the base years in the income averaging calculation – does not have to be from a farming business.
You are not required to use all of your taxable income from the previous year for income averaging. In fact, it may be better to use only a portion in order to even out your tax liability across the three years. The portion of your income you decide to include is called elected farm income and can be made up of gain or loss from the sale of property or assets used in your business. Since the amount you decide to elect as taxable for the current year will affect your tax bracket for the current and past years, it may be advantageous to include less than your current taxable income.
Your tax professionals can help you assess the benefits, make the decisions, and provide the proper reporting.
This post was originally published on December 16, 2015. It was updated on April 5, 2017 to provide you the most current information.