New York Advisory Opinion TSB-A-87 (10)I: For purposes of the section 603-A maximum tax on personal service income, is a shareholder-employee's personal service income from an S corporation limited to the amount the corporation designated as salary on his W-2?

Plain-English summary

Zalman C. Bernstein was chief executive officer, chairman, and chief financial officer of Sanford C. Bernstein & Co., Inc. ("SCB"), an S corporation and registered stockbroker/investment advisor whose income came almost entirely from the personal services of its key employees (fees and commissions) rather than from trading profits or capital. For 1984 and 1985, Bernstein's compensation was reported partly on a W-2 (as SCB-designated salary) and partly on a K-1 (his pro rata share of SCB's income, whether or not distributed).

For those years, Tax Law § 603-A capped the tax rate on "New York personal service income" - defined as wages, salaries, professional fees, and similar compensation, but specifically excluding any part of a corporate distribution that represents earnings or profits rather than a reasonable allowance for services actually rendered. When computing his personal service income for the maximum tax, Bernstein included his W-2 wages plus his K-1 ordinary income (minus amounts he characterized as "net investment income"), excluding only dividends and capital gains reported on the K-1. On audit, the Department's Audit Division instead limited his personal service income to just the W-2 amount.

The Department's advisory opinion did not simply bless the Audit Division's approach - it explained the legal framework and left the ultimate factual question open. Under 20 NYCRR 100.4(c)(2)(iii), an individual's personal service income from a corporation (including an S corporation) generally is only the portion that represents "a reasonable allowance for salaries and other compensation for personal services actually rendered" - the regulations specify no fixed test for this and do not restrict personal service income to W-2 amounts alone. What counts as a "reasonable allowance" is a case-by-case factual question, looking at factors like the nature and scope of the taxpayer's work, his qualifications, the size and complexity of the business, comparisons to other employees' and shareholders' compensation, and prevailing rates for comparable positions - a non-exhaustive list. Critically, the burden of proving that K-1 income (beyond the W-2 amount) represents a reasonable allowance for services falls on the taxpayer, citing Matter of Coppola. Because that determination turns on facts the Department cannot adjudicate in an advisory opinion, it held only that the Audit Division was justified in using the W-2 figure as a starting point if that figure is itself a reasonable allowance - and that Bernstein could still prove additional K-1 income should count, but only through the audit process.

What this means for you

Shareholder-employees of S corporations paid partly by W-2, partly by K-1

Don't assume your "personal service income" for a maximum-tax-style calculation is fixed to whatever your corporation happened to designate as W-2 salary. The Department has said the regulations impose no such limit - what matters is whether the compensation, in whatever form, represents a reasonable allowance for the services you actually performed. But be aware the burden is on you to prove that additional K-1 income should be treated as personal service income, not investment or capital returns.

Owner-operators of service-heavy S corporations (investment advisors, brokers, professional firms)

If your company generates income primarily through your and other key employees' personal services rather than capital, that fact supports treating a larger share of your K-1 income as personal service income - but you still need to substantiate it with the kind of factors the Department listed: your role's scope, your qualifications, comparisons to other employees' and shareholders' pay, and industry-comparable compensation.

Accountants and tax preparers handling a NY audit dispute over W-2 vs. K-1 characterization

Recognize that this is squarely a factual dispute to be built in the audit record, not resolved by seeking another advisory opinion. Marshal comparables and documentation on reasonable compensation up front, since the Department will not pre-decide the reasonable-allowance question in the abstract - and remember the burden of proof sits with the taxpayer, not the Audit Division.

Common questions

Q: Is my S-corp personal service income for the maximum tax automatically limited to my W-2 salary?
A: No. The Department confirmed the regulations "contain no provisions restricting 'New York personal service income' to amounts reported on W-2 forms." The W-2 amount is only a valid figure if it itself represents a reasonable allowance for your services; you may be able to show additional K-1 income should also count.

Q: Who has to prove that my K-1 income represents a reasonable allowance for services, not just a profit distribution?
A: You do. The Department cited Matter of Coppola for the rule that the taxpayer bears the burden of proving that income received from the corporation represents a reasonable allowance for personal services actually rendered.

Q: How is "reasonable allowance for compensation" determined?
A: It's a case-by-case factual question. Relevant (non-exhaustive) factors include the nature, extent, and scope of your work; your qualifications; the size and complexity of the business; comparisons of your pay to other employees' and other shareholders' pay; and prevailing compensation rates for comparable positions at comparable companies.

