Is Income Averaging Still Allowed by the IRS?

Income averaging is a tax method designed to alleviate the impact of significantly fluctuating income on an individual’s tax liability. This approach allows a taxpayer to spread out a portion of their current year’s high income over previous tax years, potentially reducing the overall tax burden by avoiding higher marginal tax brackets in the peak income year. For the vast majority of taxpayers, however, this method is generally no longer permitted by the Internal Revenue Service (IRS). There are very specific and limited exceptions to this general rule, allowing only certain groups to utilize income averaging.

Historical Context and Current Status

Income averaging was historically implemented to provide relief to taxpayers whose income varied substantially from one year to the next. Before its widespread restriction, it allowed individuals with a sudden surge in earnings, perhaps from a large bonus, a significant sale, or a successful venture, to smooth out their taxable income over several years. This mechanism aimed to prevent such income spikes from pushing taxpayers into higher tax brackets, which would result in a disproportionately larger tax bill compared to individuals with more consistent earnings.

The Tax Reform Act of 1986 significantly altered the landscape of income averaging. This legislation, among other changes, reduced the number of individual income tax brackets and lowered marginal tax rates across the board. These structural changes to the tax code diminished the need for broad income averaging, as the progressive nature of the tax system was less punitive for income fluctuations. Consequently, the provision for general income averaging was largely phased out for most taxpayers.

While general income averaging ceased, its fundamental concept of smoothing income for tax purposes persists in limited forms. The current tax framework instead relies on other provisions, such as capital gains rates or various deductions and credits, to address certain income scenarios. Income averaging remains a specific, albeit restricted, tool for a narrow segment of the population.

Who Can Still Use Income Averaging?

Income averaging is primarily available to individuals engaged in farming or fishing businesses. These professions often experience significant fluctuations in income due to factors beyond their control, such as weather conditions, market prices, and disease outbreaks.

To qualify for income averaging, a taxpayer must meet specific criteria related to their gross income derived from farming or fishing. For both farmers and fishermen, at least two-thirds (66.67%) of their gross income for the current tax year, or for the three prior tax years, must come from their farming or fishing business.

Qualifying income for farmers includes:
Earnings from the cultivation of land, raising livestock, poultry, or fish.
Production of dairy products, fruits, or vegetables.
Income from the sale of timber.
Certain government payments related to farming.
Rental income from land used for farming activities.

For fishermen, qualifying income stems from:
Catching, taking, harvesting, cultivating, or farming aquatic resources.
Operating a fishing vessel.
Furnishing services directly related to these activities, such as providing equipment or labor for fishing operations.

How Income Averaging Works for Qualified Taxpayers

Qualified taxpayers, specifically farmers and fishermen, utilize IRS Schedule J (Form 1040, Farm Income Averaging) to perform the necessary calculations for income averaging. This allows taxpayers to allocate a portion of their current year’s farm or fishing income to prior tax years. The process involves identifying “elected farm income” (EFI), which is the amount of current year farm or fishing income the taxpayer chooses to average.

This elected farm income is spread back over three base years, which are the three tax years immediately preceding the current tax year. The elected farm income is divided equally among these three base years. For instance, if a taxpayer elects to average $90,000 of farm income, $30,000 would be allocated to each of the three prior base years.

After allocating the EFI, the taxpayer must recalculate their tax liability for each of the base years. This involves adding the allocated portion of the EFI to the taxable income originally reported for each base year. The difference between the original tax liability and the new tax liability for each base year represents the increase in tax attributable to the averaged income. These increases in tax from all three base years are then summed.

This total sum of increased taxes from the base years is then added to the current year’s tax liability, which is calculated without including the elected farm income. The result is the total tax due for the current year, effectively applying the lower marginal tax rates from the base years to a portion of the current year’s income.

Wages, salaries, investment income, or income from non-farm or non-fishing businesses do not qualify as elected farm income and cannot be averaged. Taxpayers must also have taxable income in the base years for the averaging to provide a benefit, as the purpose is to shift income to potentially lower-taxed prior periods. Guidance for completing Schedule J can be found in IRS Publication 225, “Farmer’s Tax Guide.”