Publication 533
Self- Employment Tax

For use in preparing 2002 Returns

Trader in Securities

You are a trader in securities if you are engaged in the business of buying and selling securities for your own account. As a trader in securities, your gain or loss from the disposition of securities is not subject to SE tax. However, see Dealer in Securities, earlier, for an exception that applies to section 1256 contracts. For more information about traders in securities, see Publication 550, Investment Income and Expenses.

Figuring Earnings Subject
to Self-Employment Tax

Generally, you need to figure your total earnings subject to SE tax before you can figure your net earnings from self-employment. This section will help you figure these total earnings.

Sole proprietor or independent contractor.   If you are self-employed as a sole proprietor or independent contractor (see Are You Self-Employed, earlier), use Schedule C or C-EZ (Form 1040) to figure your earnings subject to SE tax. For information about figuring earnings on Schedule C or C-EZ, see Publication 334. Commercial fishermen should also see Publication 595. Direct sellers should see Publication 911.

Farmer.   If you are self-employed as a farmer, use Schedule F (Form 1040) to figure your earnings subject to SE tax. For information about figuring earnings on Schedule F, see Publication 225.

Partner.   If you are self-employed as a member of a partnership, use information from your Schedule K-1 (Form 1065) or (Form 1065-B) to figure your earnings subject to SE tax. For more information, see Partnership Income or Loss, later.

Church employee.   If you are a church employee who must pay SE tax (see Who Must Pay Self-Employment Tax, earlier), use information from your Form W-2 to figure your earnings subject to SE tax. For more information, see the Schedule SE instructions.

Minister, Christian Science practitioner, or member of religious order.   If you are a minister, Christian Science practitioner, or member of a religious order who must pay SE tax (see Minister, Christian Science Practitioner, or Member of Religious Order, earlier), see Publication 517 for information about figuring your earnings subject to SE tax.

More Than One Business

If you have earnings subject to SE tax from more than one trade, business, or profession, you must combine the net profit (or loss) from each to determine your total earnings subject to SE tax. A loss from one business reduces your profit from another business.

Community Income

If any of the income from a trade or business, other than a partnership, is community income under state law, it is included in the earnings subject to SE tax of the spouse carrying on the trade or business. The identity of the spouse carrying on the trade or business is determined by the facts in each case.

Gain or Loss

Do not include in earnings subject to SE tax a gain or loss from the disposition of property that is neither stock in trade nor held primarily for sale to customers. It does not matter whether the disposition is a sale, exchange, or an involuntary conversion. For example, gains or losses from the disposition of the following types of property are not included in earnings subject to SE tax.

• Investment property.
• Depreciable property or other fixed assets used in your trade or business.
• Livestock held for draft, breeding, sport, or dairy purposes and not held primarily for sale, regardless of how long the livestock were held or whether they were raised or purchased.
• Standing crops sold with land held more than one year.
• Timber, coal, or iron ore held for more than one year, if an economic interest was retained, such as a right to receive coal royalties.

A gain or loss from the cutting of timber is not included in earnings subject to SE tax if the cutting is treated as a sale or exchange. For more information on electing to treat the cutting of timber as a sale or exchange, see Timber in chapter 2 of Publication 544, Sales and Other Dispositions of Assets.

Lost Income Payments

If you are self-employed and reduce or stop your business activities, any payment you receive from insurance or other sources for the lost business income is included in earnings subject to SE tax. If you are not working when you receive the payment, it still relates to your business and is included in earnings subject to SE tax, even though your business is temporarily inactive.

If there is a connection between any payment you receive and your trade or business, the payment is included in earnings subject to SE tax. A connection exists if it is clear the payment would not have been made but for your conduct of the trade or business.

Partnership Income or Loss

If you are a member of a partnership that carries on a trade or business, the partnership should report your earnings subject to SE tax on line 15a of your Schedule K-1 (Form 1065) or in box 9 of your Schedule K-1 (Form 1065-B). The partnership can use the worksheet in the form instructions to figure these earnings.

General partner.   If you are a general partner, you may need to reduce these reported earnings by amounts you claim as a section 179 deduction, unreimbursed partnership expenses, or depletion on oil and gas properties.

If the amount reported is a loss, include only the deductible amount when you figure your total earnings subject to SE tax.

For more information, see the Partner's Instructions for Schedule K-1. For general information on partnerships, see Publication 541.

Limited partner.   If you are a limited partner, your partnership earnings are generally not subject to SE tax. However, guaranteed payments you receive for services you perform for the partnership are subject to SE tax and should be reported to you on line 15a or in box 9 of your Schedule K-1.

