Kentucky Overhauls Its Tax Code
Some Taxpayers Benefit -- Others Face New Tax Burdens
Some Taxpayers Benefit -- Others Face New Tax Burdens
Governor Fletcher’s tax plan was first introduced in Kentucky’s 2004 General Session but failed to garner sufficient support from the General Assembly. In February, 2005, a revised version of the tax plan (the “2005 Tax Act”) was introduced into the Kentucky General Assembly. The 2005 Tax Act passed both the House and Senate, and the Governor signed the 2005 Tax Act into law on March 18, 2005. Over 300 pages long, the 2005 Tax Act brings major changes to Kentucky’s taxation of businesses and their owners. Governor Fletcher described the 2005 Tax Act as historic tax modernization legislation. This Advisory highlights some of the most significant changes.
Elimination and Reduction of Certain Business Taxes
The 2005 Tax Act repeals the license tax imposed on corporations for tax periods ending on or after December 31, 2005, and, for tax returns due without regard to extension on or after April 15, 2004, fixes the problem of double taxation for parent-subsidiary affiliated groups of corporations caused by the Franklin Circuit Court’s decision in the Illinois Tool Works case. The corporate license tax was viewed by many as a burdensome, anti-business tax, which discouraged business from locating in Kentucky; its repeal is a welcome development both for businesses currently operating in Kentucky and for groups attempting to attract new businesses to the Commonwealth. Since limited liability companies were never subject to the corporate license tax, this change eliminates one of the incentives under Kentucky tax law to choose a limited liability company over a corporation.
The 2005 Tax Act also abolishes the tax on intangible property and reduces the top marginal corporate income tax rate from 8.25% to 7% in 2005 and 2006, with a further reduction to 6% in 2007. It is hoped that these tax reductions will encourage multi-state corporations to locate or expand their operations in Kentucky.
Retroactive to January 1, 2005- Imposition of an Entity Level Income Tax on Pass Through Entities and an Alternative Minimum Tax on both Corporations and Pass Through Entities
For taxable years beginning on or after January 1, 2005, C and S corporations, limited liability companies, limited partnerships, registered limited liability partnerships, and several other types of pass through type entities doing business in Kentucky will pay the greater of: (a) an income tax with a marginal rate of 7% (reduced to 6% in 2007); (b) the lesser of an alternative minimum tax of nine and one-half cents ($0.095) per one hundred dollars ($100) of the entity’s gross receipts (defined as the numerator of the sales factor under KRS 141.120(8)(c)) or seventy-five cents ($0.75) per one hundred dollars ($100) of the entity’s Kentucky gross profits; or (c) $175.
The 2005 Tax Act eliminates the most significant difference between taxation of C corporations and pass through entities by imposing a new entity level tax on most pass through entities. Only a few entities such as general partnerships, qualified investment partnerships, and certain types of corporations previously exempted from corporate income tax (e.g., Section 501 tax exempt entities), are spared from the new entity level tax. A number of other types of pass through entities which typically do not pay federal income tax, such as agricultural cooperatives, may be subject to the new Kentucky entity level tax. We expect that Kentucky businesses will see increased compliance costs because of the substantial differences between Kentucky’s new taxing regime and the federal tax system. Perhaps even more troubling is the fact that the new entity level tax is retroactive to January 1, 2005. This means that businesses planning to restructure or reorganize to legally reduce overall Kentucky tax liability will still be subject to the new entity level tax for a least part of the 2005 tax year.
For entities with little or no taxable income, the 2005 Tax Act imposes an alternative minimum tax based on either the entity’s gross receipt or gross profits. Only a handful of states currently impose gross receipts taxes on businesses. This taxing regime means that even unprofitable businesses, or start-up ventures which typically have losses in early years, may be subject to taxation. The alternative minimum tax may also cause entity level taxes to increase for businesses with high volumes of receipts and low margins.
