BY SUZANNE S. WILLIS, CPA

If you are like most farmers, you will do everything legally possible to avoid paying income taxes. Some may ask, How are farmers able to beat the system and pay little or no taxes? Well, it's simple. A farmer who is just starting out can actually show a loss on his tax return by waiting until the next calendar year to sell his crop. Technically, this is done by incurring the expenses of farming in Year 1 while deferring the income generated from that crop until Year 2. But what happens the next year? Well, the farmer will carry on his business as usual, but when the time comes to sell the next year's crop, he must sell that crop in Year 3 to avoid paying income and self-employment taxes on two years worth of income. This scenario continues year after year. Of course, with careful tax planning, the farmer is able to minimize the taxes owed by either selling a portion of the crop early or prepaying some expenses. However, when it is all said and done, this farmer has gotten himself into a situation that he canÕt get out of without paying a substantial tax bill.

The Taxpayer Relief Act of 1997 created a provision that will help farmers who want to minimize their tax liability during a prosperous year or who want to Òsquare upÓ with the IRS. Income averaging allows farmers to elect to move part or all of their farm income from the current tax year and spread it evenly over the previous three tax years. This election was created by Congress to smooth out the economic misfortunes that farmers are confronted with on a daily basis. LetÕs face it, many variables associated with farming are simply beyond our control. These factors generally affect cash flow, profits, losses and ultimately your tax liability. Since income averaging is available to farmers in 1998, 1999, and 2000, it is essentially a three-year window of opportunity to shift income from a very good year to a less profitable year in order to be taxed in lower tax brackets.

Several items should be addressed at this point. The income averaging election only applies to individuals engaged in farming, either as a proprietorship or through an S corporation or a partnership. It is not available to estates or trusts. Also, this election does not affect self-employment taxes. Therefore, you will pay the same self-employment taxes in the current year that you would have paid if you had not elected to income average your crop. Elected farm income encompasses all taxable income attributable to any farming business, including the gain from the sale or disposition of property, other than land, regularly used by the farmer for a substantial period. Therefore, if you have a gain on the sale of a tractor that was used in your farming operation, this income may be included in the elected income. In addition, a farming business is defined as the trade or business of farming, including operating a nursery or sod farm, or the raising or harvesting of tree bearing fruit, nuts or other crops, or ornamental trees. Finally, the elected income must be carried back to the previous three years equally. You can not move all or a portion other than one-third of the elected income to any one specific year.

The following example shows how a farmer with a very strong crop in 1998 may benefit from income averaging. Joe Smith is a producer who has shown losses on his Schedule F for the past three years due to low yields and low market prices. However, in 1998, Smith had a bumper crop and was able to hedge the market and get top dollar for his corn. Smith is currently in the 31% bracket with a Schedule F income of $115,000 and a taxable income of $140,000. Due to income averaging, Smith would be advised to elect to shift $99,000 over the previous three years, in which he was in lower tax brackets. Before income averaging his crop, SmithÕs tax burden was approximately $34,800 in 1998. After taking advantage of the income averaging election, Smith owes approximately $21,400 in income taxes for 1998 with a tax savings of $13,500.

Another example of when income averaging is beneficial is retirement. Most farmers think that retiring is impossible. They have carried their crops over for so long that the tax consequences of this cycle are frightening. In fact, many farmers are only able to retire if they have family that will continue the farming operation is their absence. In other words, the tax burden gets shifted from generation to generation. Consider John Brown who is a farmer in his sixties. He operates through an S-corporation, and he has no family that will carry on the farming operation when he retires. Brown has always carried his crop over in an effort to minimize his taxes in previous years. Through careful tax planning, he has managed to remain in the 28% tax bracket. However, if he is to retire in the year 1999 on schedule, he is faced with farm income of $200,000 since he was forced to sell his 1998 crop in January of 1999 with no expenses to offset the income. Through income averaging, Brown is able to save approximately $6,300 in income taxes.

Keep in mind, though, that income averaging is not beneficial for everyone. If a farmer is typically on the low end of the 28% bracket, and after a good year is on the high end of the 28% bracket, this producer will not gain anything from income averaging.

The bottom line, in any situation, is to talk with your tax advisor and to consider all options. In fact, with careful planning and forethought, you may be able to reduce your tax liability by thousands. DonÕt miss out on considerable tax savings, because income averaging may apply to you. DBJ

Suzanne S. Willis, CPA, is an accountant with May & Company, CPA in Vicksburg.

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