How income averaging can take the sting out of tax bills
Farmers with another trade or profession can now join scheme, writes Martin O'Sullivan
Averaging of farm profits has proven to be a very popular and effective measure to even out tax liabilities over a period of years, and in many instances create a permanent saving in tax, particularly where a farm is expanding and profits are growing.
Unfortunately, where the farmer or their spouse had other non-farm self-employed income, averaging was not permitted.
This has now changed since January 1, 2019 and farmers with another trade or profession are eligible to average their farm incomes.
It is probably fair to say that the extension of the average period to five years in the 2014 Finance Act has turned a lot of people off averaging as they are now committed for at least five years, and if they wish to cease averaging after that, there is a review of the previous four years which may result in a claw-back of any benefit gained over those four years.
That said, averaging may be an attractive option for some and while it can be a long-term commitment, it deserves careful consideration, bearing in mind the medium-term plans for the farmer and his farm business.
Where profits are growing, entering averaging can create a significant saving in tax over time, and when profits level out, it may be possible to cease averaging without any claw-back. I have set out a case study opposite which illustrates the potential tax savings.
Income averaging is available to all farmers operating as sole traders or in partnership. There are a number of conditions that apply as follows:
l Opting for averaging is only possible where the farmer has been charged to tax in respect of farming profits for each of the four immediately preceding years of assessment in which the election is made.
l An individual is not entitled to enter income averaging if a tax loss was incurred in any of the four preceding tax years. This restriction does not apply if the tax loss was created by capital allowances or losses forward.
HOW AVERAGING WORKS
The farmer's taxable profit is based on one fifth of the combined farming profits for the previous five years after taking account of stock relief, but before deduction of capital allowances. If the average results in a net loss over the period, this loss can be offset against other income that the farmer or his/her spouse may have, including any self-employed income since the recent Finance Act changes as referred to above. An individual who has opted out of the averaging regime may subsequently re-elect for income averaging, but only after his/her farming profits have been assessed on the normal basis for at least four years before re-electing.
There is a facility to temporarily step-out of averaging once every five years. Farmers may avail of this option for a single year which allows them to pay their income tax based on the actual profits of that particular year as opposed to the five-year averaged profit. This can be a welcome relief in a year where profits have collapsed and the money simply is not there to pay a tax bill based on the five-year average.
However, as with most apparent tax concessions, there is a sting in the tail in that the additional tax that would have been payable will now be payable in instalments over the following four years once you remain in averaging. If, however, you opt out of averaging, the deferred tax becomes payable straight away. Another negative point to note is that the concession applies to income tax only and not to PRSI and USC. These will continue to be levied on the averaged profit.
CEASING TO AVERAGE
The minimum duration of averaging is five years after which the farmer can opt out and revert to the normal basis of assessment. However, where a farmer does decide to opt-out, the four years prior to the final year of averaging are reviewed to ensure that the amount charged in those years is not less than that charged for the final year of averaging. If a farmer is ceasing as a sole trader, the position is not as penal in that there is not a four-year review and normal cessation rules apply.
Case study: How income averages could cut your tax bill
The important message on opting to income average is that an appraisal needs to be done on the likely future benefits. For the purposes of this case study, I have set out Joe’s profits below for the years 2014 to 2018 and I have assumed that he has capital allowances each year of €12,000.
His wife is a PAYE worker and paying tax at the 40pc rate. As his tax bill in 2018 is considerably increased on the previous year, he is considering income averaging as a means of reducing the liability.
By opting for averaging in 2018, he will reduce his profit by €11,400 thereby effecting a saving in tax, PRSI and USC of €5,280.
If his profit in 2019 were also to amount to €65,000, his average profit would be €55,000, thereby resulting in a saving in that year of €4,811.
If we project forward to 2020 and assume a profit of €70,000, there would be a further tax saving of €5,781. Accordingly, Joe makes an overall saving of €15,871 over the first three years of averaging.
If Joe’s profits were to remain reasonably stable in future years, the saving would be permanent or if his profits were to continue on an upward curve, there would be further savings.
It is only in a situation where Joe’s profits had dropped that the benefit might prove to be temporary. There is also more good news for Joe in that if he were to cease as a sole trader and become a limited company, there would be no four-year review. He would, however, be assessed on the actual profits earned in the final two tax years.
Martin O'Sullivan is the author of the ACA Farmers Handbook. He is a partner in O'Sullivan Malone and Company, accountants and registered auditors: www.som.ie
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