Definition of net earnings: Net earnings must be from self-employment where your personal services are a material income-producing factor. "Net earnings" equals your business gross income, minus allowable deductions from that business (including contributions to the plan for your employees), reduced by the tax deduction for your self-employment tax. Net earnings are also reduced by the deduction for contributions you make for yourself. This adjustment is made indirectly by reducing the contribution rate called for in the plan when you figure the maximum contribution for yourself. Thus, for example, the 15% contribution becomes a contribution of 13.0435% of net earnings before the contribution, and the 25% rate becomes 20%.

For more information see Publication 560 Retirement Plans for Small Business (SEP, Keogh, and SIMPLE Plans).

Only a sole proprietor or a partnership (but not a partner) can set up a Keogh plan. For plan purposes, a self-employed person is both an employer and an employee. It is not necessary to have employees besides yourself to set up a Keogh plan. The plan must be for the exclusive benefit of employees or their beneficiaries. You generally can deduct contributions to the plan. Contributions are not taxed to your employees until plan benefits are distributed to them.

<Picture: TaxTip: >

See the glossary near the end of Publication 560 for the definition of

employer, employee, and common-law employee.

Deduction Limits

The limit on your deduction for your contributions to a Keogh plan depends on the kind of plan you have.

Defined contribution plans. The deduction limit for a defined contribution plan depends on whether it is a profit-sharing plan or a money purchase pension plan.

Profit-sharing plan. Your deduction for contributions to a profit-sharing plan cannot be more than 15% of the compensation from the business paid (or accrued) during the year to the common-law employees participating in the plan. You must reduce this 15% limit in figuring the deduction for contributions you make for your own account. See Deduction of contributions for yourself, later.

Money purchase pension plan. Your deduction for contributions to a money purchase pension plan is generally limited to 25% of the compensation from the business paid during the year to a participating common-law employee. You must reduce this 25% limit in figuring the deduction for contributions you make for yourself, as discussed later.

Defined benefit plans. The deduction for contributions to a defined benefit plan is based on actuarial assumptions and computations. Consequently, an actuary must figure your deduction limit.

<Picture: Caution: >

In figuring the deduction for contributions, you cannot take into account any contributions or benefits that exceed the limits discussed under Limits on Contributions and Benefits in Publication 560.

The deduction limit for contributions to a defined benefit plan may be greater than the defined contribution plan limits just described, but actuarial calculations are needed to determine the amount. For more information about these plans, see Kinds of Plans in Publication 560.

Deduction of contributions for yourself. To take a deduction for contributions you make for yourself to a plan, you must have net earnings from the trade or business for which the plan was established.

Limit on deduction. If the Keogh plan is a profit-sharing plan, your deduction for yourself is limited to the smaller of $30,000 or 13.0435% (15% reduced as discussed below) of your net earnings from the trade or business that has the plan. If the plan is a money purchase pension plan, the deduction is limited to the smaller of $30,000 or 20% (25% reduced as discussed below) of your net earnings.

Net earnings. Your net earnings must be from self-employment in a trade or business in which your personal services are a material income-producing factor. If you are a partner who only contributed capital, and who did not perform personal services, you cannot participate in the partnership's plan. Your net earnings do not take into account tax-exempt income (or deductions related to that income) other than foreign earned income and foreign housing cost amounts.

Your net earnings are your business gross income minus allowable deductions from that business. Allowable deductions include contributions to the plan for your common-law employees along with your other business expenses.

If you are a partner other than a limited partner, your net earnings include your distributive share of the partnership income or loss (other than separately computed items such as capital gains and losses) and any guaranteed payments you receive from the partnership. If you are a limited partner, your net earnings include only guaranteed payments you receive for services rendered to or for the partnership. For more information, see Partners under Who Must Pay Self-Employment Tax in Publication 533.

Net earnings do not include income passed through to shareholders of S corporations.

Adjustments. You must reduce your net earnings by the income tax deduction for one-half of your self-employment tax. Also, net earnings must be reduced by the deduction for contributions you make for yourself. This reduction is made indirectly, as explained next.

Net earnings reduced by adjusting contribution rate. You must reduce net earnings by your deduction for contributions for yourself. The deduction and the net earnings depend on each other. You can make the adjustment to your net earnings indirectly by reducing the contribution rate called for in the plan and using the reduced rate to figure your maximum deduction for contributions for yourself.

Annual compensation limit. You generally cannot take into account more than $160,000 of your compensation in figuring your contribution to a defined contribution plan.

<Picture: TaxTip: >

For employees in a collective bargaining unit covered by a plan for which the $160,000 limit does not apply for the plan year beginning in 1997, the compensation limit is $250,000.

Figuring your deduction. Use the Rate Worksheet for Self-Employed illustrated in the following example to find the reduced contribution rate for yourself. Make no reduction to the contribution rate for any common-law employees.

After you have your self-employed rate, you can figure your maximum deduction for contributions for yourself by using the Deduction Worksheet for Self-Employed also illustrated in the example:

Example. You are a sole proprietor and have employees. The terms of your plan provide that you contribute 10 1/2% (.105) of your compensation, and 10 1/2% of your common-law employees' compensation. Your net earnings from line 31, Schedule C (Form 1040) are $200,000. In figuring this amount, you deducted your common-law employees' pay of $100,000 and contributions for them of $10,500 (10 1/2% x $100,000). You figure your self-employed rate and maximum deduction for employer contributions for your benefit as follows:

Rate Worksheet for Self-Employed1)Plan contribution rate as a decimal (for example, 10 1/2% would be 0.105)     0.1052)Rate in line 1 plus one, (for example, 0.105 plus one would be 1.105)     1.1053)Self-employed rate as a decimal (divide line 1 by line 2)    0.0950Deduction Worksheet for Self-EmployedStep 1 Enter the contribution rate shown in line 3 above    0.0950Step 2 Enter your net earnings (net profit) from: line 31, Schedule C (Form 1040); line 3, Schedule C-EZ (Form 1040); line 36, Schedule F (Form 1040); or line 15a, Schedule K-1 (Form 1065).  $200,000Step 3 Enter your deduction for self-employment tax from line 26, Form 1040    $6,733Step 4 Subtract step 3 from step 2 and enter the result  $193,267Step 5 Multiply step 4 by step 1 and enter the result   $18,360Step 6 Multiply $160,000 by your plan contribution rate. Enter the result but not more than $30,000   $16,800Step 7 Enter the smaller of step 5 or step 6. This is your maximum deductible contribution. Enter your deduction on line 28, Form 1040.   $16,800

When to make contributions. To take a deduction for contributions for a particular year, you must make the contributions not later than the due date (plus extensions) of your tax return for that year.

More information. See Publication 560 for more information about retirement plans for small business owners, including the self-employed. It also discusses the reporting forms that must be filed for these plans.