The Internal Revenue Service had previously taken the position that in computing the increase in tax for an earlier year, the taxable income for such an earlier year, before adding the third of elected farm income from the current year, could not be less than zero. Now, however, the service, in its 2000 Farmers Tax Guide (IRS Pub No. 225), has changed its position, and agrees that taxable income from an earlier year can be a negative number. As a result of this changed position, the amount that tax averaging can save a farmer who had a loss in one or more base years can be substantially increased.
The service’s new position is retroactive. Assume a farmer who could have used income averaging in 1998 and/or 1999 had negative taxable income in a base year. Schedule J (the schedule used by farmers to average, their income) for both 1998 and 1999 did not allow the use of a negative taxable income for a base year. The service now says that a farmer may file an amended return on Form 1040X to claim any refund that would result from using the actual negative taxable income for a base year instead of zero.
Thus, farmers who did not use Schedule J for 1998 and/or 1999 and who would benefit from the service’s new position may now amend those returns to elect to use farm averaging. Similarly, farmers who used Schedule J for 1998 and/or 1999, and reported their taxable income for a base year as zero even though it was actually a negative amount, may now amend their return to refigure their tax using the actual negative amount.
Example: In 1998, your farmer client, a single taxpayer, had taxable income of $110,000, of which $80,000 was from his farming business. He had taxable income of $15,000 in 1997, $10,000 in 1996, and a taxable loss of $15,000 in 1995.
He elected to average $75,000 of farming income for 1998 over the three previous years. Based on the instructions for Schedule J, you computed your client’s Federal income tax for 1998 as follows:
(1) You subtracted the elected part of his 1998 taxable farm income ($75,000) from his total taxable income of $110,000 for that year. This left your client with taxable income of $35,000 for 1998. The tax for a single taxpayer on $35,000 for 1998 is $6,512.
(2) You then added $25,000 (one-third of his total elected farm income of $75,000) to his taxable income for each of the previous three years, except that in the case of 1995, you used zero as the taxable income instead of the taxable loss of $15,000 for that year. You then figured the tax for each of those years taking into account the elected farm income that was included for that year. You then subtracted the tax shown on your client’s actual returns for those years from the tax you calculated for him after including the $25,000 of elected farm income. As a result for 1997, your client’s taxable income was increased to $40,000, from $15,000, and his tax was increased to $8,003, from $2,254, an increase of $5,749.
For 1996, your client’s taxable income was increased to $35,000, from $10,000, and his tax was increased to $6,687, from $1,504, an increase of $5,183.
For 1995, your client’s taxable income for farm income averaging purposes was increased to $25,000 from zero since under the Schedule J instructions for 1998, he could not use less than zero for a base year. Thus, his tax for 1995 was increased to $3,972 from zero.
(3) You then computed your client’s tax for 1998 by adding the increases for 1995, 1996, and 1997 to the tax you computed for 1998 after deducting the $75,000 of elected farm income. This made your client’s total tax for 1998 $21,416 ($6,512 plus $5,749, plus $5,183, plus $3,972). This was $7,547 less than the $28,963 tax your client would have to pay on taxable income of $110,000 for 1998 if farm income averaging had not been used.
Observation: The use of income averaging allows your client to get part of his income that would otherwise have been taxed at a 31 percent rate taxed at a 15 percent rate, and part of it taxed at a 28 percent rate.
Example: As a result of the service’s change in position as to the use of negative taxable income in a base year, you now decide to amend your client’s 1998 income tax return. You would calculate the tax in the same manner as in the above example except that for 1995 you would add the $25,000 of elected farm income for that year to his negative taxable income of $15,000 instead of to zero. This would leave your client with taxable income of $10,000 for 1995 instead of $25,000. His tax for 1995 only would be $1,504 instead of $3,972, and the total tax on his 1998 tax return would be reduced to $18,948 ($6,512 plus $5,749, plus $5,183, plus $1,504) from $21,416. Thus, your client would be entitled to a refund of $2,468 plus interest for 1998.
Observation: In the above example, I have assumed that no part of the negative taxable income for 1995 resulted from a net operating loss that could be carried over to another year.