While every type of business is prone to unpredictable income, many don’t rely on Mother Nature to determine whether they succeed or fail. Fishermen and farmers deal with that reality, though, and their hard work has a direct impact on the food supply across the country. To help out these essential business owners, the Internal Revenue Service allows something called income averaging, which lets you spread out profits from your business over the three tax years that came before this one.
Income averaging lets farmers and fishermen offset their taxable income by averaging it out over the three preceding years, but there are restrictions attached to it.
What Is Income Averaging?
Income averaging is a perk offered only to fishermen and farmers in order to help offset the tax burden of a particularly profitable year. If your business falls in one of these two professions and you had a lower income in the previous three years, you can average your income out over this and the previous years and base your tax bracket on that average.
Once you have your documents together, you’ll use the worksheet on Schedule J to get the amount you’ll need to report on Form 1040. You’ll insert this information on Line 11.
Completing Schedule J
On Line 1 of Schedule J, you’ll notice it asks for your total income for the current tax year. This is found on Form 1040, Line 10. But the next line, 2a, asks for your elected farm income, which is the amount of that year’s taxable earnings that you’re choosing to claim this year.
In order to arrive at this figure, you’ll first need to tally your full income for the year from all sources, minus any expenses you’ve had for the year. The amount you claim can’t exceed the amount of total net capital gain for the year. To figure your farming or fishing income, you’ll subtract your expenses or losses for the year from your total income from those activities.
Eligibility for Income Averaging
In order to be eligible for income averaging, your business will have to meet the IRS’s definition of a farming or fishing business. This is:
- Farming: A business that engages in the act of, “cultivating land or raising or harvesting any agricultural or horticultural commodity.”
- Fishing : The act of capturing fish for commerce purposes.
In order to participate in income averaging, you won’t be able to have used it in previous years. The good news is that you don’t need to have earned that income through fishing or farming to be able to average your income over those years, as long as that’s your income source now. You will, however, need to file in the current year as an individual, partnership co-owner or shareholder in an S corporation.
Individual Tax Rates
The tax brackets have changed under the Tax Cuts and Jobs Act, so before you decide to average your income, you may want to take a look at them. The 2018 brackets break down as follows for single filers:
- $0 to $9,525: 10 percent
- $9,526 to $38,700: 12 percent
- $38,701 to $82,500: 22 percent
- $82,501 to $157,500: 24 percent
- $157,501 to $200,000: 32 percent
- $200,001 to $500,000: 35 percent
- $500,001 or more: 37 percent
For those who are married filing jointly, here are the 2018 tax brackets:
- $0 to $19,050: 10 percent
- $19,051 to $77,400: 12 percent
- $77,401 to $165,000: 22 percent
- $165,001 to $315,000: 24 percent
- $315,001 to $400,000: 32 percent
- $400,001 to $600,000: 35 percent
- $600,001 or more: 37 percent
These rates will change slightly in 2019, but this can give you a general idea of what you’ll owe if you file individually and your business makes significant income for the year. Only individuals can use income averaging. So if your business is set up as a corporation, partnership, S corporation, estate or trust, those entities can't use income averaging.
Self-Employment Tax and Farmers
In addition to the tax you’ll pay on your income, you’ll also pay self-employment tax on the money you earn. Unlike your friends who work for someone else in exchange for a paycheck, you aren’t having Social Security and Medicare taxes taken out every couple of weeks. That means you’ll need to set some extra money aside. You’ll pay 15.3 percent of your taxable income, 12.4 percent of which goes toward Social Security, while the other 2.9 percent goes to Medicare.
If you know you’ll owe taxes for the year, you’ll likely want to pay estimated taxes to avoid a big bill, plus penalties, on tax day. Form 1040-ES has a worksheet to help you calculate how much you’re likely to owe. You’ll pay one-fourth of that amount using the included voucher on April 15, June 15, Sept. 15 and Jan. 15. If that date falls on a weekend, it will be due on the following Monday.
Sale of Land and Income
To determine your elected farm income, you’ll need to make sure the amount you’re electing doesn’t exceed your taxable income for the year. One thing that can throw this calculation off is if you sold a land or grazing rights that year. If you sold your property during the tax year, but you used it for the majority of that tax year, you will be able to include those gains or losses in your EFI that year.
However, when your EFI includes capital gains from the sale of land or any other activity, you will need to use the tax rates for every applicable base year to determine what capital gains taxes you’ll need to pay on that income. Schedule J will help walk you through that.
10-Year Income Averaging
Farming and fishing aren’t the only types of income tax averaging. Some may confuse it with 10-year income averaging, which applies to lump-sum distributions from retirement accounts. In order to participate in 10-year averaging, a person must be born before Jan. 2, 1936 or be a beneficiary of someone who is eligible for it. There’s also a 20 percent capital gains rate that may be applied to contributions made before 1974.
With 10-year averaging, retirees can choose to pay taxes on distributions using averaging or to roll the amount over to another retirement account. If there is more than one distribution in a tax year, the retiree must choose the same taxation method for all distributions. Ten-year averaging can only be used once in a taxpayer’s lifetime.
Filing Taxes on Farm Income
If your income comes from farming or fishing, you’ll use Schedule F to report your income and losses for the year. Your income includes proceeds from the sale of crops, livestock and other relevant products, as well as any money you make from the sale of farm equipment or land.
Like other business owners, you’ll be able to reduce your taxable income by deducting costs related to running your farm. Some expenses will need to be depreciated under the IRS Modified Accelerated Cost Recovery System table, but they can include the following when connected to the cost of running your business:
- Vehicle expenses
- Conservation practices
- Home office space
- Aldrich Advisors: Lower Your Federal Tax Rate This Year by Averaging Farming Income
- IRS Tax Map: Income Averaging for Farmers
- IRS: 2018 Instructions for Schedule J
- NerdWallet: 2018-2019 Federal Income Tax Brackets and New Tax Rates
- CNBC: Tax Day Comes With an Extra Task for the Self-employed
- This Matter: Lump-Sum Distributions
- IRS: Business Start-up and Organizational Costs
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.