For a farmer, uneven earning from year to year is a fact of life. But it can also wreak havoc on your taxes. A bumper crop, the sale of a large farm asset, or a new business venture can cause a quick jump not only in your income but also in your income tax. How can you mitigate the tax bill that may follow a good year? The answer is with income averaging. Here's what you need to know about it.
What Is Income Averaging?
The IRS allows some taxpayers — primarily farmers and fishermen — to add up their current year's income and that of the prior two years, then report the average dollar amount as income in all three. This method used to be allowed to most taxpayers, but it's currently a very limited choice open only to those whose livelihoods are dependent on the vagaries of natural yields.
If you opt to use income averaging in a good year, you and your accountant would look back at your prior tax returns when completing the current one. Then, you likely need to amend the completed returns to account for the new averaging method.
What's Included in Income Averaging?
The taxpayer has some leeway in what they wish to include in income averaging. You might include all your farming income or only some of it, such as income from your profitable hay business while not including your new farmer's market business. You may even include income earned from other sources, like a side job or unrelated business. The choice can be made depending on what results in the lowest taxes.
Who Can Use Income Averaging?
Because this tax calculation method can be very generous, only a few taxpayers qualify. Traditional farmers are generally included, as are fishermen, ranchers, and nursery operators. But you don't have to own the land you farm. A lessee farmer who does their own production is considered a farmer for these purposes.
One stipulation you do have to abide by is that you must file as an individual, partnership, or S Corporation. This prevents the abuse of a system designed to help out the small American farmer.
Where Should You Start?
Could the application of past earning years make current taxes better? If you think it may help, start by consulting with an accountant in your home state. Income averaging is an unusual tax process with which few taxpayers are familiar. So it should be done with the assistance of an experienced tax pro. Get started by making an appointment with an accountant today.
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