Retired partner.   If you are a retired partner, retirement income you receive from the partnership under a written plan is not subject to SE tax if all the following apply.

• You receive lifelong periodic payments.
• Your share of the partnership capital was fully paid to you.
• You did not perform any services for the partnership during the year.
• You are owed nothing but the retirement payments by the partnership.

Husband and wife partners.   If you and your spouse join together in the conduct of a business and share in the profits and losses, you have created a partnership. A partnership must report business income and expenses on Form 1065, U.S. Return of Partnership Income, along with Schedules K-1 showing each partner's share of the earnings. Both of you must report the earnings on Form 1040 and file a separate Schedule SE (Form 1040) to report your individual SE tax.

However, if your spouse is your employee, not your partner, you must withhold and pay social security and Medicare taxes for him or her. For more information about employment taxes, see Publication 15.

Investment club partner.   If you are a member of an investment club partnership, your share of the club's earnings is not included in earnings subject to SE tax if the club limits its activities to the following activities.

• Investing in savings certificates, stock, or securities.
• Collecting interest or dividends for its members' accounts.

Community income from a partnership.   If you are a partner and your distributive share of any income or loss from a trade or business carried on by the partnership is community income, treat your share as your earnings subject to SE tax. Do not treat any of your share as earnings of your spouse.

Different tax years.   If your tax year is not the same as your partnership's, report your share of partnership income (or loss) on your return for the year that includes the end of the partnership tax year.

Example.   You file your return on a calendar year basis, but your partnership uses the fiscal year ending January 31. You must include on your return for calendar year 2002 your partnership earnings subject to SE tax for the fiscal year ending January 31, 2002.

Death of a partner.   When a partner dies, his or her partnership earnings subject to SE tax are figured through the end of the month in which the death occurs. This is true even though the decedent's estate or heirs may succeed to rights in the partnership. The partnership earnings subject to SE tax for the year are treated as though they were earned in equal amounts each month.

Example.   ABC Partnership operates a business. Its tax year ends on December 31. A partner dies on August 18. The deceased partner's (and his or her estate's) partnership earnings subject to SE tax for the year of death are $12,000. That partner's SE income from the partnership is $8,000 (8/12 × $12,000).

Corporate Director, Employee,
or Shareholder

This section provides information to help you determine whether your earnings are subject to SE tax if you are one of the following.

• A corporate director.
• A corporate employee or officer.
• A shareholder or officer of an S corporation.

Corporate director.   Fees you receive for performing services as a director of a corporation are subject to SE tax. It does not matter whether the fees are for going to directors' meetings or for serving on committees.

Corporate employee or officer.   Even if you own most or all of the stock of a corporation, your income as an employee or officer of the corporation is not subject to SE tax.

S corporation shareholder and officer.   If you are a shareholder in an S corporation, your share of the corporation's earnings are not subject to SE tax, even though you include them in your gross income for income tax purposes.

If you are a shareholder and also an officer of an S corporation and perform substantial services, you are an employee of the S corporation. Your payment for services is subject to withholding of social security and Medicare taxes and is not subject to SE tax, regardless of what the S corporation calls the payments.

Real Estate Rent

Rental income from real estate and personal property leased with real estate is not included in earnings subject to SE tax unless either of the following applies to you.

• You are a real estate dealer.
• You provide services for your tenants.

Real estate dealer.   You are a real estate dealer if you are engaged in the business of selling real estate to customers with the purpose of making a profit from those sales. Rent you receive from real estate held for sale to customers is subject to SE tax. However, rent you receive from real estate held for speculation or investment is not subject to SE tax.

Trailer park owner.   Rental income from a trailer park is subject to SE tax if you are a self-employed trailer park owner who provides trailer lots and facilities and substantial services for the convenience of your tenants.

You generally are considered to provide substantial services for tenants if they are primarily for the tenants' convenience and normally are not provided to maintain the lots in a condition for occupancy. Services are substantial if the compensation for the services makes up a material part of the tenants' rental payments.

Examples of services that are for the tenants' convenience include supervising and maintaining a recreational hall provided by the park, distributing a monthly newsletter to tenants, operating a laundry facility, and helping tenants buy or sell their trailers.

Examples of services that are normally provided to maintain the lots in a condition for tenant occupancy include city sewerage, electrical connections, and roadways.

Hotels, boarding houses, and apartments.   Rental income you receive for the use or occupancy of hotels, boarding houses, or apartment houses is subject to SE tax if you provide services for the occupants.

