New Kentucky Tax Legislation Mitigates Negative Consequences of Kentucky’s 2005 Tax Act
On June 28, 2006, the Kentucky General Assembly passed, and Governor Fletcher signed into law, new tax legislation (the “New Tax Bill”) for the stated purpose of providing relief for Kentucky’s small businesses.
Kentucky’s 2005 Tax Act brought major changes to Kentucky’s taxation of businesses and their owners. There were a number of provisions beneficial to business in the 2005 Tax Act, including the repeal of the corporate license tax and the tax on intangible property. However, the 2005 Tax Act also increased taxes for a number of businesses and their owners. For example, companies with low profits or which were operating at a loss formerly paid little or no income tax, but as a result of the 2005 Tax Act were required to pay tax based on their gross receipts or gross profits. Further, because of the entity level tax on pass-through entities and the nonrefundability of the credit passed through to owners for taxes paid at the entity level, owners of multiple pass-through entities were effectively unable to offset losses from one entity against income from another entity, and individual owners of a pass-through entity were in some cases unable to take advantage of personal deductions. Finally, Kentucky’s divergence from federal taxation, particularly with regards to the new tax on pass-through entities, greatly complicated Kentucky’s tax code, making compliance much more costly and burdensome.
The General Assembly attempted to mitigate these new tax burdens in the 2006 Regular Session. The House and Senate each passed different versions of corrective legislation, but the Conference Committee was unable to reach agreement regarding several differences in the House and Senate versions of the legislation. In particular, the House and Senate could not agree on the level of relief from the gross receipts/gross profits alternative minimum calculation (the “AMC”) and the timing for reducing the highest corporate income tax rate to 6%.
On June 21, 2006, Governor Fletcher signed a proclamation calling for a special session of the Kentucky General Assembly to provide tax relief for Kentucky’s small businesses and small business owners. On June 28, 2006, the General Assembly passed the New Tax Bill, and the Governor signed the bill into law. This Advisory highlights some of the most significant aspects of the new legislation.
AMC Relief Retroactive to January 1, 2006.
For taxable years beginning on or after January 1, 2006 (and before January 1, 2007), entities previously subject to the AMC (a) will be exempt from the AMC if the entity’s gross receipts or gross profits are $3 million or less, and (b) will pay a reduced amount of tax on either gross receipts or gross profits (whichever results in a lesser tax burden) over $3 million but less than $6 million. The provision should provide relief for relatively small Kentucky businesses with little or no taxable income, including start-up ventures and businesses with high sales volumes but low profit margins. The New Tax Bill also more clearly defines cost of goods sold, which is used in making the gross profits computation. Beginning in 2007, the AMC is repealed and replaced by the Limited Liability Entity Tax (the “LLET”) discussed later in this Tax Law Advisory.
Scheduled Reduction in Corporate Income Tax Rate.
The House and Senate’s previous plans contemplated delaying until 2009 the decrease in the corporate income tax rate to 6%. The New Tax Bill maintains the scheduled reduction of the corporate income tax rate to 6% in 2007.
Beginning January 1, 2007 – Return to Federal Conformity for Pass-Through Entities.
For taxable years beginning on or after January 1, 2007, the New Tax Bill restores flow-through tax treatment for pass-through entities such as limited liability companies, S corporations, limited partnerships, and registered limited liability partnerships, which were previously subject to Kentucky’s entity level tax. However, the return to federal conformity is not complete because of the imposition of the LLET.
Imposition of Limited Liability Entity Tax.
For taxable years beginning on or after January 1, 2007, the New Tax Bill imposes the LLET on every corporation and limited liability pass-through entity (e.g., limited liability companies, S corporations, and limited partnerships) doing business in Kentucky. The LLET replaces and is similar to the AMC. The LLET is imposed on the entity’s Kentucky gross receipts or Kentucky gross profits, and there is a minimum of $175 in LLET due from all corporations and limited liability pass-through entities. The LLET has the same exemptions and reductions for the gross receipts and gross profits of small business as the AMC exemptions and reductions previously described (i.e., a $3 million exemption and reduced amount of tax for gross receipts/gross profits over $3 million but less than $6 million). Certain types of entities are exempt from the LLET. Exempt entities include financial institutions, savings and loan associations, banks for cooperatives, production credit associations, insurance companies, charitable and non-profit organizations, public service corporations, open-end registered investment companies, fluidized bed and alcohol production facilities, REITS, RICS, REMICS, personal service corporations under IRC 269A(b)(1), cooperatives, homeowners associations, political organizations, and publicly traded partnerships.
There is a credit against income tax for the amount of LLET paid by the corporation or the limited liability pass-through entity. In the case of limited liability pass-through entities, this credit flows through to the owners of such entities. However, the credit is nonrefundable, cannot be carried forward, and can be applied only to income tax assessed on income from the limited liability pass-through entity.
There are several potential problems for owners of limited liability pass-through entities associated with the use of the credit. The credit cannot be used to offset the owner’s Kentucky income tax on income unrelated to the limited liability pass-through entity that paid the tax. For a fairly profitable limited liability pass-through entity, an individual owner’s income tax liability related to income from the entity will be greater than the amount of the credit that the owner receives, and so the owner generally will fully utilize the credit on his or her Kentucky tax return. This will not be the case where the limited liability pass-through entity is unprofitable. The entity will pay the LLET, and the owner will not be able to take advantage of the credit because there will be insufficient income from the entity against which to use the credit.
Furthermore, because the LLET is imposed on the limited liability pass-through entity itself, non-resident individuals might not receive a credit on their home state returns for the amount of LLET paid to Kentucky. In certain circumstances, these two issues could discourage investment in new business ventures in Kentucky.
Mandatory Withholding by Limited Liability Pass-Through Entities.
All pass-through entities doing business in Kentucky (other than publicly traded partnerships) will be required to withhold Kentucky income tax on the distributive share of each nonresident individual owner and each corporate owner that is doing business in Kentucky only through its ownership interest in the pass-through entity. If the pass-through entity demonstrates to the Department of Revenue that a nonresident owner has filed an appropriate tax return for the prior year with the Department, then the pass-through entity is not required to withhold on such owner’s distributive share for the current year. However, if the owner does not file returns and pay all taxes due in a timely manner, the exemption is revoked, and the Department may require the pass-through entity to pay the Department the amount that should have been withheld from such owner. The pass-through entity is entitled to recover the payment made to the Department from the owner on whose behalf such payment was made.
Qualified Investment Partnerships.
The exemption from Kentucky income tax for the investment income of a qualified investment partnership allocated to nonresident individuals remains unchanged, except that the New Tax Bill expands the types of entities that may now be treated as qualified investment partnerships to include all pass-through entities, including limited liability companies and S corporations.
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This Advisory focuses on the most important provisions in the New Tax Bill impacting businesses and their owners. Please note that the New Tax Bill includes other changes to Kentucky’s tax code.
We would be glad to discuss how the New Tax Bill 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.