As is often the case, farm related tax returns have advantages over other businesses when it comes to Federal income tax. One of those unique options available to farmers is called income averaging. Income averaging gives farmers the option of shifting some farm-related taxable income from this years’ taxable income to the three previous tax years, called base years. You may elect to use farm income averaging if, in the year of the election, you are engaged in a farming business as an individual, a partner, or a shareholder of a Sub S Corporation.
It works like this. Upon calculating your farm net income, you may elect to shift some amount of this income from this year’s income that you would prefer not to include in taxable income. You may shift any or all farming net income to the three previous years (and three previous years only) evenly. You may not pick and choose the years or amounts that you would like to shift to. Again, you must shift to the three previous years, and you must shift evenly to those years.
Farm income is defined as the net income from your farming business – which is the total of farm income or gain minus any farm deductions or losses allowed as deductions in computing your taxable income. Self-employment taxes due from this year’s farm net income, and self-employment taxes as a result of the three base years are unaffected by the farm income averaging calculations. In other words, self-employment tax is determined before any income shifting utilized by the farm income averaging method.
Ultimately, the purpose of this tax planning technique is to shift this year’s higher tax bracket income to the base years’ marginal tax brackets. In other words, tax preparers should be looking to shift taxable income due from farm income to previous years income to the extent that marginal tax bracket benefits may be available. Remember, the taxable income shifted from current year income will be equally shifted to the three prior years. Shifted income will be divided by three, and added to the three prior years. This may result in a benefit, and it may not. Generally, the taxpayer will find benefit when base years (three years prior) have average marginal rates that are lower than this year’s marginal rate.
Finally, it is important to note that farming net income is not necessary to be present in the three base years. Only net farming income is necessary in the current year, and may be applied evenly to the three prior base years, even if farming income doesn’t exist in those three base years.