Defining compensation for self-employed participants can be difficult. Assume a client is the owner and sole employee of an LLC (or LLP, partnership, sole proprietorship, subchapter S corporation, or any other business not taxed as a subchapter C corporation). The business sponsors a profit sharing plan and the owner’s Schedule C income (or self-employment income from Form K-1) was $160,000 in 2002. Can he contribute $40,000 or 25% to the profit sharing plan? No!

The Code permits an allocation to an individual of up to the lesser of 100% of compensation or $40,000. To be deductible, profit sharing contributions must not exceed 25% of compensation otherwise paid to participants. Thus, for a one participant plan, contributions are limited to 25% of compensation. Compensation, for a self-employed individual, means his or her “earned income.”

The Code provides a detailed formula to calculate earned income. Which starts with the Net Profit reported on Schedule C from Self-Employment reported on Form K-1. On our facts, this is $160,000.

A self-employed individual reports the net profit on his or her Form 1040. Prior to computing the individual’s taxable income, the net profit is reduced by ½ of the self-employment taxes calculated on Form 1040 Schedule SE. Net profit is further reduced by the contribution to the tax-qualified plan. If the business was taxed as a corporation, these two items would be paid and deducted by the corporation and would not be reflected in the individual’s compensation. To account for this tax difference, the self-employed individual’s earned income is net profit reduced by (i) ½ of the self employment tax; and (ii) the plan contribution.

Self employment tax is calculated based on the individual’s compensation and the taxable wage base in effect for the year (the point at which taxpayers stop paying FICA). Self employment tax for an individual earning net profit of $160,000 is $15,073.

The true difficulty in calculating earned income is that it must be reduced by the amount of the plan contribution, which, in turn, is limited to 25% of earned income. Algebraic formulas have been developed to aid in this circular calculation (do you remember thinking in high school, “when am I ever going to use this stuff”). The maximum deductible contribution for an individual earning net profit of $160,000 is $30,492.70. Need proof, earned income equals $121,970.78 (25% of which is the maximum contribution) plus the contribution ($30,492.70) plus 1/2 of the self employment tax ($7,536.52) equals net profit ($160,000). Its not magic, only algebra.

Many clients would assume they could contribute $40,000, 25% of $160,000. As shown this is not the case. The following chart estimates the maximum deductible amount at various profit levels. Note that the addition of employees will alter the calculation significantly.

Schedule C or K-1 Net Profit	Maximum deductible contribution (25%)
$25,000	$4,646.76
$50,000	$9,293.52
$100,000	$18,653.39
$125,000	$23,586.43
$150,000	$28,519.48
$175,000	$33,452.52
$200,000	$38,385.57
$225,000	$40,000

The fact that a self employed individual’s compensation is limited to earned income is one of the most overlooked rules imposed on tax-qualified plans. The impact on deductible contributions is evidenced above. However, equally overlooked is the impact this limitation has on the various tax-qualification test. Consider a 401(k) plan in which a self employed individual participates. Calculations under the ADP test may limit what the self employed individual is permitted to defer. For purposes of that test, earned income is the determining factor.

Self employed individuals who find their contributions limited by the earned income calculation are urged to consider converting their plan to provide a section 401(k) feature. A one-participant 401(k)/profit sharing plan may permit greater contributions because of the fact that the 401(k) deferrals are not subject to the deduction limitation. The contributions permitted under a one-person 401(k) plan are as follows.

Schedule C or K-1 Net Profit	401(k) Deferral	Maximum deductible contribution (25%)	Total Contribution
$25,000	$12,000.00	$4,646.76	$16,646.76
$50,000	$12,000.00	$9,293.52	$21,293.52
$100,000	$12,000.00	$18,653.39	$30,653.39
$125,000	$12,000.00	$23,586.43	$35,586.43
$150,000	$11,480.52	$28,519.48	$40,000.00
$175,000	$6,547.48	$33,452.52	$40,000.00
$200,000	$1,614.43	$38,385.57	$40,000.00
$225,000	$0.00	$40,000	$40,000.00