The purpose of the farm income averaging rules is to alleviate the problem of your 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 'farm income' over three years. If you make the election, your farm income subject to the election (elected farm 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.

For this purpose, farm income is income from the trade or business of farming; but, farm income does not include wages or income, gain, or loss from the sale of development rights, grazing rights, and other similar rights. It also includes income from the sale or disposition of property (other than land), regularly used for a substantial period in a farming business. Thus, investment income is not eligible for income averaging. A farming business includes operating a nursery or sod farm and raising or harvesting ornamental trees or trees bearing fruit, nuts, or other crops.

Here's a simple example of how averaging works. Assume that F, a single farmer, sold some of his farm machinery and more corn than usual, and all of this happened in 2000. F's 2000 taxable income is $50,000, of which $30,000 is from his farming business. F had no taxable income in 1999, $5,000 in 1998, and $10,000 in 1997. Since F's 2000 income is higher than in previous years, F elects to average $30,000 of his 2000 income over the three base years (1999, 1998, and 1997). F figures his 2000 tax in this manner:

(1) He subtracts the elected portion of his current year's taxable farm income ('elected farm income') from his total taxable income. Thus, in 2000, F subtracts the elected farm income ($30,000) from his taxable income of $50,000. His remaining 2000 taxable income is $20,000.

(2) He figures the tax on the amount in (1) using the tax tables or tax rate schedules for the current year (in this case, 2000). Under the 2000 tax tables, the tax on $20,000 is $3,004.

(3) For each of the three base years (1999, 1998, and 1997), F adds one-third of the current year's (2000) elected farm income ($10,000 each year) to his taxable income for that year and figures the tax on that amount. Then, in each of the three base years (1999, 1998, and 1997), F subtracts his actual tax from the tax computed for the base year.  For 1999, F's taxable income was $10,000. The tax (computed using the 1999 tax tables) was $1,504. Since F didn't pay any tax in 1999, there is no reduction for his actual tax paid in 1999.For 1998, F adds $10,000 to his 1998 taxable income of $5,000 for a taxable income of $15,000. The tax (computed using the 1998 tax tables) on this amount is $2,254. F reduces this amount ($2,254) by the actual tax he paid in 1998 ($754) to $1,500.For 1997, F adds $10,000 to his 1997 taxable income for a taxable income of $20,000. The tax (computed using the 1997 tax tables) on this amount is $3,004. F reduces this amount ($3,004) by the actual tax he paid in 1997 ($1,504) to $1,500.

(4) Then, F adds the amounts computed for the three base years (1999, 1998, and 1997) to the amount of tax computed for the current year (2000) ($1,504 + $1,500 + $1,500 + $3,004) for a total tax of $7,508. If F had not elected to average his farm income, his 2000 tax would have been $10,660. Thus, by making the election, F saved $3,152.  

With careful year-end tax planning, you may be able to maximize the benefits of averaging. For example, it could be beneficial to accelerate income this year (e.g., sell appreciated farm equipment this year). This acceleration would increase this year's farm income (the income that is potentially subject to averaging) and the increase would receive the benefits of averaging. The reduction in your taxable income in the next year as a result of the acceleration of income might result in overall tax savings. However, you also need to keep in mind that any amounts allocated to the three previous years as additional income will continue to be allocated to those years should you elect to average your farm income in future years. Thus, the allocated amounts will increase your taxable income in those years and may reduce any benefits that you might get from an election in later years.

Once you make the election, it is irrevocable and you can't change it on an amended return in later years. Therefore, before making an election, you  will need to consider all of the implications of the election. For example, you  need to determine the appropriate portion of your farm income that should be subject to the election, and whether making the election would subject you this year (or one of the previous years) to the alternative minimum tax.

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