Self-employed income is earned income that only applies to entities taxed as a partnership or sole proprietorship (i.e., entities not taxed as corporations). Additional calculations and adjustments are required for plans that have owner-employees who receive earned income when determining an owner’s or partner’s compensation for plan purposes.
The IRS requires owners earning self-employed income to take a few deductions from self-employment earnings to determine the owner’s compensation for purposes of a 401(k) plan and to conduct nondiscrimination testing. Guideline calculates these deductions and adjustments. Note that IRS 401(k) nondiscrimination testing deadlines do not always align with tax reporting deadlines.
What to report to Guideline
For a self-employed sole proprietor or a partner in an entity taxed as a partnership, compensation is equal to earned income from your company. For a sole proprietor, this amount will be reported on Schedule C of your Form 1040 (net profit or loss). If you are a partner in a partnership, this amount will be reported on Line 14a of the Schedule K-1 (Form 1065 ) of your Form 1040 (self-employment earnings or losses). Guideline must receive the actual amounts you include on tax filings and cannot use estimated amounts as this will be used to determine the compensation used in nondiscrimination and limit testing.
Please note that if you are a C-corp or S-corp owner, please report only your W-2 compensation, as only those wages would be considered compensation for purposes of the 401(k) plan (any K-1 income for an S-Corp owner reported on Form 1120-S cannot be included as 401(k) compensation).
If you have compensation over the annual compensation cap, this limit would be applied after we determine adjusted earned income. It is important that you report your full compensation even if you believe it will be over the compensation cap as this limit is applied after all of the adjustments have been made.
If you have questions about your individual circumstances, you should always consult your tax advisor. To learn more about compensation in your 401(k) plan, please refer to your Summary Plan Description (SPD), located in your Guideline dashboard in Resource Library under the Your Plan Information folder.
Deadlines
Compliance refund deadlines are March 15 for automatic contribution arrangement (ACA) plans and June 30 for eligible automatic contribution arrangement (EACA) and qualified automatic contribution arrangement (QACA) plans, regardless of your company’s tax filing deadline.
If any required refunds are not removed from the plan by the deadline, a 10% penalty tax may be due. Note that Guideline will not run ADP and ACP tests (if applicable to your plan) if you have not provided and confirmed your compensation.
How we adjust earned income
Calculating compensation for owners who have earned income is one of the more complex calculations required when administering a 401(k) plan. The IRS explains this same adjustment on their website in a different way (but the results are the same).
Owners who do not receive employer contributions
For an owner who does not receive any employer contributions (i.e., a plan with a matching contribution where the owner did not make a salary deferral), the steps to calculate compensation are as follows:
If ownership is shared, the applicable profits of the company will be divided accordingly (e.g., if you own 50% of the company, you earn 50% of the profits). This step should already be completed for each K-1. Skip this step if the company is owned 100% by one owner.
The profits/gross earned income are reduced by the employer contributions made to participants (match, nonelective, profit sharing, and/or top-heavy minimum contributions). If the plan is owned by a partnership, the employer contributions are adjusted for each owner’s share of expenses (share of expenses is usually the same as ownership percentage and is reflected on the "capital" line in Section J of the K-1). In the example below, ownership profits and expenses are all shared at 30%.
Profits/gross income are further reduced by ½ of the self-employment tax. To calculate the self-employment tax, see schedule SE and other IRS resources.
The result is the owner’s compensation, as defined in the plan, that will be used for compliance testing (e.g., ADP/ACP testing).
Example: Fred is a 30% owner who is responsible for 30% of the company’s costs. The partnership’s net income is $450,000, and the partnership contributes $50,000 in employer contributions to the plan participants. The plan has a matching contribution and Fred did not defer into the plan.
Step 1:
| Partnership income = $450,000
Fred’s portion of income = 30% ( X 0.30)
Net income (Step 1) = $450,000 X 0.30 = $135,000 (this should be the amount reported on the K-1)
|
Step 2:
| Less Fred’s share of employer contributions to employees
(30% of $50,000) = $15,000
Net Income (Step 2) = $135,000 - $15,000 = $120,000
|
Step 3: | Less ½ of self employment tax of $8,477.73
Net Income (Step 3) = $120,000 - $8,477.73 = $111,522.27
|
Step 4: | Final Net Income for plan purposes = $111,522.27 |
Owners who receive employer contributions
For an owner who receives employer contributions, calculating compensation has one additional step (marked as “NEW” below) that makes this calculation more complicated. If the contribution made to the owner depends on compensation (e.g., a comp-to-comp or pro rata contribution that is a percentage of compensation), the compensation used to calculate the percentage (determined at Step 5) must be reduced by the contribution (Step 4 below), making the calculation circular.
