As any farmer knows, farm profits can greatly vary from one year to the next. Crop yields, drought conditions, and feed prices are among the reasons that a booming year can be followed immediately by a meager one, and with those swings in profit, large variations in tax from year to year can be a common issue faced by farmers. For exactly that reason, our tax code contains a provision, created solely for farmers, called income averaging.
Income averaging is a complex topic, but it’s important that farmers not be scared away by the complexity. A working knowledge of this provision can lead to huge tax savings – so we’ll touch on the basics that will allow you and your tax preparer to take advantage of those saving opportunities.
The best way to explain income averaging is with a very simplified example. Fred and Mary are grain farmers. In 2013, the couple had a bumper crop and their taxable income was $100,000. In each of the three years prior, crops had been average at best, and their taxable income was $50,000 in 2010, 2011 and 2012. At $50,000 of taxable income, Fred and Mary were in the 15 percent federal marginal tax bracket. In 2013, with the bumper crop, their tax bracket was 25 percent.
From 2010-2012, the couple’s total tax income tax would have been roughly $6,630. For 2013, that number jumped to approximately $16,857. If the couple’s tax preparer correctly carries out income averaging on the 2013 tax return, then income from 2013 can be slotted into each of the previous years – taking advantage of the remaining room under the 15 percent brackets each year, rather than being taxed under the 25 percent bracket. This is done only on the 2013 tax return, without amendments to prior years.
For 2010, 2011 and 2012, there is roughly $22,500 of income that could still be taxed at 15 percent before any would be taxed at 25 percent. By moving $67,500 ($22,500 x 3 years) of income into 15 percent tax brackets available in those years, under this very simplified scenario, income averaging saves the taxpayers $2,727.
The important thing to realize from this article is certainly not how to calculate tax in a given year, but to recognize that when farm income rises sharply, an opportunity likely exists to take advantage of this important provision. By working closely with a tax professional who is familiar with farm taxation, you can ensure that this opportunity is not missed, and you can keep significant sums of money in your own pocket.
Talk to your tax professional about income averaging, and ask if it has been useful to you in the last three years. If it has been missed, it’s not too late to amend tax returns for potential refunds.
