Methods for Figuring Net Earnings

There are three ways to figure your net earnings from self-employment.

1. The regular method.
2. The nonfarm optional method.
3. The farm optional method.

Which Method Should You Use?

You must use the regular method unless you are eligible to use one or both of the optional methods. See Table 4. Can I Use the Optional Methods?

Why use an optional method? You can generally use the optional methods (discussed later) when you have a loss or a small amount of net income from self-employment and any one of the following applies.

• You want to receive credit for social security benefit coverage.
• You incurred child or dependent care expenses for which you could claim a credit. (An optional method will increase your earned income, which could increase your credit.)
• You are entitled to the earned income credit. (An optional method will increase your earned income, which could increase your credit.)

Table 4. Can I Use the Optional Methods?

Effects of using an optional method. Using an optional method could increase your self-employment tax. Paying more self-employment tax can result in your getting higher benefits when you retire.

If you use either or both optional methods, you must figure and pay the SE tax due under these methods even if you would have had a smaller tax or no tax using the regular method.

The optional methods may be used only to figure your SE tax. To figure your income tax, include your actual SE income in gross income, regardless of which method you use to determine SE tax.

Regular Method

Multiply your net SE income by 92.35% (.9235) to get your net earnings under the regular method. See Short Schedule SE, line 4, or Long Schedule SE, line 4a.

You must use the regular method unless you are eligible to use one or both of the optional methods.

Nonfarm Optional Method

Use the nonfarm optional method only for SE income that does not come from farming. You may use this method if you meet all the following tests.

1. You are self-employed on a regular basis. This means that your actual net earnings from self-employment were $400 or more in at least 2 of the 3 tax years before the one for which you use this method. The net earnings can be from either farm or nonfarm earnings or both.
2. You have not previously used this method more than 4 years. (There is a 5-year lifetime limit.) The years do not have to be one after another.
3. Your net nonfarm profit is:
   1. Less than $1,733, and
   2. Less than 72.189% of your gross nonfarm income.

You can find your net nonfarm profit on:

• Line 31, Schedule C (Form 1040),
• Line 3, Schedule C-EZ (Form 1040),
• Line 15a, Schedule K-1 (Form 1065), or
• Box 9, Schedule K-1 (Form 1065-B).

Optional net earnings less than actual earnings. You cannot use this method to report an amount less than your actual net earnings from self-employment. Your actual net earnings are your net earnings figured using the regular method, explained earlier.

Figuring Nonfarm Net Earnings

If you meet the three tests explained earlier, use the following table to figure your net earnings from self-employment under the nonfarm optional method.

Table 3. Figuring Non-Farm Net Earnings

Gross income of $2,400 or less. The following examples illustrate how to figure net earnings when gross income from all nonfarm trades or businesses is $2,400 or less.

Example 1--net nonfarm profit less than $1,733 and less than 72.189% of gross nonfarm income. Ann Green had actual net earnings from self-employment of $800 in 1998 and $900 in 1999 from her craft business. She meets the test for being self-employed on a regular basis. Her gross income and net profit in 2000 are as follows:

Because her net profit is less than $1,733 and less than 72.189% of her gross nonfarm income, Ann can use her nonfarm optional method net earnings of $1,400 ( 2/3 x $2,100).

Example 2--net nonfarm profit less than $1,733 but not less than 72.189% of gross nonfarm income. Assume that in Example 1 Ann's gross income is $1,000 and her net profit is $800. She must use the regular method to figure her net earnings. She cannot use the nonfarm optional method because her net profit is not less than 72.189% of her gross nonfarm income.

Example 3--net loss from a nonfarm business. Assume that in Example 1 Ann has a net loss of $700. In this situation, she can use $1,400 ( 2/3 x $2,100) as her net earnings under the nonfarm optional method.

Example 4--net earnings less than $400. Assume that in Example 1 Ann has gross income of $525 and a net profit of $175. In this situation, she would not pay any SE tax under either the regular method or the nonfarm optional method because her net earnings under both methods are less than $400.

Gross income of more than $2,400. The following examples illustrate how to figure net earnings when gross income from all nonfarm trades or businesses is more than $2,400.