Here are the steps:
If ownership is shared, the applicable profits will be divided accordingly (e.g. if you own 50% of the company, you earn 50% of the profits). Skip this step if the company is owned 100% by one owner.
The profits/gross earned income are reduced by the employer contributions made to Participants (match, nonelective, profit sharing, and/or top heavy minimum contributions). If the plan is owned by a partnership, the employer contributions are adjusted for each owner’s share of expenses (reflected on the "capital" line in Section J).
Profits/gross income are further reduced by ½ of the self-employment tax. To calculate the self-employment tax, see schedule SE and other IRS resources.
NEW: Reduce by the employer contribution made for the owner (e.g. 3% of compensation determined at Step 5).
The result is the owner’s compensation, as defined in the plan, that can be used to calculate contributions (e.g. multiply by 3% to determine the contribution at Step 4) and for compliance testing (e.g. ADP/ACP testing).
Example: Sue runs a sole proprietorship with $200,000 in net profits. She contributes $5,000 in employer contributions to the plan for the year and the plan has a 3% safe harbor nonelective contribution.
Step 1:
| Gross profits = $200,000
Sue is 100% owner so is assigned 100% of gross profits
Net income (Step 1) = $200,000 X 1.0 = $200,000
|
Step 2:
| Less Sue’s share of employer contributions to employees
(100% of $5,000) = $5,000
Net Income (Step 2) = $200,000 - $5,000 = $195,000
|
Step 3: | Less ½ of self employment tax of $13.064.40
Net Income (Step 3) = $195,000 - $13.064.40 = $181,935.60
|
Step 4: | Less Sue’s nonelective contribution of $5,299.10
Net Income (Step 4) = $181,935.60 - $5,299.10 = $176,636.51
|
Step 5: | Final Net Income for plan purposes = $176,636.51 |
Sue’s nonelective contribution is equal to 3% of her Compensation (0.03 x 176,636.51 = $5,299.10). The contribution can be determined algebraically and the IRS also provides a rate table to help calculate the contribution. If Sue has a matching contribution, the calculation becomes even more complex and the compensation is generally determined through an iterative process of estimated guesses.
Owners who also have W-2 income
If an owner earned both self-employment income and W-2 wages, Guideline will need each amount in order to accurately complete compliance testing and contribution calculations. Examples of when owners may earn both wage types:
The entity type changed, resulting in the owner’s wage type changing effective mid-year;
A W-2 employee becomes a partner during the year;
A partner relinquished ownership and became a W-2 employee during the year; or
An owner earned a W-2 from an unrelated employer, which should be collected as it will affect the self-employment taxes in the earned income calculation for the plan (but generally will not otherwise affect the calculation of the contribution)
To ensure accurate administration of your plan, please report this information to Guideline by preparing an email to clients@guideline.com reflecting "Reporting W2 and SEI compensation" in the subject line with the following in the body of the email:
Account ID for account verification
Entity type of the company sponsoring the Guideline plan
For LLCs, please include how the LLC will be taxed
If there were entity type changes or changes to how the entity was taxed effective mid-year, please list:
The time period for each entity type/how it was taxed, and
Which entity type will the employer contributions be deducted, or how much of a deduction each entity type will take
List your self-employment income
From Schedule C (Form 1040), line 31, or
From Schedule K-1 (Form 1065) Part III, line 14(a); note that K-1 (Form 1120-S) is not self-employment income and should not be reported
List the W-2 income paid from an unrelated employer (if applicable)
If W-2 income paid by the employer, list amount with reason:
Entity type changing mid-year and/or
W2 employee become a partner or partner relinquished partnership mid-year
Losses or high-earned income
Guideline needs accurate earned income numbers in order to properly calculate contribution limits and complete nondiscrimination testing, even if an owner has a loss or high income (above the IRS 401(k) income limit).
Since the annual additions limit (Code section 415) caps overall contributions to the plan to the lesser of 1) 100% of compensation or 2) $69,000 in 2024, if an owner has a loss, any owner’s draws made during the year will need to be refunded as an excess contribution. The owner will not be eligible for a contribution, as 100% of their compensation for plan purposes will be $0.
If an owner has high compensation over the annual compensation limit that can be used for the plan ($345,000 in 2024), please report the gross profits or earned income even if above this limit so Guideline can properly calculate compensation and plan contributions.
If you report compensation equal to the compensation cap when it is actually above that limit, the compensation we use for compliance testing and employer contributions will actually be below the limit and our calculations will not be accurate (as the amount reported would be further reduced by self employment deductions and the employer contributions made for W-2 employees as described above).