Utilizing Income Averaging for Farmers & Fishermen
Income for farmers and fishermen can fluctuate drastically from year to year due to elements outside of their control. In the years where profits are significant, farmers and fishermen will be subjected to higher tax rates. Whereas in years where profits are little or loss is reported, they will be subjected to minimum tax liability. Utilizing income averaging can help with the ebbs and flows of the industry.
What is Income Averaging?
Income averaging for farmers and fishermen is a method of tax management that can be elected after the end of the tax year. It provides a way to balance an income tax burden over several years which reduces the effects of high and low grossing years. Farmers and fishermen may consider taking advantage of Schedule J (Form 1040), if income from their activities is significantly higher than income from any source over the previous three years (base years). This election allows farmers and fishermen to average their income equally over a three-year tax period to prevent being taxed at a higher rate.
Who Can Utilize Schedule J (Form 1040)?
Individuals engaged in any farming and fishing business, including sole proprietors, partners or shareholders in an S corporation, can file a Schedule J (Form 1040). Individuals must be involved in the farming and fishing industry in the year that they file. However, it is not necessary for the individual to have been involved in previous years. Any individuals involved in the two industries through estates and trusts are not eligible to utilize income averaging.
What Qualifies for Farm Income Averaging?
The IRS defines a farming business as being involved in the trade or business of cultivating land or the raising or harvesting of any agricultural or horticultural commodity. This excludes buying and reselling plants or animals raised by someone else, or the harvesting under contract of agricultural or horticultural commodities grown by someone else.
The IRS considers farm income to be the overall income, deduction, gain and loss attributable to an individual’s farming business for averaging purposes. Other farming income includes the rental income on a share production from a tenant’s farming operating and gain on the sale or other disposition of non-land property used in an individual’s general farming operating. If lease payments are based on a share of the tenant’s production rather than a fixed fee, then leasing land to a tenant engaged in farming is allowed for income averaging. Compensation received by an employee and cash rent farming operations are not considered farm income by the IRS.
What Qualifies for Fishing Income Averaging?
A fishing business is defined as fishing in which fish harvested are intended to or do enter commerce through sale, trade or barter. Fishing means catching, taking or harvesting finfish, mollusks, crustaceans, marine animal and plant life, other than marine mammals and birds. Fishing does not include any scientific research activity conducted by a scientific research vessel. Crew members on board commercial fishing vessels can qualify for income averaging if their income is based on a share of the catch. If lease arrangements are made based on the share of the catch, then the owner of the fishing boat is eligible for income averaging.
Using Elected Income Averaging on Schedule J (Form 1040)
Farmers and fishermen are not required to use all their taxable income from the current year for income averaging. It might be beneficial to use a portion of income to even out tax liability across the three years. The income portion that is included on Schedule J is called elected farm income and it can include gain or loss from the sale of non-land property and assets used in farmers and fishermen’s business. This cannot exceed the taxable income reported on Form 1040.
If you have any questions on how your farming or fishing business can take advantage of income averaging, contact your BSSF advisor.