Example 1--net nonfarm profit less than $1,733 and less than 72.189% of gross nonfarm income. John White runs an appliance repair shop. His actual net earnings from self-employment were $8,500 in 1997, $10,500 in 1998, and $9,500 in 1999. He meets the test for being self-employed on a regular basis. His gross income and net profit in 2000 are as follows:

Because his net profit is less than $1,733 and less than 72.189% of his gross nonfarm income, John may use $1,600 as his net earnings.

Example 2--net nonfarm profit not less than $1,733. Assume that in Example 1 John's net profit is $1,800. He must use the regular method. He cannot use the nonfarm optional method because his net nonfarm profit is not less than $1,733.

Example 3--net loss from a nonfarm business. Assume that in Example 1 John has a net loss of $700. He can use the nonfarm optional method and report $1,600 as his net earnings from self-employment.

Farm Optional Method

If you are in the farming business, either as a sole proprietor or as a partner, you may be able to use the farm optional method to figure your net earnings from farm self-employment.

Figuring Farm Net Earnings

Use Table 5 to determine what you may report as your net earnings from self-employment under the farm optional method.

Table 5. Net Earnings from Farming

Optional earnings less than actual earnings. If your net earnings under the farm optional method are less than your actual net earnings, you can still use the farm optional method. Your actual net earnings are your net earnings figured using the regular method, explained earlier.

Example. Your actual net earnings from self-employment are $425 and your net earnings figured under the farm optional method are $390. You owe no SE tax if you use the optional method because your net earnings under the farm optional method are below $400.

Gross income from farming. Farming income includes what you receive from cultivating the soil or raising or harvesting any agricultural commodities. It also includes income from the operation of a livestock, dairy, poultry, bee, fish, fruit, or truck farm, or plantation, ranch, nursery, range, orchard, or oyster bed. This includes income in the form of crop shares if you materially participate in production or management of production.

Government commodity program payments. If you receive government commodity program payments on land you rent out, do not include these payments unless you meet the material participation test. For more information on material participation, see chapter 15 in Publication 225.

Gross income from a farm sole proprietorship. If you operate your farm as a sole proprietorship, use the following table to determine your gross farm income.

Table 6. Gross Farm Sole Proprietorship

Determining gross income from a farm partnership. If you are a member of a farm partnership, your gross income includes your distributive share of the partnership's gross income from farming. The partnership must follow the steps in Table 7 to determine your distributive share of gross farm income.

Table 7. Gross Partnership Farm Income

The result determined in (3) above is your distributive share of the partnership's gross income from farming. Use this distributive share of gross income, any guaranteed payments (discussed next), and any other gross income from farming to determine whether you can use the farm optional method to figure your net earnings from self-employment.

Guaranteed payments. Any guaranteed payments you receive from a farm partnership that are determined without regard to partnership income are gross income from your farming business (not the partnership's). Use the total of these guaranteed payments, your distributive share of gross income from a farm partnership, and any other gross income you receive from farming to determine whether you can use the farm optional method to figure your net earnings from self-employment.

Using Both Optional Methods

If you have self-employment income from both farming and nonfarming businesses, you may be able to use both optional methods to determine your net earnings from self-employment.

To figure your net earnings using both optional methods, you must:

1. Separately figure your earnings from farming and nonfarming under each method. Do not combine farming income with nonfarm income to figure your net earnings under either method.
2. Add the net earnings figured under each method to arrive at your total net earnings from self-employment.

You can report less than your total actual net earnings from farm and nonfarm self-employment but not less than actual net earnings from nonfarm self-employment. If you use both optional methods, you can report no more than $1,600 as your combined net earnings from self-employment.

Example 1. You are a self-employed farmer. You also operate a retail grocery store. Your gross income, actual net earnings from self-employment, and optional farm and optional nonfarm net earnings from self-employment are as follows:

Table 8. Farm and Nonfarm Earnings -- Example 1.

You can figure your net earnings from self-employment in any of the four combinations shown below:

Table 9. Net earnings--Example 1.

Example 2. Assume that in Example 1 your gross income, actual net earnings from self-employment, and 2/3 of your gross income from self-employment are as follows:

Table 10. Farm and Nonfarm Earnings--Example 2.

Your net earnings from self-employment may be either of the amounts figured below:

Table 11. Net Earnings--Example 2.

You can not use the nonfarm optional method for the year because your actual net earnings from nonfarm self-employment ($800) are not less than 72.189% of gross nonfarm income (.72189 x $1,000 = $721.89).

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