Legal Definitions - income averaging

Term: Income Averaging

Income averaging was a tax method that allowed certain taxpayers to spread out a large, unusually high amount of income received in one year over several preceding years for tax calculation purposes. This approach was designed to reduce the tax burden on individuals whose income fluctuated significantly or who received a substantial portion of their lifetime earnings in a single year. By treating a large income spike as if it had been earned more evenly over a period, it helped prevent taxpayers from being pushed into higher tax brackets and paying a disproportionately large amount of tax due to the progressive nature of income tax rates. This method was available in the United States until it was repealed by the Tax Reform Act of 1986.

Examples:

• Example 1: A Farmer's Bumper Harvest
  Imagine a farmer, Sarah, who typically earns a moderate income from her crops. However, one year, due to exceptionally favorable weather conditions and high market prices, she experiences a "bumper crop" and earns three times her usual annual income. If income averaging were available, Sarah could have treated a portion of that unusually high income as if it had been earned in the previous lower-income years. This would have prevented her entire large income from being taxed at the highest marginal rates applicable to that single peak year, potentially lowering her overall tax liability.
• Example 2: An Inventor's First Major Royalty Payment
  Consider David, an inventor who spent ten years developing a new medical device with little to no income from his invention during that period. Finally, his device is patented and licensed, resulting in a substantial lump-sum royalty payment in a single year. Without income averaging, David's entire large payment would be taxed at the highest rates for that year. Income averaging would have allowed him to distribute that large payment across the previous years he spent developing the invention, reflecting the long-term effort involved and potentially reducing the total tax owed.
• Example 3: A Small Business Owner's Successful Sale
  Suppose Maria owned a small, niche manufacturing business for many years, drawing a modest salary. After two decades, she receives an unexpected offer and sells her company for a significant profit, resulting in a very large personal income in the year of the sale. If income averaging were an option, Maria could have spread that substantial gain from the sale over the preceding years. This would have helped to smooth out the tax impact of such a large, one-time financial windfall, rather than having it all taxed at the highest possible rates in the year it was received.