Individual Owners of Pass Through Entities
For an individual owner of a pass through entity, income taxed at the entity level, as well as loss and deduction items, will be treated as distributed to the individual. A nonrefundable credit for the tax paid at the entity level is provided to the individual based on the individual’s percentage of ownership in the entity. The credit is limited to the amount of tax owed on the income passed through to the individual, and unused credits cannot be carried forward. We note that there is a very limited 1% credit refund provision for the 2005 and 2006 tax years.
Because the credit is nonrefundable, an individual owner of a pass through entity may not be able to take advantage of certain personal itemized deductions and perhaps other items for Kentucky individual income tax purposes unless the owner has ordinary income from other sources to utilize against those deductions. In other words, if all of an individual’s income is from his or her ownership interest in a pass through entity, the credit will offset the income passed through to the individual, and the individual will not have any additional income to use against personal itemized deductions. Similarly, because the tax is at the entity level, it appears that an individual owner of several pass through entities would not be able to net profitable and unprofitable activities in determining his or her Kentucky income tax liability.
Furthermore, because the new tax is imposed at the entity level, the home state of a nonresident individual owner of a pass through entity operating in Kentucky could take the position that the new tax is not an individual income tax and not allow the individual a credit for taxes paid to Kentucky by the entity. This could result in double taxation to nonresident owners of pass through entities operating in Kentucky, thereby discouraging nonresident individuals from investing in entities domiciled or operating in Kentucky.
Non-individual Owners of Pass Through Entities
For a non-individual owner of a pass through entity, the income taxed at the entity level is not treated as flowing through to the owner, and so no credit for the tax paid at the entity level is provided to the owner. The entity’s net operating loss also would not flow through to the non-individual owner. Although this is the stated position of the Governor’s office, the 2005 Tax Act does not make it completely clear that the taxation of non-individual owners works in this manner. We note however that where the non-individual owner of an entity and the entity itself file a Kentucky consolidated return, the losses of one group member should offset income of other group members.
Disregarded Entities including Single Member Limited Liability Companies
The federal check the box regulations provide that an eligible entity with a single owner is disregarded for federal tax purposes, unless the entity elects to be taxable as a corporation. In other words, a single member limited liability company (“SMLLC”) generally is treated as a disregarded entity taxed as a sole proprietorship. The 2005 Tax Act generally does not recognize the concept of a disregarded entity for Kentucky tax purposes. This means that an SMLLC owned by an individual will now be required to file a separate return and pay an entity level tax. This may have more limited implications for an SMLLC owned by a corporation or other entity since the SMLLC and its parent may be part of an affiliated group required to file a consolidated Kentucky tax return.
Qualified Subchapter S subsidiaries (“QSubs”) also are treated as disregarded entities for federal tax purposes. The 2005 Tax Act provides that a QSub that is included in the return filed by the Subchapter S parent corporation does not file a separate return. This indicates that a QSub will file a consolidated Kentucky tax return with its parent S corporation.
Qualified Investment Partnerships
There generally is no change in the tax treatment of qualified investment partnerships (other than a change to three factor apportionment). The 2005 Tax Act provides that nonresident individuals are not taxable on investment income distributed by a qualified investment partnership. A qualified investment partnership is defined as a general partnership, limited partnership, or limited liability partnership (but not a limited liability company) formed to hold only investments that produce income that would not be taxable to the nonresident individual if held or owned individually. A qualified investment partnership is not subject to the new entity level tax imposed pursuant to KRS 141.040. Instead, a qualified investment partnership is treated as a general partnership, which is not subject to the new entity level tax and continues to be treated as a pass through entity, although administrative regulations promulgated in 2004 (prior to the 2005 Tax Act) generally require that that the distributive income on nonresident partners is subject to entity level withholding.