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_1987.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a87_10i.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-87 (10) I
Income Tax
December 15, 1987

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. I870901C

On September 1, 1987, a Petition for Advisory Opinion was received from Zalman C. and
Elaine K. Bernstein, c/o Seidman & Seidman, 15 Columbus Circle, New York, New York 10023.
The issue raised is whether Petitioners' personal service income for purposes of computing
their maximum tax pursuant to section 603-A of the Tax Law is limited to the amount paid to
Petitioner Zalman Bernstein and designated by his employer as salary.
While the Petition for Advisory Opinion was received from Zalman C. and Elaine K.
Bernstein, the income here at issue is that of Petitioner Zalman C. Bernstein.
For taxable years 1984 and 1985, Petitioner Zalman C. Bernstein was the chief executive
officer, chairman of the board of directors and chief financial officer of Sanford C. Bernstein & Co.,
Inc. (hereinafter "SCB"). SCB is an "S" corporation for federal and New York State tax purposes and
a registered stockbroker/investment advisor.
Petitioner states that SCB generates substantially all of its income through the personal
services of its key employees, rather than through the employment of capital and that SCB derives
nearly all of its income from fees and commissions, rather than trading profits.
Petitioner states that he serves as SCB's chief financial officer. In this capacity, he approves
all significant SCB expenditures. His other responsibilities include: (1) serving on SCB's Investment
Policy Committee; (2) developing and implementing SCB's investment banking activities; (3)
maintaining and developing existing business and attracting new business to SCB; and (4) approving
all professional personnel decisions. Additionally, Petitioner directs SCB's Institutional Management
and Investment Management activities, and also is responsible for formulating SCB's strategic plan
for the future.
For taxable years 1984 and 1985, Petitioner received compensation from SCB, which
amounts were reported on W-2 forms furnished to him by SCB. Petitioner also reported as income
for taxable years 1984 and 1985 his share of the income of SCB, whether or not distributed, which
was reported on K-1 forms furnished to him by SCB.
In computing his personal service income for purposes of the maximum tax under section
603-A of the Tax Law for taxable years 1984 and 1985, Petitioner included as personal service
income the amounts reported on his W-2 forms plus the amounts of ordinary income reported on his
K-1 forms less amounts characterized as "net investment income." Amounts reported on such K-1

RODERICK G. W. CHU, COMMISSIONER
TP-8 (3/83)

GABRIEL B. DiCERBO, DEPUTY COMMISSIONER
FRANK J. PUCCIA, DIRECTOR

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TSB-A-87 (10) I
Income Tax
December 15, 1987

forms as "dividends", "long term capital gain" and "short term capital gain" were not included as
personal service income by Petitioner. Petitioner does not describe in his Petition how the "net
investment income" figures were determined.
Upon audit of Petitioner, Petitioner's personal service income for purposes of section 603-A
was limited by the Audit Division to the amounts reported on Petitioner's W-2 forms.
Section 603-A of the Tax Law provided for a maximum tax rate on New York personal
service income for taxable years 1984 and 1985. Section 603-A(b)(1) defines "New York personal
service income", in part, as:
wages, salaries, or professional fees, and other amounts received as
compensation for personal services actually rendered, but does not
include that part of the compensation derived by the taxpayer for
personal services rendered by him to a corporation which represents
a distribution of earnings or profits rather than a reasonable allowance
as compensation for the personal services actually rendered.
For the taxable years at issue, the personal income tax regulations of the State Tax
Commission provided that "[i]f an individual performs personal services for a corporation (including
an electing small business corporation), personal service income generally is only the portion of
income received from the corporation that represents a reasonable allowance for salaries and other
compensation for personal services actually rendered. "20 NYCRR 100.4(c)(2)(iii). (Emphasis
supplied).
The regulations of the State Tax Commission specify no test to determine the portion of
income received from a corporation that represents a reasonable allowance for salaries and other
compensation for personal services actually rendered. Nor do the regulations contain any provisions
restricting "New York personal service income" to amounts reported on W-2 forms.
The determination of what represents a reasonable allowance for salaries and other
compensation for personal services actually rendered is a factual question which must be answered
on a case by case basis based upon a careful review of the relevant facts and circumstances of each
case. Factors which may be taken into account in arriving at a reasonable allowance include: the
nature, extent and scope of Petitioner's work, Petitioner's qualifications, the size and complexities
of the trade or business, a comparison of Petitioner's compensation to the compensation of other
employees, a comparison of Petitioner's income from the corporation to the income of other
shareholders of the corporation and the prevailing rates of compensation for comparable positions
in comparable companies. However, the above list is not intended to be an exhaustive list.
The burden of proving that income received from SCB by Petitioner represents a reasonable
allowance for compensation for personal services actually rendered falls upon Petitioner. Antonio
and Frances Coppola, Joseph and Marie Coppola, Decision of the State Tax Commission, February

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TSB-A-87 (10) I
Income Tax
December 15, 1987

18, 1986, TSB-H-86(44)I; Migliore v. Commissioner, 36 TCM 1004 (1977) (applying the provisions
of Internal Revenue Code section 1348); Paula Construction, Co. v. Commissioner, 58 T.C. 1055
(1972).
Accordingly, the Audit Division is justified in limiting Petitioner's personal service income
to the amount designated by SCB as salary if such amount represents a reasonable allowance for
personal services actually rendered. Petitioner bears the burden of proving that any amount of
income included on his K-1 forms is also personal service income. Inasmuch as any such proof will
entail a question of fact, such proof must be presented in the context of the audit performed by the
Audit Division since questions of fact cannot be resolved in an advisory opinion.

DATED: December 15, 1987

s/FRANK J. PUCCIA
Director
Technical Services Bureau

NOTE: The opinions expressed in Advisory Opinions
are limited to the facts set forth therein.