Using Farm Income Averaging to Deal with Economic Uncertainty and Resulting Income Fluctuations

Overview

Economic conditions swing back and forth for agricultural producers.  Grain farmers in the Midwest have benefitted from high grain and oilseed prices during the Spring of 2022.  New crop prices are presently very high.   However, the conflict in Ukraine has had global impacts, including a significant increase in fertilizer prices.  Farmers that had already pre-paid for inputs last year before the significant run-up in price avoided the higher prices, but input costs will likely be significantly higher for Spring 2023 crops.  That will have an impact on net profit for farmers next year.  The World Bank is estimates that crop fertilizer prices will rise about 70 percent in 2022 before falling slightly in 2023.  Compared to the Spring of 2021, prices for Anhydrous Ammonia, Potash and Phosphorous have were 116 percent, 103 percent and 54 percent higher in the Spring of 2022. 

Commodity prices will remain strong as long as the Ukraine conflict continues, but if the conflict ends, some are estimating that the price for corn could drop about $1.50 per bushel and soybeans could drop $2 to $3 per bushel.  Over the long-run prices will eventually drop. The question is how long the long-run will be. There certainly is more uneasiness and uncertainty among agricultural producers presently.  Inflation and supply chain issues creates that uncertainty. 

With respect to farmland, the underlying drivers of value are constantly shifting.  Those drivers are interest rates; commodity prices; on-farm profitability; and supply of farms.  Interest rates are rising and must in order to deal with the enormous amount of inflation in the economy.  Commodity prices are high, but as noted above will come down at some point.  Farm profitability will not be as good in 2023 as it is in 2022.  So, the long-term outlook for land value is that the upward trend over the past couple of years will likely not last to much longer.

What does all this mean for tax planning?  It means that farm income will likely be lower next year than this year.  The uncertainty also means that there will be a significant swing in farm income over multiple years. 

One tool for “smoothing-out” fluctuations in income from year-to-year for farmers is income averaging.  It’s a tax planning tool that may be more important now than ever.

Farm income averaging – it’s the topic of today’s post.

In General

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.

Basics of Averaging

In General.  Farm income averaging is a tax management tool that farmers and ranchers can elect after the tax year ends to spread a certain amount of income from the year to be spread over a three-year period.  The technique can be used to prevent a farmer or rancher from being pushed into a higher tax bracket in a high-income year, such as 2022 will likely be for many farmers.  An income averaging election is made on Form 1040 Schedule J. 

Who is eligible?  Only individuals with farm (or fishing) income are eligible to utilize income averaging.  The individual must be involving engaged in farming in the year for which the election is made.   It isn’t required that the taxpayer have been engaged in farming in prior years.  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.  Treas. Reg. §1.1301-1(b)(1)(iii).  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, as noted above, 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.

Note:  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. 

Planning Points

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. 

Note:  The Tax Cuts and Jobs Act increased the AMT exemption amount.  For 2022, the amount is $75,900 for single filers and $86,200 for married filing joint filing status. 

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.   §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.  § 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.

Conclusion

Farm income averaging can provide a significant tax savings for farm (and fishing) clients in certain situations.  One of those is 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.  In addition, keep an eye on future tax legislation.  A change in tax rates and/or brackets can make an income averaging election important.  Of course, the present uncertainty in farm markets will influence farm income with swings from year-to-year, making a farm income averaging election a potentially useful tool.