Imposition of Tax on Entities Doing Business in Kentucky
In the past, a corporation was required to have a physical presence in Kentucky in order to be subject to Kentucky income tax. The 2005 Tax Act substantially broadens the nexus standard for income tax purposes to include entities “doing business” in Kentucky. Doing business in Kentucky includes, without limitation, entities which: (a) are organized under Kentucky law; (b) have a commercial domicile in Kentucky; (c) own or lease property in Kentucky; (d) have one or more individuals performing services in Kentucky; (e) maintain an interest in a general partnership doing business in Kentucky; (f) derive income from or attributable to sources within Kentucky, including deriving income directly or indirectly from a trust doing business in this state; or (g) direct activities at Kentucky customers for the purpose of selling them goods or services. The 2005 Tax Act does limit this extremely broad statutory language by stating that nothing in the definition of “doing business” is to be interpreted in a manner that goes beyond the limitations imposed and protections provided by the U.S. Constitution or Public Law 86-272 (a federal law limiting the ability of the states to impose income tax on out of state corporations).
New Consolidated Return Requirements
Previously, corporate groups had the option of filing separate or consolidated Kentucky income tax returns. Under the 2005 Tax Act, certain groups of affiliated entities will be required to file consolidated returns. The Kentucky consolidated filing rules require the consolidation of non-corporate entities subject to the new entity level tax. This may create administrative and compliance problems because the Kentucky consolidated return requirements differ from those under federal tax law.
Elimination of Net Operating Loss Carrybacks
The 2005 Tax Bill disallows the net operating loss carryback deduction for corporate losses incurred for taxable years beginning on or after January 1, 2005. Entities may carry losses forward and take advantage of the losses in future years.
Apportionment of Income to Kentucky
Previously, corporations conducting businesses both within and outside Kentucky apportioned their income to Kentucky by using a three factor (payroll, property, and sales) apportionment formula with a double weighted sales factor, while entities taxed as partnerships (including most limited liability companies) used only the sales factor in determining income apportioned to Kentucky. Under the 2005 Tax Act, all entities other than general partnerships and publicly traded partnerships doing business in Kentucky will now use the three factor apportionment formula.
Resident individuals, estates and trusts which are partners in a general partnership or publicly traded partnership pay tax in Kentucky on 100% of their distributive share of partnership income. All nonresident individuals, estates, trusts and entities taxed as corporation which are partners in a general partnership or publicly traded partnership which does business solely in Kentucky (i.e., 100% of its property and payroll is within Kentucky) pay tax on 100% of their distributive share of income. Nonresident individuals, estates, trusts and entities taxed as corporations which are partners in a partnership which does business within and without Kentucky pay tax on their distributive share of partnership income apportioned to Kentucky using the standard three-factor formula (double-weighted sales factor) applied to corporations generally.
This change represents an effort to eliminate one tax planning strategy used by out-of-state corporations which entailed operating in Kentucky through a limited liability company in order to take advantage of the old single sales/gross receipts factor. Historically, a corporation with substantial property and payroll in Kentucky and sales outside of Kentucky could reduce its Kentucky tax burden through this planning technique.
Disallowance of Deductions for Inter-Company Management Fees and Intangible Interest Expense
The 2005 Tax Act generally prohibits entities from deducting certain payments for inter-Company management fees and intangible interest expense (e.g., payments for the use of intellectual property). The deductions are allowable under certain circumstances, either by meeting specific statutory requirements or by establishing the propriety of the payments by a preponderance of the evidence. These changes were intended to eliminate a tax planning strategy involving the payment of deductible expenses and interest by Kentucky businesses to out-of-state entities (often located in Delaware). These deductible payments often had the effect of substantially reducing or eliminating the Kentucky business’ income, and taxation of the corresponding income was often avoided in the other state (e.g., Delaware has no tax on income derived from intellectual property).
This Advisory focuses on the most important provisions in the 2005 Tax Act impacting businesses and their owners. The 2005 Tax Act includes many other changes to the tax code, including a number of revenue raising measures such as increases in cigarette and alcohol excise taxes.
We would be glad to discuss how the 2005 Tax Act affects you or your business in more detail. If you are interested in learning more, please contact Sam Graber at 502.568.0248, firstname.lastname@example.org, Scott Dolson at 502.568.0203, email@example.com, or any of the members of Frost Brown Todd’s Tax Practice Group.