Wednesday, March 1, 2017
An individual engaged in a farming (or fishing) business can elect to spread whatever portion of current taxable income attributable to any farming business (termed “elected farm income”) evenly over the three prior taxable years by using Schedule J. I.R.C. §1301. Thus, if rates were lower in the prior years, the taxpayer will get the benefit of applying the lower rates to current taxable income from farming. The current year's income tax liability is calculated by determining the current year's tax (without the amount of elected farm income) plus the increases in income tax for each of the three prior taxable years by taking into account the allocable share of elected farm income for each of those years. Any adjustment for any taxable year is taken into account for income averaging purposes in subsequent tax years.
Income averaging can be a great tool for farm clients in certain situations? But what are those situations, and how best can the election be utilized? Farm income averaging planning – that’s the focus of today’s post – after reviewing the basics of the provision.
Basics of Averaging
Who is eligible? Only individuals with farm (or fishing) income are eligible to utilize income averaging. Estates and trusts are not eligible and C corporations are not considered to be individuals. For entities taxed as partnerships, it is the individual partners or members, that can be eligible to elect income averaging. For Subchapter S corporations engaged in farming, the S corporation is not eligible to make an income averaging election, but the S corporation individual shareholder is. Likewise, income attributable to a farming business carried on by a partnership can be averaged without regard to the partner’s level of participation in the partnership or the size of the ownership interest.
Engaged in a “farming business.” An individual electing income averaging must be “engaged in a farming business” in the year for which the election is made. But, the individual doesn’t need to necessarily have been engaged in a farming business in the three prior carryback years. A “farming business” means a trade or business involving the cultivation of the land or the raising and harvesting of any agricultural or horticultural commodities, but does not include the processing of commodities or products “beyond those activities which are normally incident to the growing, raising or harvesting of such products.”
An individual's relationship to the “farming business” is critical in determining eligibility. Clearly eligible for income averaging are operators of farming businesses that bear the risks of production and the risks of price change and provide substantial involvement in management. That means that a landlord is engaged in a rental activity and not in a farming business if the rental is a fixed rent (cash rent). Whether the landlord materially participates in the tenant’s farming business is irrelevant for income averaging purposes. But, non-materially participating landlords are only eligible for income averaging if the landlord’s share of a tenant’s production is set in a written rental agreement before the tenant begins significant activities on the land.
What about a recently retired farmer? Individuals who have ceased farming operations with the only activity in the year in question being the sale of inventory and the sale of machinery are not engaged in a “farming business” in that year. However, gains or losses from property regularly used in a farming business after cessation of the farming business are treated as attributable to a farming business if the property is sold within a reasonable time after cessation of the farming business. If the sale or other disposition of such assets occurs within one year of the cessation of farming, it is presumed to be within a reasonable time. After that, it is a facts and circumstance test.
Are gains eligible? Gains from the “sale or other disposition of property (other than land) regularly used by the taxpayer in such a farming business for a substantial period” are eligible for averaging. I.R.C. § 1301(b)(1)(B). Clearly, gains from the sale or exchange of land do not qualify. Although not completely clear, it would appear that gain from land sales is ineligible for averaging whether that gain is taxed as capital gain, ordinary income, recaptured depreciation or “unrecaptured § 1250 gain” and where that gain is attributable to the soil.
The IRS position is that gains from assets considered to be part of the land (buildings, fences and tile lines, for example) are eligible for income averaging.
Phase-outs, rates and limitations. Income averaging doesn’t impact the taxable income or tax of any of the three base years. That means that it is not a “carryback” of current income to the base year. Instead, it’s just a reference to the base year’s marginal income tax rate for the purpose of applying that rate to a portion of current year taxable income. What that means is that income averaging does not change the phase-outs or percentage limitations of the base year tax returns. Treas. Reg. §1.1301-1(d)(1). Also, when tax rates go up, all else staying the same, an income averaging election can benefit top bracket filers. In that situation, the election will always reduce the tax rate. While an increase in rates isn’t going to happen in the near future, when they increased starting in 2013, top bracket filers benefited from income averaging for 2013, 2014 and 2015.
Capital gain rate reduction. The averaging election can be made on both ordinary and capital gains, but clarification by the IRS indicates that an equal portion of each type of income must be carried to each prior year. From a tax planning standpoint, an income averaging election can be made on ordinary income and, with proper planning, the effective rate on non-farm capital gains can be reduced. Likewise, when the top capital gain rate increased 33 percent to a 20 percent rate beginning in 2013, the averaging election had the impact of reducing the rate to 15 percent. It also could, perhaps, eliminate it. That could be a big deal for a farmer that sells breeding stock or other assets that trigger capital gain.
Alternative minimum tax. The income averaging election has no direct impact on how the alternative minimum tax (AMT) is calculated. The taxpayer can’t “average” the AMT calculation. But, look to make the averaging election in a year in which the farmer triggers AMT. A tax benefit can be derived. Also, see whether an increase in taxable income might decrease the AMT. In that event, the marginal tax rate for top bracket farmers will drop. Likewise, look for situations where AMT income exceeds the phase-out of the AMT exemption and the tentative minimum tax exceeds the regular income tax before averaging both before and after adding incremental income. If you have that situation, the AMT will decline. Also, because there is no AMT floor on the use of averaging, the election can be quite beneficial in a year when a farmer has an income spike (maybe from a machinery sale or because a large amount of carryover grain is sold (especially at high prices). In addition, watch for planning opportunities when the farmer has substantial nonbusiness expenses that exceed nonbusiness income in the base years.
Other tax items. There are numerous other tax items that can potentially be impacted by an averaging election. Here’s a listing of a few of the more prevalent ones:
- An income averaging election doesn’t impact self-employment tax. But, it can generate big self-employment tax savings if it drops income beneath the social security base.
- As for the “kiddie tax,” making the election on the parents’ return will cause the child’s tax on investment income to be applied by using the parents’ rate after shifting the elected farm income. But, in the base years, the kiddie tax is not affected by the election. Reg. §1.1301-1(f)(5).
- For losses and carrybacks, any net operating loss carryovers or net capital loss carryovers to an election year are applied to the election year income before the elected farm income is subtracted. Think that one through. The election could create a tax advantage.
- An individual is not prohibited from making an income averaging election solely because the individual’s filing status is not the same as in the base years. Reg. § 1.1301-1(f)(2). However, the IRS has not provided guidance on how the remaining bracket amounts are to be divided between the spouses if both spouses have elected income averaging in a year following divorce.
- In addition, negative figures can be utilized. That’s good news for many farmers that are presently experiencing tough economic times. However, it appears that negative elected farm income figures in the year of election cannot be used to reduce tax liability as calculated with reference to the three carryback years.
- An income averaging election can be made on a late or amended return if the period of limitations on filing a claim for credit or refund has not expired. Also, a previous election can be changed or revoked if the period of limitations has not expired. This feature provides great flexibility in utilizing the election.
Farm income averaging can provide a significant tax savings for farm (and fishing) clients in certain situations. Watch for the retiring farmer that has carryover grain sales and/or income from a machinery auction. Also, it may be worthwhile to try to cause a farm client’s farm income to spike periodically (every three to four years) to avoid self-employment tax, while simultaneously lowering income tax costs by an election. Also, look to utilize the election on behalf of maximum tax bracket taxpayers. Finally, keep an eye on future tax legislation. Once it is known what the new rates and brackets will be, then a reevaluation can be done of the potential impact of farm income averaging for farm clients.