IRC 1402: What Are Net Earnings From Self-Employment?

Internal Revenue Code (IRC) Section 1402 defines “net earnings from self-employment.” This figure is used to determine who must pay self-employment tax, which covers Social Security and Medicare contributions for those who work for themselves. The rules apply to anyone who is not an employee but receives income for providing goods or services. This section of the tax code establishes the framework for calculating the income base upon which these taxes are levied.

Defining Net Earnings from Self Employment

The core definition of net earnings from self-employment begins with the gross income an individual derives from any trade or business they carry on. From this gross income, the individual subtracts all allowable business deductions attributable to that enterprise. This calculation results in the net profit of the business, which serves as the starting point for determining the earnings subject to self-employment tax. The concept is parallel to how an employee’s wages are subject to FICA taxes, but it applies to independent workers.

For an activity to qualify as a “trade or business,” the Internal Revenue Service (IRS) requires that it be carried on with continuity and regularity, with the primary purpose of generating a profit. This distinguishes a business venture from a hobby. The definition encompasses sole proprietors, independent contractors, and members of a partnership. If an individual holds themselves out to the public as offering goods or services, they are generally considered to be engaged in a trade or business for tax purposes.

Income Included in the Calculation

Gross income from a trade or business includes earnings received by individuals working as independent contractors, freelancers, or consultants. This applies whether you operate a formally registered business or simply provide services on a project basis across a wide range of professions, from graphic designers to rideshare drivers.

A common way this income is reported is on Form 1099-NEC, Nonemployee Compensation. Businesses that pay an independent contractor $600 or more for services during a calendar year must issue this form, and the amount reported represents gross revenue.

Beyond payments reported on a 1099-NEC, all other income earned from a trade or business must be included. This includes direct payments from customers that do not meet the $600 threshold from any single payer. The responsibility for tracking and reporting all business income rests with the self-employed individual.

Income is not limited to cash payments. It also includes property or services received in exchange for your work, which must be reported at its fair market value.

Statutory Exclusions from Self Employment Earnings

The tax code provides several specific statutory exclusions for income not subject to self-employment tax. One exclusion is for rentals from real estate, which applies to individuals holding property for investment. However, if an individual is a real estate dealer, the rental income is subject to the tax. A real estate dealer is someone engaged in the business of selling real estate to customers for profit.

An exception to the real estate exclusion occurs if an owner provides substantial services for occupants, such as regular cleaning, maid service, or other hotel-like amenities. Simply providing utilities and trash collection does not elevate rental income to self-employment income.

The code also excludes dividends from stocks and interest from bonds or other debt instruments. This passive investment income is not subject to the tax unless the individual is a dealer in stocks or securities.

Gains and losses from the sale or exchange of capital assets, such as investment property or stocks, are also excluded from self-employment earnings for most individuals.

Special Rules and Optional Methods

Partners

A general partner’s share of the partnership’s business income is included in their net earnings from self-employment, even if not distributed. In contrast, a limited partner’s share is generally excluded. However, any guaranteed payments a limited partner receives for services provided to the partnership are considered self-employment income.

LLC Members

For members of a Limited Liability Company (LLC), the tax treatment depends on how the LLC is taxed. A single-member LLC is treated as a sole proprietorship, and the member’s net profit is subject to self-employment tax. If the LLC is taxed as a partnership, the members’ treatment follows partnership rules. Actively participating members are generally treated like general partners, while passive members may be treated as limited partners.

Corporate Directors

Fees paid to individuals for serving on a corporation’s board of directors are considered self-employment income. This applies even if the director is also an employee of the corporation, and the fees are subject to self-employment tax.

Farmers

The tax code provides an optional method for farmers to calculate their net earnings from self-employment. This method allows a farmer to report a portion of their gross farm income as net earnings, which can be beneficial in years with low income or a loss. Using this method may allow a farmer to receive credit for Social Security coverage they might not otherwise qualify for.

Religious Exemptions

An exemption from self-employment tax is available for members of recognized religious sects who are conscientiously opposed to accepting insurance benefits like Social Security and Medicare. To claim this exemption, an individual must file Form 4029, Application for Exemption From Social Security and Medicare Taxes and Waiver of Benefits. If the IRS approves the form, the individual’s self-employment earnings are not subject to the tax.

Calculating Your Net Earnings for Tax Reporting

The calculation process begins with the net profit figure from your business, which is calculated on Schedule C (Form 1040), Profit or Loss from Business. To determine the amount subject to tax, you must multiply this net profit by 92.35%. This adjustment accounts for the fact that employees do not pay FICA taxes on the portion of their wages that their employer pays for Social Security and Medicare taxes. In essence, this multiplication gives self-employed individuals a similar deduction.

The result is your “net earnings from self-employment.” This figure is carried over to Schedule SE (Form 1040), Self-Employment Tax, where your tax liability is computed.

The self-employment tax consists of a 12.4% Social Security tax up to an annual income limit and a 2.9% Medicare tax on all net earnings.

You must file Schedule SE and pay self-employment tax if your net earnings from self-employment are $400 or more. This threshold applies to the earnings after the 92.35% calculation.