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Income Averaging for Farmers
Sec.
1301 permits farmers to average income from one year over the three
prior years, which can be useful in a year of large income. However,
there are many tricks and traps along the way.
This
Ted D. Englebrecht, Ph.D.
For more information about this article, contact Dr. Englebrecht at TEnglebr@cab.latech.edu.
Executive Summary
The Taxpayer Relief Act of 1997 (TRA 97), Section 933, enacted Sec. 1301, income averaging for farmers, to alleviate the adverse tax consequences created by fluctuating farm income and progressive tax rates. Although originally scheduled to last only through 2000, the provision was extended indefinitely by Section 2011 of the Tax and Trade Relief Extension Act of 1998. The provision permits an individual engaged in a farming business to elect to compute his or her current-year (election year) income tax liability by averaging, over the prior three-year period (base years), all or a portion of current-year electible farming business income (EFBI). This article presents an overview of income averaging, provides examples and illustrates the procedures and resulting benefits.
What Is Farming? Sec. 1301(b)(3) defines a farming business via Sec. 263A(e)(4). Under that provision and the instructions to Form 1040, Schedule J, Farm Income Averaging, farming is the trade or business of cultivating land or raising or harvesting any agricultural or horticultural commodity, including:
A farming business does not include:
Who Can Average Income? Regs. Sec. 1.1301-1(b) defines an individual engaged in a farming business to include sole proprietors, partners, S corporation shareholders and certain landlords. Sec. 1301(b)(2) excludes estates and trusts. The classification of a sole proprietor as an individual eligible for farm income averaging is readily apparent; however, the remaining three classifications are more complex.
Partner A partner in a partnership engaged in a farming business can use income averaging in a variety of situations. However, under Regs. Sec. 1.1301-1(e)(1)(i), only the portion of partnership income actually attributable to the farming business can be income averaged. Once this threshold has been reached, it is irrelevant whether the income represents a distributive share or a guaranteed payment. Income averaging is available regardless of the partners level of participation in the partnership or his or her ownership percentage.
S Shareholder A shareholder of an S corporation engaged in a farming business is treated similarly to a partner; the passthrough S income must be attributable to a farming business to be eligible for income averaging. Under Regs. Sec. 1.1301-1(e)(1)(i), compensation received from an S corporation and attributable to a farming business is also farm income.
Landlord According to Regs. Sec. 1.1301-1(b)(2), a landlord can use income averaging for rental income based on a share of production from a tenants farming business, effective for amounts received after 2002. Such rental income will be eligible only if it is based on a written agreement entered into before the tenant began significant activities on the land. Rental income is not eligible if rent is fixed, based on an unwritten agreement or based on a written agreement entered into after the tenant began significant activities on the land. Whether a landlord materially participates in the tenants farming business is irrelevant for Sec. 1301 purposes.
How Is Income Averaging Elected? Regs. Sec. 1.1301-1(c)(1) provides that an individual can elect farm income averaging by filing Schedule J with his or her Federal return for the election year. This includes a late or amended return, as long as the statute of limitations (SOL) on filing for a credit or refund has not expired.
Revocation Regs. Sec. 1.1301-1(c)(2) provides that a taxpayer may change the amount of farm income averaged in a prior year, if the SOL on filing a claim for credit or refund has not expired for that election year.
EFBI Definition In general, under Regs. Sec. 1.1301-1(e)(1)(i), EFBI consists of income, deduction, gain and loss items attributable to a farming business. A farm loss includes a net operating loss (NOL) carryover or carryback, or a net capital loss carryover to an election year attributable to a farming business. A farming business does not include income, gain or loss from the sale of grazing, development and other similar rights. It also does not include wages paid by an employer to an employee (except as previously discussed).
Computation Determining the EFBI eligible for averaging appears straightforward, but can be complex. According to Regs. Sec. 1.1301-1(e)(2)(i), the maximum income eligible is the sum of any farm income and gains, less any farm deductions or losses (including loss carrybacks and carryovers). EFBI cannot exceed taxable income. Net capital gain derived from EFBI may not surpass total net capital gain. A taxpayer with both ordinary and net capital gain income can elect to average any combination of both incomes.
Income Averaging Step-by-Step Calculation There are four main steps to income averaging. 1. Subtract EFBI from total taxable income. 2. Calculate the tax on the resulting amount using the election-years rates. 3. For each of the three previous years: (a) Add one-third of EFBI to taxable income for that year. (b) Compute the tax on that amount at that years rates. (c) Subtract that years actual tax. 4. Add each years 3.(c) amount in 2. The result is the current-years tax (see Example 9 in the box below).
Additional Considerations Regs. Sec. 1.1301-1(d)(2) allows for negative taxable income in a base year, instead of zero. As a result, farmers who had made prior income-averaging elections could file an amended return using negative taxable income, and generate a refund. Additionally, the control of certain discretionary expenses can be used to generate an NOL that a farmer can carry back for five years, under Sec. 172(i). The ability to control the timing of discretionary cash revenues and expenses is a powerful tool (see Example 10 in the box below).
Miscellaneous Rules Regs. Sec. 1.1301-1(f)(1)(5) provide five miscellaneous rules that may affect various aspects of farm income averaging.
Short Tax Year The first applies to a short tax year. If either a base year or an election year is a short year, Sec. 443 and the regulations thereunder are used to compute the income tax. Specifically, when a base year is a short tax year, EFBI is allocated to that year after taxable income for that year has been annualized. When an election year is a short tax year, the taxable income and the EFBI must be annualized. Further, the taxpayer must designate all or part of the annualized income as EFBI.
Change in Filing Status A taxpayer may use farm income averaging regardless of a change in filing status.
Employment Taxes The income averaging election has no effect on self-employment net earnings for purposes of the Self-Employment Contributions Act. The election also has no effect in determining income tax withholding, FUTA or FICA.
AMT The election to use income averaging does not apply to Sec. 55 alternative minimum tax (AMT) for a base year, or to Sec. 55(b) tentative minimum tax for the election year or the base year. The election, however, does apply to the determination of the election-year regular tax under Secs. 53(c) and 55(c).
Minor Child In a base year, the election to in-come average does not affect the tax on a minor childs taxable investment income under Sec. 1(g). For an election year, however, a minor childs taxable investment income tax rate is determined after application of the election.
Conclusion The TRA 97 provided fairness by enacting Sec. 1301. The regulations have served to clarify some troublesome areas. At a minimum, they provide a number of needed examples to assist tax advisers. |
