Farmers enjoy a unique method of computing their income tax liability versus other taxpayers. Due to wild swings in farm income, the Tax Code allows farmers to spread their current year farm income over a four-year period (current year plus past three years). By electing this spread, a farmer could substantially reduce his or her current income tax liability by dropping income taxed at current high brackets back to lower tax brackets from previous years.
Electable Farm Income. Not all kinds of farm income can be elected for this special provision. Allowable types include active farm income (Schedule F and farm income from a flow-through entity), crop share rent income (with a written lease), sales of raised breeding stock and other farm assets plus wages from an S corporation involved in farming. From this total, a farmer must subtract: (1) self-employment tax deduction and (2) domestic production activities deduction. Cash rent income is never allowed. Even first-year farmers who had no farm income the prior three years can move farm income to prior years.
For example, assuming a married farmer earns $300,000 from farming in the current year, without using income averaging, his tax liability would be about $65,000. The farmer elects to spread $210,000 of his current year farm income over the past three years. During those years, he had exactly zero taxable income. His income tax liability will now be taxed in the 15% bracket, resulting in total taxes of about $30,000, thus creating savings of $35,000.
With the imposition of the new 39.6% high-income tax bracket for 2013, high-income farmers will always want to use farm income averaging to eliminate any 2013 farm income being taxed in both the 35% and 39.6% tax bracket. Here’s an example:
A married farmer typically has $1 million of taxable farm income each year. The normal tax liability for 2013 is about $340,000. The farmer elects to carry back $600,000 of farm income to the previous three years that is all taxed at 35%. (The 35% bracket starts at $400,000 in 2013.) He saves 4.6% on $550,000 or $25,300. In 2014, he has the same amount of income and saves another $25,300 less $6,900 because $150,000 of elected farm income is now taxed at 4.6% on the 2013 year.
In 2015, he has the same amount of income. He saves $25,300 in 2015 less about $16,100 because $350,000 of elected farm income is taxed at 39.6% in 2013 and 2014. In 2016, he makes the same election; however, now his savings are only about $4,600 since his only savings is the part of the income that will be taxed at 35% in the 2015 and 2016 tax years. The rest of the income will all be taxed at the highest rate. Therefore, by electing farm income averaging, the farmer saves about $57,500 during the four-year period.
Opportunity for Refunds. After you get your return back from your tax adviser, make sure to check that Schedule J has been prepared and enough farm income was carried back. If it was not, you can prepare an amended tax return to achieve tax savings. Also, if your farm income has been higher during 2010, 2011 or 2012 and you do not see a Schedule J in your income tax return, review the return with your tax adviser.
We see many farm income tax returns where farm income averaging is not elected, and in some cases, farmers receive refunds in excess of $50,000 from filing an amended tax return. To get a refund for 2010, you must file an amended return by April 15, 2014 (or Oct. 15 if you extended your return). This might be a year when it pays to be "average."
Paul Neiffer is a tax accountant with CliftonLarsonAllen and author of the blog, The Farm CPA. He grew up on a wheat farm in Washington and owns a corn and soybean farm in Missouri. Contact him at paul.neiffer@CLAconnect.com.