Farm income swings with weather and prices. Section 1301 lets an individual engaged in a farming or fishing business elect to compute tax on part of the year's income as if it had been earned in equal thirds over the three prior years. In a strong year after weak ones, the election can pull income out of a high bracket and into low base-year brackets. The computation is on Schedule J (Form 1040).
How the election works
Under section 1301(a), the tax for the election year equals the sum of two pieces:
- Tax computed on taxable income reduced by elected farm income (EFI).
- The increase in tax that would result if taxable income for each of the three prior taxable years (the base years) were increased by one-third of the EFI.
Any adjustment for a year is taken into account in applying the section for later years.
What counts as elected farm income
EFI is so much of the taxable income that is attributable to a farming or fishing business and specified in the election. The taxpayer chooses how much, and Publication 225 says EFI cannot be more than taxable income. Income from the farming business is farm income or gain minus allowed farm expenses and losses, and it does not include gain or loss from the sale of land or from the sale of development rights, grazing rights and similar rights. Gain from the sale of property other than land that was regularly used in the farming business for a substantial period is treated as attributable to farming. Farming business has the meaning in section 263A(e)(4). The election is not available to estates and trusts.
IRS Publication 225 adds practical points. An individual, a partner or an S corporation shareholder engaged in a farming business can use it. Services as an employee are disregarded, though an S corporation shareholder may treat compensation attributable to the farming business as farm income. The taxpayer does not need to have been in a farming business in any base year, and filing status need not match the base years. If EFI includes both ordinary income and capital gains, the base-year rates must be applied to an equal portion of each type, not all capital gains at one year's rate.
What the election does not change
Per Publication 225, the allocation of EFI to the base years does not affect other determinations. These are made before EFI is subtracted or added:
- the amount of self-employment tax;
- whether section 1231 transactions produce long-term capital gain or ordinary loss;
- NOL and net capital loss carryovers applied;
- the itemized deduction limit based on AGI.
Income averaging is not used when figuring the alternative minimum tax. The election is made by filing Schedule J with a timely filed return, including extensions.
Worked example
A farmer has $150,000 of taxable income in 2026, all from farming. She elects EFI of $90,000. For a 2026 return the base years are 2023, 2024 and 2025. Assume, for illustration, that the added $30,000 is taxed at 12 percent in 2023 and 2024 and 22 percent in 2025, and that without the election the whole $90,000 would be taxed at 32 percent in 2026.
- One-third of EFI: $30,000 allocated to each base year.
- Base-year tax on $30,000: $3,600 (12 percent), $3,600 (12 percent) and $6,600 (22 percent). Total $13,800.
- Tax on the $90,000 at the current-year rate: $28,800.
- Savings from averaging on that income: $28,800 minus $13,800, or $15,000.
- The tax on the remaining $60,000 of 2026 taxable income is computed normally.
The real computation uses each base year's actual tax rate schedule, so the savings depend on how much room those years had in lower brackets. Pull the three prior returns before running the numbers.
Second example: ordinary income and capital gain
Suppose the same farmer elects $90,000 of EFI made up of $60,000 of ordinary farm income and $30,000 of net capital gain from selling a breeding herd she used in the business for years. Gain on property other than land that was regularly used in the farming business for a substantial period is treated as attributable to farming, and Publication 225 allows designating it as EFI.
Schedule J instructions limit the capital gain portion of EFI to the smaller of total net capital gain or the net capital gain attributable to the farming business. The base-year tax is then computed on an equal portion of each type of income. Each of the three base years receives $20,000 of ordinary income and $10,000 of net capital gain, and each year's own rates apply to each portion. She cannot put all $30,000 of the gain into the lowest-rate year.
Compare with a farmer who elects only $30,000 of EFI. One-third, or $10,000, goes to each base year. A smaller election leaves more income taxed at current-year rates, so the election amount is a modeling choice, run at several levels and compared.
Planning points and file checklist
- Identify farm taxable income, including gain on breeding stock or machinery sales.
- Obtain the three prior returns, including any year with negative taxable income, which Publication 225 says can be combined with EFI.
- Compare the Schedule J result with the unelected result and record both in the file. For the entity-level books behind farm income, see the farm and agribusiness audit guide.
- Keep the Schedule J computation with the return, because the election affects later years' base-year amounts.
- Remember that self-employment tax does not fall, so evaluate the full cost.
Common errors
- Including gain from the sale of land in EFI. It is excluded from income from the farming business.
- Treating contract harvesting or buying and reselling plants or animals grown by someone else as a farming business. The Schedule J instructions exclude both.
- Allocating all capital gain to one base year instead of an equal portion of each type to each year.
- Expecting the election to reduce self-employment tax, change section 1231 character, or alter the itemized deduction limit. Publication 225 says those are determined before EFI is subtracted.
- Using the election in the AMT computation. It does not apply there.
- Forgetting the election after the fact. It can be made on a late return, or used, changed or cancelled on an amended return while the refund claim period is open.
Frequently asked questions
Can an S corporation or partnership elect averaging?
No. Corporations, partnerships, S corporations, estates and trusts cannot. An individual, a partner or an S corporation shareholder engaged in a farming business can.
Does a base year with a loss matter?
Yes. Publication 225 says a base year with taxable income of zero because deductions exceeded income may have negative taxable income to combine with EFI.
Does a fisher qualify?
Yes. Section 1301 covers an individual engaged in a fishing business, defined by reference to commercial fishing under the Magnuson-Stevens Act.
Sources
- Legal Information Institute, 26 U.S.C. 1301, Averaging of farm income: https://www.law.cornell.edu/uscode/text/26/1301
- Internal Revenue Service, Publication 225, Farmer's Tax Guide: https://www.irs.gov/publications/p225
- Internal Revenue Service, Instructions for Schedule J (Form 1040): https://www.irs.gov/instructions/i1040sj
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