Generally, you are considered to provide services for the occupants if the services are primarily for their convenience and are not services normally provided with the rental of rooms for occupancy only. An example of a service provided for the convenience of the occupants is maid service. However, providing heat and light, cleaning stairways and lobbies, and collecting trash are not services primarily for the occupants' convenience.

U.S. Possession Self-Employment Income

If you have income from self-employment in a U.S. possession, include it in earnings subject to SE tax even if your U.S. possession income is exempt from U.S. income tax.

Places treated as U.S. possessions.   The following places are treated as U.S. possessions.

• Guam
• American Samoa
• The Virgin Islands
• The Commonwealth of
  the Northern Mariana Islands
• Puerto Rico

Form to file.   Use the following table to select the appropriate form to file to report your earnings subject to SE tax.

More information.   For more information on income from U.S. possessions, see Publication 570, Tax Guide for Individuals With Income From U.S. Possessions.

Research Grant

If you receive payments under a research grant and perform services for the grantor as an independent contractor, the payments you receive are subject to SE tax.

For more information about whether you are an independent contractor, see Independent contractor, earlier.

Wages, Salaries, and Tips

Wages and salaries received for services performed as an employee and covered by social security or railroad retirement are not included in earnings subject to SE tax. Tips received for similar services as an employee also are not included in earnings subject to SE tax.

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.

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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 3.)

Why use an optional method?   You may want to use the optional methods (discussed later) when you have a loss or a small net profit 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 may increase your earned income, which could increase your credit.)
• You are entitled to the earned income credit. (An optional method may increase your earned income, which could increase your credit.)
• You are entitled to the additional child tax credit. (An optional method may increase your earned income, which could increase your credit.)

Table 3. Can I Use the Optional Methods?

Effects of using an optional method.   Using an optional method could increase your SE tax. Paying more SE 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 earnings in gross income, regardless of which method you use to determine SE tax.

Regular Method

Multiply your total earnings subject to SE tax 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.

Net earnings figured using the regular method are also called actual net earnings.

Nonfarm Optional Method

Use the nonfarm optional method only for earnings that do 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 profits were:
   1. Less than $1,733, and
   2. Less than 72.189% of your gross nonfarm income.

Net nonfarm profits.   Net nonfarm profits generally is the total of the amounts from:

• Line 31, Schedule C (Form 1040),
• Line 3, Schedule C-EZ (Form 1040),
• Line 15a, Schedule K-1 (Form 1065), (from nonfarm partnerships), and
• Box 9, Schedule K-1 (Form 1065-B). (Look for code K1.)

However, you may need to adjust the amount reported on Schedule K-1 if you are a general partner or if it is a loss. For more information, see Partnership Income or Loss, earlier.

Gross nonfarm income.   Your gross nonfarm income generally is the total of the amounts from:

• Line 7, Schedule C (Form 1040),
• Line 1, Schedule C-EZ (Form 1040),
• Line 15c, Schedule K-1 (Form 1065), (from nonfarm partnerships), and
• Box 9, Schedule K-1 (Form 1065-B). (Look for code K2.)

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.

Optional 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.

Gross income of $2,400 or less.   The following examples illustrate how to figure net earnings when gross nonfarm income 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 runs a craft business. Her actual net earnings from self-employment were $800 in 2000 and $900 in 2001. She meets the test for being self-employed on a regular basis. She has not previously used the nonfarm optional method for more than 4 years. Her gross income and net profit in 2002 are as follows:

Ann's actual net earnings for 2002 are $1,108 ($1,200 × .9235). Because her net profit is less than $1,733 and less than 72.189% of her gross income, she can use the nonfarm optional method to figure net earnings of $1,400 (2/3 × $2,100). Because these net earnings are higher than her actual net earnings, she can report net earnings of $1,400 for 2002.

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 income.

Example 3 - net loss from a nonfarm business.   Assume that in Example 1 Ann has a net loss of $700. She can use the nonfarm optional method and report $1,400 (2/3 × $2,100) as her net earnings.

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 nonfarm income 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 $10,500 in 2000 and $9,500 in 2001. He meets the test for being self-employed on a regular basis. He has not previously used the nonfarm optional method for more than 4 years. His gross income and net profit in 2002 are as follows:

John's actual net earnings for 2002 are $1,108 ($1,200 × .9235). Because his net profit is less than $1,733 and less than 72.189% of his gross income, he can use the nonfarm optional method to figure net earnings of $1,600. Because these net earnings are higher than his actual net earnings, he can report net earnings of $1,600 for 2002.

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.

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