Douglas Condon (Trager, Glass & Co., CPAs) asked how New York's now-repealed 1987-1988 tax on unearned income applies to a resident individual's income from an S corporation that made the New York S election, and from rental real property, across five ownership/participation/salary scenarios.

Plain-English summary

Douglas Condon, a CPA with Trager, Glass & Co., asked the Department how New York's tax on unearned income - a short-lived surtax under Tax Law § 601(d) that applied only to tax years beginning after 1986 and before 1989, i.e., essentially the 1987 and 1988 tax years - applied to a resident individual's income from an S corporation and from rental real property. The surtax hit "New York unearned income" of a resident with New York adjusted gross income over $100,000 (or $50,000 if married filing separately). Condon posed five examples: (1) a sole S-corp owner who actively participates and takes no salary, only distributions; (2) the same, but with under 50% ownership; (3) the same as (1), but the taxpayer does not materially participate; (4) the same as (1), but the taxpayer does receive a salary; and (5) a taxpayer who owns rental real property, actively participates, and had $10,000 of net profit in 1987. For Examples 1 through 4, the facts assumed the S corporation had made the New York S election under Tax Law § 660.

Section 601(d)(6) lists several categories of income that get subtracted from New York adjusted gross income in arriving at "unearned income" - meaning these categories are treated as earned and excluded from the surtax base. The key category here is "earned income" as defined in IRC § 911(d)(2): wages, salaries, professional fees, and other compensation for personal services actually rendered, but NOT the part of a corporate distribution that's really a share of earnings and profits rather than a genuine pay-for-services allowance. Notably, New York's version of this test drops the federal 30%-of-net-profits cap that otherwise limits the reasonable-allowance portion for combined services/capital businesses.

Because this federal earned-income concept closely tracks the old, already-repealed Tax Law § 603-A "New York personal service income" definition, the Department applied § 603-A precedent by analogy. Under former regulations, income from an S corporation is personal service income only to the extent it represents a reasonable allowance for services actually rendered - and the same reasonable-allowance principle applies to income from an unincorporated trade or business. Tax Law § 617(b) reinforces this: an S corporation's income keeps the same character for a shareholder as it would have had if the shareholder had realized it directly from the S corporation's own source, so earned income can never include something that would have been unearned if received directly.

The Department's conclusion across all five examples was the same: New York unearned income includes the S-corp and rental income that flows into New York adjusted gross income, reduced by whatever portion is a reasonable allowance for personal services actually rendered - and that reasonable allowance is not restricted to amounts reported as W-2 salary. But figuring out exactly what portion of any taxpayer's distributions or rental profit qualifies as a reasonable allowance is a factual question, decided case by case using factors like the nature and scope of the taxpayer's work, qualifications, business size and complexity, and comparable compensation - and the taxpayer bears the burden of proving it. Because that determination is inherently factual, the Department could not resolve it for any of the five examples within the advisory opinion itself. The opinion did resolve one purely legal point, though: earned income for this surtax is not determined by reference to the federal passive activity rules of IRC § 469, so whether a taxpayer materially participates does not itself control the analysis. A companion advisory opinion issued a few weeks earlier to the same petitioner and accounting firm, TSB-A-88(12)I, addressed a related but factually distinct scenario - a New York resident's interest in a federal S corporation operating in another state that had not made the New York S election.

What this means for you

High-income S-corp owner-operators (historically, for 1987-1988 returns)

If you were a New York resident S-corp owner during the 1987 or 1988 tax years with New York AGI above $100,000, taking no salary and only distributions did not automatically make all of your pass-through S-corp income "unearned" for purposes of this surtax. The Department would have looked at what a reasonable allowance for your actual services would have been, regardless of what (if anything) was reported as W-2 wages, and only the excess above that reasonable allowance counted as unearned. Ownership percentage (Example 2) and whether you took an actual salary (Example 4) didn't change this basic framework, though they could affect the facts used to determine the reasonable allowance.

Accountants and preparers reconstructing old-law positions

This surtax has been repealed for decades, but the reasoning here is a useful template any time you need to sort S-corp or partnership pass-through income (or unincorporated-business income, like rental real estate) into "earned" versus "unearned" or "passive" versus "active" buckets under some other still-live New York or federal provision that turns on a similar distinction. The core test - a facts-and-circumstances reasonable allowance for services actually rendered, uncapped by any percentage ceiling under the New York version, and not limited to salary reported on a W-2 - traces back through this opinion to the Bernstein opinion and the old § 603-A personal-service-income regulations.

