The need for Income Averaging after COVID-19

Income averaging was a tax break that assisted people with large income deviations up until 1986.  After the 1986 Tax Reform Act, income averaging was eliminated for everyone except fishermen and farmers.  In the shadow of a wrecked economy and record unemployment caused by the COVID-19 pandemic, I encourage everyone to reach out to their Senators and Representatives and ask that income averaging be reinstated to assist those people and businesses suffering income losses for tax year 2020.

How does income averaging work?  Prior to the 1986 Tax Reform Act, income averaging allowed a taxpayer who had large swings in income to average the adjusted gross income from two prior tax years together with the current year in order to average the taxes that had to be paid.  For example, suppose a taxpayer earned $100,000 and paid $20,000 in taxes in year one, then the taxpayer made $300,000 and paid $80,000 in year two, but then lost $100,000 in year three.  Without income averaging, in year three the taxpayer would pay no taxes since there is no income.  But with income averaging, the taxpayer would be able to average his income for all three years, resulting in an average of $100,000 per year.  How do I get $100,000 per year average?  The taxpayer earned $100,000 in year one, plus $300,000 in year two, minus $100,000 in year 3, divided by 3 years equals an average of $100,000 per year.

How much tax would the taxpayer pay under income averaging?  Under income averaging, the taxpayer would be permitted to recalculate the taxes owed in year one, year two, and year three based on an average income of $100,000 per year.  Since we know that the tax on $100,000 is $20,000, the taxpayer would need to pay $20,000 in taxes for year 1, plus another $20,000 for year 2, and another $20,000 for year 3.  A total of $60,000 in taxes is owed over the three years based on the income average of $100,000 for each year.  However, the taxpayer already paid $20,000 in year one, and $80,000 in year two for a total of $100,000.  Therefore, in year 3, the taxpayer would receive a refund of $40,000, the difference between the $100,000 paid in taxes and the $60,000 owed due to income averaging, because he overpaid his income taxes using income averaging.

How will this help people and businesses affected by the COVID-19 pandemic?  Individuals and businesses who had a dramatic downturn in income can income average their losses this year to get a refund from taxes previously paid when their incomes were higher.  On the other hand, businesses and individuals that are prospering despite the pandemic, would continue to pay taxes at the regular tax rates since income averaging would not produce a lower average taxable income.

I am asking for a call to action.  If you have read this far, hopefully you understand why income averaging would help those affected by the COVID-19 pandemic the most.  I encourage you to share this post.  Copy and email it to your Senators and Representatives.  Encourage them to help those being hurt right now by adding income averaging to the tax code.  Help the hard-working Americans and American Businesses losing money this year.

Dated:  April 12, 2020

Written by Attorney John H. Phillips