Basically, if you are an employee, your compensation is your wages, but your wages are subject to an additional withholding of 7.65% for social security and medicare tax paid by the employer. Effectively, for every $100 of gross wages, your income really was $107.65, with the employer paying $7.65 of social security and medicare tax before you pay your own social security and medicare tax plus federal and state tax via withholding.
For that reason and to make things equitable between employees and self-employed, a self-employed person's "compensation" for IRA purposes is the net profit minus the "employer half" of social security and medicare (which in case of a self-employed person is half their self-employment tax). That's the basis of the calculation, although it works out to a little less than 7.65% because of how the formula is applied.