The general lesson about factual burdens in reasonable-allowance disputes

Any time a characterization question turns on "what's a reasonable allowance for services," expect the Department (or IRS) to decline to give you a bright-line answer in an advisory opinion, and expect the burden of proof to sit with the taxpayer. Documentation - comparable compensation studies, records of hours and duties actually performed, and comparisons to what other employees or shareholders were paid - matters far more than the label attached to a payment.

Common questions

Q: If I take no salary from my own S corporation, does that mean all of my distributions count as unearned income?
A: No. Even where a sole S-corp owner takes no formal salary and only distributions (Example 1), the Department held that a portion of those distributions can still be "earned income" if it represents a reasonable allowance for the personal services the owner actually performed. The absence of a W-2 salary doesn't convert 100% of the distributions into unearned income - but it also doesn't establish what the reasonable allowance actually is; that's a factual determination the taxpayer must support.

Q: Does materially participating (or not) under the passive-loss rules affect this earned/unearned analysis?
A: No. The opinion states directly that for purposes of the tax on unearned income, earned income is not determined by reference to the federal passive activity rules under IRC § 469. Example 3 (a non-materially-participating S-corp owner) is analyzed under the same reasonable-allowance-for-services test as Example 1 (an actively participating owner) - material participation under the separate passive-loss framework doesn't by itself make the income earned or unearned here.

Q: Does owning less than 50% of the S corporation change the analysis?
A: No, not as a matter of law. Example 2 posed the same facts as Example 1 except for a sub-50% ownership stake, and the Department applied the identical reasonable-allowance framework. Ownership percentage might be one fact relevant to determining what a reasonable services allowance should be (for instance, in comparing the taxpayer's compensation to other shareholders'), but it doesn't create a different legal rule.

Q: How is rental real estate income treated differently from S-corp income under this test?
A: It isn't treated differently in kind - Example 5's rental income is analyzed the same way as the S-corp examples, because former 20 NYCRR 100.4(c)(1)(v) applied the reasonable-allowance-for-services test to unincorporated trades or businesses generally, not just to S corporations. The Department reached the same conclusion: the $10,000 net profit is unearned income except to the extent it represents a reasonable allowance for the taxpayer's personal services in actively participating in the rental activity, capped at the business's net profits.

Q: Why couldn't the Department just tell Condon exactly how much of each example's income was earned versus unearned?
A: Because "reasonable allowance for personal services actually rendered" is inherently a facts-and-circumstances test - it depends on the nature and scope of the work, the taxpayer's qualifications, the size and complexity of the business, and comparisons to what others in similar roles are paid. An advisory opinion resolves legal questions on stated facts; it can't adjudicate an open factual dispute, and the burden of proving the reasonable-allowance amount falls on the taxpayer, not the Department.

Citations and references

• Tax Law § 601(d)(1) - imposed the tax on unearned income, for tax years beginning after 1986 and before 1989, on a resident individual with New York AGI over $100,000 ($50,000 if married filing separately)
• Tax Law § 601(d)(4) - defines "New York unearned income" as New York adjusted gross income with certain adjustments
• Tax Law § 601(d)(6)(A)-(F) - lists the amounts subtracted from New York AGI to arrive at unearned income, including IRC § 911(d)(2) earned income (without the 30%-of-net-profits cap), IRC § 401(c)(2)(C) earned income, capital gain net income, and alimony/separate maintenance income
• IRC § 911(d)(2)(A) - defines "earned income" as compensation for personal services actually rendered, excluding the part of a corporate distribution that's really a share of earnings and profits
• IRC § 911(d)(2)(B) - for a taxpayer whose trade or business involves both material personal services and material capital, a reasonable services allowance up to 30% of net profits counts as earned income (federal cap not imported into the New York test)
• IRC § 401(c)(2)(C) - certain pension, annuity, IRA, and deferred-compensation amounts treated as earned income
• former Tax Law § 603-A (repealed 1987) - prior "New York personal service income" maximum-tax provision with a substantially similar earned-income definition, applied here as precedent
• former 20 NYCRR 100.4(c)(1)(iii) - personal service income from a corporation (including an S corporation) is limited to a reasonable allowance for services actually rendered
• former 20 NYCRR 100.4(c)(1)(v) - personal service income from an unincorporated trade or business with both services and capital as material factors is limited to a reasonable allowance, capped at net profits
• Tax Law § 617(b) - an S corporation's income items keep the same character for a shareholder as they would if realized directly from the S corporation's source
• Zalman C. and Elaine K. Bernstein, TSB-A-87(10)I - lists non-exhaustive factors for determining a reasonable compensation allowance (nature/scope of work, qualifications, business size/complexity, comparable compensation, prevailing rates)
• Antonio and Frances Coppola, Joseph and Marie Coppola, TSB-H-86(44)I; Migliore v. Commissioner, 36 TCM 1004 (1977); Paula Construction Co. v. Commissioner, 58 T.C. 1055 (1972) - the taxpayer bears the burden of proving a claimed reasonable-allowance amount
• IRC § 469 - federal passive activity loss rules, held not controlling for characterizing earned versus unearned income under this New York provision

