The taxable income for farmers can vary greatly from year to year, whether it be from deferring insurance proceeds, deferring grain sales, or general cycles in the futures market. As a result of this income variation, an individual’s applicable tax rate may vary from 0% to 39.6%. One way to help “balance out” these odd years is through the use of “income averaging”, which is only available to farmers and fisherman.
The purpose of the income averaging rules is to alleviate the problem of you paying more tax overall if a substantial portion of your income happens to be bunched in one year. As a farmer, you can elect to average all or part of your taxable “farming income” over three years. If you make the election, your farming or fishing income subject to the election (elected farm or fishing income) is treated as if earned in the three previous years. Thus, the elected farm income is allocated to the three previous years (base years) in equal amounts, possibly reducing your tax liability. In general, you will benefit from the election if the income allocated to the three previous years will be subject to a lower tax rate than it would be in the current year.
Every year it is important to analyze whether you will benefit from averaging your income. Be sure that your tax advisor is looking into it each year during your fall tax planning meeting.