The Taxpayer Relief Act of 1997 added a special income averaging tax computation privilege for farmers, effective for taxable years beginning after December 31, 1997:
- Individuals engaged in farming are allowed to elect to average farm income over three years; the provision does not apply to estates or trusts or corporations.
- A farming business includes, the trade or business of farming, along with the operation of a nursery or sod farm, the raising or harvesting of trees bearing fruit, nuts, or other crops, or ornamental trees.
- Elected farm income, which may be averaged over the prior three years, means the amount of taxable income attributable to any farming business which is specifically elected by the taxpayer as subject tot he three year averaging method. Farming taxable income includes gain from the sale or disposition of property (other than land) regularly used by a farmer for a substantial period in a farming business.
- The tax imposed for the year in which income averaging is elected is the sum of the tax for that year on income reduced by the amount of elected farm income, plus the increase in tax which would have occurred if taxable income for each of the three previous tax years was increased by an amount equal to one-third of the elected farm income.
- Income averaging was originally enacted to be available for only three years: 1998, 1999, and 2000. However, October 1998 budget legislation made income averaging for farmers a permanent feature of the tax law.
- Any adjustment to taxable income for a previous year because of the elected farm income amount carried back to that year is taken into account in applying the income averaging provision for any subsequent taxable year
- Income averaging has no application to calculation of the self-employment tax or the Alternative Minimum Tax, nor does a provision require the recalculation of the tax liability of any other taxpayer, such as a minor child subject to kiddie tax rules.
- Observations:
- The fact that income averaging has no impact on self-employment tax creates interesting planning opportunities. In the base years prior to income averaging, a farmer could report income beneath the first tier social security base, and subsequently report substantial farm self-employment income exceeding the SE base. Income averaging would smooth out the income tax costs of the high tax year, and significant self-employment tax would be saved by having much of the income exceeding the SE base.
- On the other hand, the fact that regular income tax after income averaging must be compared to current AMT without averaging imposes a significant risk. If income averaging is used to significantly reduce the regular income tax, it is likely that AMT will come into play.
- Income averaging will need to be considered in virtually every individual farm return through 2000. To the extent that the prior three years contain any lower bracket years, averaging a sufficient amount of income to fill the lower bracket availability will be appropriate. Recognize the significant flexibility which occurs because any portion of current year net farm income can be elected for averaging.
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