Income averaging allows you to reduce your tax liability by averaging the income earned in a banner year with other years when you didn't do so well. The practice was established with the Revenue Act of 1964, but you can only do that now if you make your living as a farmer or a commercial fisherman -- or have a time machine that can take you back to the early 1980s. Income averaging was repealed by the Tax Reform Act of 1986.
How It Worked
An aspiring writer struggled for years to make a living. He got an occasional part-time job writing greeting card poems while he worked on the next great American novel. After four years, he finally landed an agent who got him a high six-figure advance on his book. When it came time to do his taxes, he realized that he had been catapulted into a high tax bracket and a big chunk of his advance was going to Uncle Sam. Under the Revenue Act of 1964, he could have taken the average of his big windfall over the lean years and significantly lowered his tax bracket and, consequently, his tax liability.
For most Americans, income averaging is a thing of the past. However, if you are in the farming business as an individual or as a partner in a partnership or a shareholder in an S corporation, you can still income average; but farming corporations, the farming partnership itself, the farming S corporation itself and a farming trust cannot income average. Even if you qualify, you can only average over three years, not five.
Taxes are due the year you earn the income. There’s really no way around that. However, you may be able to decrease the amount of tax you owe by offsetting some of your income. The rules for that are very specific to your situation, so you really need to seek expert tax advice. Don’t wait until the end of the year to do some proactive tax planning.
Interesting Tax Facts
The income tax did not exist in America until 1861 and it was originally a flat rate tax, although it was revised to graduated rates the following year. The income tax was seen as a war-time provision and was allowed to expire in 1872 after the Civil War ended. Congress tried to re-enact the income tax in 1894, but it was declared unconstitutional by the Supreme Court in 1895. On Feb. 25, 1913, the Sixteenth Amendment was ratified giving Congress the power to levy an income tax and it’s been with us ever since. Originally, the maximum tax rate for an individual was 7 percent, but it shot up to 77 percent in 1918 due to World War I, while rates for corporations went from 1 percent to a measly 12 percent. Corporations always seem to get a better break than individuals. For the World War II years of 1944 and 1945, the individual income tax rates ranged from 23 percent to a whopping 94 percent – the highest rates ever imposed.
Lisa Dorward was a corporate financial executive and business consultant for more than 15 years before becoming a writer in 2003. She has B.A. degrees in both history and creative writing and earned her M.F.A. in creative writing in 2008, specializing in novel-length historical fiction.