Income averaging for farmers.

• Author: Englebrecht, Ted D.

EXECUTIVE SUMMARY

* Income averaging is available to sole proprietors, partners, S shareholders and landlords.

* The election is made by filing Form 1040, Schedule J.

* A landlord need not materially participate to make the election.

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Sec. 1301 permits farmers to average income from one year over the three prior years, which can be useful in a year of large income. However, there are many tricks and traps along the way. This article uses a number of examples to clarify the rules.

The Taxpayer Relief Act of 1997 (TRA '97), Section 933, enacted Sec. 1301, income averaging for farmers, to alleviate the adverse tax consequences created by fluctuating farm income and progressive tax rates. Although originally scheduled to last only through 2000, the provision was extended indefinitely by Section 2011 of the Tax and Trade Relief Extension Act of 1998.

The provision permits an individual engaged in a farming business to elect to compute his or her current-year (election year) income tax liability by averaging, over the prior three-year period (base years), all or a portion of current-year electible farming business income (EFBI). This article presents an overview of income averaging, provides examples and illustrates the procedures and resulting benefits.

What Is Farming?

Sec. 1301(b)(3) defines a farming business via Sec. 263A(e)(4). Under that provision and the instructions to Form 1040, Schedule J, Farm Income Averaging, "farming" is the trade or business of cultivating land or raising or harvesting any agricultural or horticultural commodity, including:

* Operating a nursery or sod farm.

* Raising or harvesting trees bearing fruits, nuts or other crops.

* Raising ornamental trees (but not evergreen trees that are more than six years old when severed from the roots).

* Raising, shearing, feeding, caring for, training and managing animals.

* Leasing land to a tenant engaged in a farming business, but only if the lease payments are based on a share of the tenant's production (not a fixed amount).

A farming business does not include:

* Contract harvesting of an agricultural or horticultural commodity grown or raised by someone else.

* Merely buying or reselling plants or animals grown or raised by someone else.

Who Can Average Income?

Regs. Sec. 1.1301-1(b) defines an individual engaged in a farming business to include sole proprietors, partners, S corporation shareholders and certain landlords. Sec. 1301(b)(2) excludes estates and trusts. The classification of a sole proprietor as an individual eligible for farm income averaging is readily apparent; however, the remaining three classifications are more complex.

Partner

A partner in a partnership engaged in a farming business can use income averaging in a variety of situations. However, under Regs. Sec. 1.1301-1(e)(1)(i), only the portion of partnership income actually attributable to the farming business can be income averaged. Once this threshold has been reached, it is irrelevant whether the income represents a distributive share or a guaranteed payment. Income averaging is available regardless...