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Income Averaging - Who is Eligible?

 

August 12, 2011

Prior to the 1987 tax year, any taxpayer who experienced a large “bulge” in their annual income from a huge work bonus, or big sales commission, or a financial windfall such as from lottery jackpot winnings, could use income averaging to reduce his tax bill. Since 1987, though, the federal tax code has been revised, and now requires taxes on an extraordinary income bulge to be paid in full in the year the money was paid, regardless of whether this pushes the taxpayer into a higher tax-rate bracket. The major exceptions are for farmers and fishermen, who are still allowed to use income averaging.

Are you in the business of farming or fishing? Did you know that you can elect to spread out your income over a three-year period? You may be able to lower your tax on the income from your farm or fishing business by using income averaging. This method allows you to move income from a high-income year to a lower-income year and lessen your taxes. You can use this method for any year that you farmed or worked as a fisherman as an individual, a partner in a partnership or as a shareholder in an S-Corporation. (However, the partnership or S-Corporation itself may not use this method, nor can other corporations, estates or trusts.) For more information on what careers qualify for farming or fishing, see the definitions below.

Income for this process is the gross farm or fish income and capital gains, minus the expenses and losses. You cannot include the gain or loss on the sale (or other disposition) of land, or from the sale or development, grazing or other rights. If you are liquidating your farm assets, you may still be able to use income averaging up to one year after your business ceases to operate. You cannot include income from another business that is not in the farming or fishing industry.

You can use this method regardless of your filing status, even if it was different in one of the years that you use for the income averaging. You don’t even have to have been in the business in those prior years. You can use this method for the current tax year, or you can use it in conjunction with an amended return for a previous year.

Definitions

Farming business. A farming business is the trade or business of cultivating land or raising or harvesting any agricultural or horticultural commodity. This includes:

  • Operating a nursery or sod farm;
  • Raising or harvesting of trees bearing fruits, nuts, or other crops;
  • Raising ornamental trees (but not evergreen trees that are more than 6 years old when severed from the roots);
  • Raising, shearing, feeding, caring for, training, and managing animals; and
  • Leasing land to a tenant engaged in a farming business, but only if the lease payments are (a) based on a share of the tenant's production (not a fixed amount), and (b) determined under a written agreement entered into before the tenant begins significant activities on the land.

 A farming business does not include:

  • Contract harvesting of an agricultural or horticultural commodity grown or raised by someone else, or
  • Merely buying or reselling plants or animals grown or raised by someone else.

Fishing business. A fishing business is the trade or business of fishing in which the fish harvested, either in whole or in part, are intended to enter commerce or enter commerce through sale, barter, or trade. This includes:

  • The catching, taking, or harvesting of fish*;
  • The attempted catching, taking, or harvesting of fish;
  • Any other activity which can reasonably be expected to result in the catching, taking, or harvesting of fish;
  • Any operations at sea in support of, or in preparation for, any activity described in (1) through (3) above;
  • Leasing a fishing vessel, but only if the lease payments are (a) based on a share of the catch (or a share of the proceeds from the sale of the catch) from the lessee's use of the vessel in a fishing business (not a fixed payment), and (b) determined under a written lease entered into before the lessee begins any significant fishing activities resulting in the catch; and
  • Compensation as a crew member on a vessel engaged in a fishing business, but only if the compensation is based on a share of the catch (or a share of the proceeds from the sale of the catch).

*The word “fish” means finfish, mollusks, crustaceans, and all other forms of marine animal and plant life other than marine mammals and birds. A fishing business does not include any scientific research activity which is conducted by a scientific research vessel.

We recommend that you meet with your professional tax preparer to determine the best use of this method. Your preparer will help you choose the proper years, by taking into account not only your income, but any gains, losses and carryovers for the years being average. Come visit your local PRO-TAX office for assistance.