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_1988.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a88_14i.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-88 (14) I
Income Tax
September 16, 1988

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. I880504A

On May 4, 1988, a Petition for Advisory Opinion was received from Douglas Condon of
Trager, Glass & Co., CPA's, 1790 Broadway, New York, New York 10019.
The issue raised is how the tax on unearned income, under Article 22 of the Tax Law, is
applied to an individual whose income is derived from an S corporation and from rental real
property.
The facts are presented as examples:
Example 1: A taxpayer is the sole owner of an S corporation in which the taxpayer actively
participates. The taxpayer draws no salary but takes distributions from the S corporation earnings.
How are the S corporation profits, which pass through to the shareholder (taxpayer), treated for
purposes of the tax on unearned income?
Example 2: The same facts as in Example 1 except that the taxpayer's ownership interest is
less than 50 percent.
Example 3: The same facts as in Example 1 except that the taxpayer does not materially
participate.
Example 4: The same facts as in Example 1 except that the taxpayer receives a salary from
the S corporation.
Example 5: The taxpayer owns rental real property in which the taxpayer actively
participates. The taxpayer had a net profit of $10,000 in 1987. How is this income treated for
purposes of the tax on unearned income?
It is assumed that for purposes of Examples 1-5 the taxpayer is a resident individual, and that
for purposes of Examples 1-4 the shareholders of the S corporation have made the election, pursuant
to section 660 of the Tax Law, to treat the corporation as a New York S corporation.
Section 601(d)(1) of the Tax Law provides that, for taxable years beginning after 1986 and
before 1989, the tax on certain unearned income is imposed on the New York unearned income of
a resident individual who has New York adjusted gross income in excess of $100,000 (or $50,000
if married filing separately). Section 601(d)(4) provides that "New York unearned income" means
New York adjusted gross income with certain adjustments. The New York adjusted gross income
of a resident individual is the individual's federal adjusted gross income with the modifications
required by section 612 of the Tax Law. An individual's federal adjusted gross income includes a
shareholder's pro rata share of a S corporation's income, loss, deduction and reduction for taxes
described in section 1366(f)(2) and (3) of the Internal Revenue Code. Section 601(d)(6) provides

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for the adjustments decreasing New York adjusted gross income and states that:
there shall be subtracted from New York adjusted gross income:
(A) Earned income within the meaning of paragraph two of subsection (d) of section nine
hundred eleven of the internal revenue code, except that the phrase "not in excess of thirty percent
of his share of the net profits of such trade or business" shall not apply. . . .
(B) Earned income within the meaning of subparagraph (C) of paragraph two of subsection
(c) of section four hundred one of the internal revenue code, including amounts (i) received as a
pension or annuity which arises from an employer-employee relationship, (ii) paid or distributed out
of an individual retirement plan or (iii) received as deferred compensation.
(C) Capital gain net income.
(D) Income in respect of alimony and separate maintenance payments.
(E) Any of the modifications required by subsection (b) of section six hundred twelve which
are properly allocable to or chargeable against the adjustments determined under this paragraph and
paragraph five of this subsection.
(F) A deduction for (i) interest on indebtedness incurred or continued to purchase or carry
obligations or securities, (ii) ordinary and necessary expenses for (I) the production or collection of
income or (II) the management, conservation or maintenance of property held for the production of
income, and (iii) amortizable bond premium, to the extent such interest, expenses and premium are
paid or incurred during the taxable year, are not deductible in determining New York adjusted gross
income and are directly related to unearned income includible in New York adjusted gross income.
Section 401(c)(2)(C) of the Internal Revenue Code states:
(C) INCOME FROM DISPOSITION OF CERTAIN PROPERTY.-For purposes of this
section, the term "earned income" includes gains (other than any gain which is treated under any
provision of this chapter as gain from the sale or exchange of a capital asset) and net earnings
derived from the sale or other disposition of, the transfer of any interest in, or the licensing of the use
of property (other than good will) by an individual whose personal efforts created such property.
Section 911(d)(2) of the Internal Revenue Code states:

