You should use method 1. Since the income is being reported to you and the IRS on a form W2, the payer is treating you as an employee and withholding social security and medicare. You should enter the form W2 as normal to report the wages in line 1 of your form 1040 per question 11 in this IRS FAQ.
You would then follow the steps outlined by @ColeenD3 to enter the W-2 Box 1 amount as a Negative (-) number and enter this description: IRS Notice 2014-7 excludable income in the "Miscellaneous Income" topic.
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