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(2)

EARNED INCOME. ­
(A) IN GENERAL. - The term "earned income" means 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.
(B) TAXPAYER ENGAGED IN TRADE OR BUSINESS. - In the case of a
taxpayer engaged in a trade or business in which both personal services and capital are
material income-producing factors, under regulations prescribed by the Secretary, a
reasonable allowance as compensation for the personal services rendered by the taxpayer, not
in excess of 30 percent of his share of the net profits of such trade or business, shall be
considered as earned income.

The Internal Revenue Code definition of "earned income" is substantially similar to the
personal income tax definition of "New York personal service income" that was contained in section
603-A of the Tax Law, prior to that section's repeal in 1987. Therefore, herein it is appropriate to
apply precedent set under such section 603-A.
Section 603-A of the Tax Law provided for a maximum tax rate on New York personal
service income. Section 603-A(b)(1) defined "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. In the
case of a taxpayer engaged in a trade or business in which both
personal services and capital are material income producing factors..,
a reasonable allowance as compensation for the personal services
rendered by the taxpayer shall be considered as earned income. . . .
The personal income tax regulations of the State Tax Commission provided that "[w]here
an individual performs personal services for a corporation (including an S 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)(1)(iii). (Emphasis supplied).

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The personal income tax regulations also provided that "[w]here an individual is engaged in
an unincorporated trade or business in which both personal services and capital are material income­
producing factors, a reasonable allowance as compensation for the personal services actually
rendered is personal service income from the trade or business." 20 NYCRR 100.4(c)(1)(v).
However, such allowance cannot be more than the net profits of the business.
The personal income tax regulations do not specify any test to determine the portion of
income received from a corporation or an unincorporated trade or business 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.
However, section 617(b) of the Tax Law provides that each item of S corporation income,
gain, loss or deduction shall have the same character for a shareholder under Article 22 as for federal
income tax purposes. In addition, where an item is not characterized for federal income tax
purposes, it shall have the same character for a shareholder as if realized directly from the source
from which realized by the S corporation or incurred in the same manner as incurred by the S
corporation. Therefore, earned income cannot include items of income or gain that would be
characterized as unearned income if realized by the taxpayer directly from the source from which
realized by the S corporation.
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 the taxpayer's work, the taxpayer's qualifications, the size and
complexities of the trade or business, a comparison of the taxpayer's compensation to the
compensation of other employees, a comparison of the taxpayer'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. Zalman C. and Elaine K. Bernstein, Advisory Opinion of the Commissioner of
Taxation and Finance, December 15, 1987, TSB-A-87(10)I.
It should be noted that the burden of proving that income received represents a reasonable
allowance for compensation for personal services actually rendered falls upon the taxpayer. Antonio
and Frances Coppola, Joseph and Marie Coppola, Decision of the State Tax Commission, February
18, 1986, TSB-H-86(44)I; Migliore v. Commissioner, 36 TCM 1004 (1977) (applying the provisions
of former Internal Revenue Code section 1348 relating to the definition of"earned income" which
is substantially the same as section 603-A of the Tax Law); Paula Construction, Co. v.
Commissioner, 58 T.C. 1055 (1972).
Accordingly, with respect to Examples 1 through 5, New York unearned income
includes the income from both the S corporation and the rental real property that is included
in New York adjusted gross income, decreased by the adjustments required by section 601(d)(6).

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In particular, New York adjusted gross income is decreased by earned income which includes
income from wages, salaries, professional fees or other amounts received as compensation for
personal services, if such amounts represent a reasonable allowance for personal services actually
rendered. Such earned income is not restricted to an amount designated as salary and reported on a
W-2 form.- However, the taxpayer bears the burden of proving that any amount of income from the
S corporation included on the taxpayer's K-1 form or from the rental of real property is earned
income. Inasmuch as any such proof will entail a question of fact, a determination of what
constitutes earned income cannot be made within the context of an advisory opinion.
Finally, it is noted that for purposes of the tax on unearned income, earned income is not
determined by reference to the passive activity rules established pursuant to Internal Revenue Code
Section 469.

DATED: September 16, 1988

s/FRANK J. PUCCIA
Director
Technical Services Bureau

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