Kentucky enacts significant income tax and sales tax reform
INSIGHT ARTICLE |
On April 3, 2018, the Kentucky General Assembly passed House Bill 366, introducing significant changes to the state’s tax code. Governor Matt Bevin subsequently vetoed the bill, citing concerns about its effect on manufacturers and the impact to the state’s budget. However, the legislature acted quickly in response, overriding the governor’s veto. In order to address some of the concerns raised by Governor Bevin and other critics, the Kentucky General Assembly passed another tax reform bill, House Bill 487, on April 14. The governor did not exercise his veto on this second bill, allowing the bill to become law without his signature.
Notably, House Bill 366 updates Kentucky’s conformity date with the Internal Revenue Code (IRC) to Dec. 31, 2017, for both individual and corporate income taxpayers, effective tax years beginning on or after Jan. 1, 2018.
Below are some of the key changes from House Bill 366 and House Bill 487:
Individual income tax
The following changes were enacted by the two tax reform bills:
- A flat personal income tax of five percent, replacing the state’s current graduated system, effective Jan. 1, 2018
- Decoupling from section 199A, the 20 percent pass-through income deduction recently enacted by the Tax Cuts and Jobs Act (TCJA)
- A $10,000 reduction of the exclusion amount for pension income to $31,110
Corporate income tax
The tax reform bills enacted the following changes to Kentucky’s corporate income tax code:
- Apportionment methodology:
- Adoption of “market-based sourcing” for purposes of apportioning sales of intangibles and services. With this change, Kentucky is also implementing a throw-out rule for these types of sales if the taxpayer is not subject to tax in the state to which the receipt would otherwise be assigned
- Adoption of a single sales factor formula instead of the traditional three-factor formula (previously property, payroll, and double-weighted sales)
- An exception to these two new apportionment provisions is provided to taxpayers that provide communication, cable, or internet services, who can continue to use the three-factor formula and cost of performance sourcing
- Elimination of the Kentucky Domestic Production Activities Deduction
- Reduction of the corporate income tax rate to a flat five percent
Continued decoupling from federal accelerated depreciation provisions under IRC Section 168(k) and Section 179. The same adjustment methods established in previous tax years will still apply and will also need to be applied to the new 100 percent bonus depreciation and expanded full expensing brought about by TCJA
House Bill 487 also provided changes to the corporate income tax in Kentucky that will be in effect Jan. 1, 2019. These changes are as follows:
- Kentucky has adopted a mandatory water’s edge combined return for corporations that are engaged in unitary business (a worldwide combined filing basis will not be available). The new law does not expressly require an ownership percentage for inclusion in the combined return. It does allow an election to file a consolidated return (similar to federal law)—this election would be binding for eight years and is similar to the election available to taxpayers prior to 2005.
- If filing a mandatory water’s edge combined return, Net Operating Losses (NOLs) are specific to each member—meaning that members cannot share their NOL with any other member of the unitary group. Kentucky is also changing NOLs for purposes of combined reporting from a pre-apportionment method previously used under the nexus consolidation regime to a post-apportionment method.
In an effort to increase tax revenues, the sales tax base has been expanded to include previously non-taxable services, effective July 1, 2018. These newly taxable services include janitorial services, landscaping, small animal veterinary services, pet care services, certain laundry and dry cleaning services, tanning services, extended warranties, and limousine services, among others. However, a new sales tax exemption is created for gross receipts derived from charges for labor or services to apply, install, repair, or maintain tangible personal property directly used in manufacturing or industrial processing process, if the charges for labor or services are separately stated on the invoice.
House Bill 366 also implements an economic sales tax nexus threshold for remote retailers, effective July 1, 2018. Under this new provision, if a remote retailer with no physical presence in Kentucky meets either of the following criteria in the current or previous calendar year, the remote seller must collect and remit the sales tax and follow all applicable procedures as if the remote seller had a physical presence in Kentucky: 1) the remote retailer’s Kentucky gross receipts from the sale of tangible personal property or digital property delivered to Kentucky purchasers exceeds $100,000, or 2) the remote retailer sold tangible personal property or digital property in 200 or more separate transactions to Kentucky customers.
The requirements are substantially similar to the economic sales tax thresholds enacted in South Dakota, the constitutionality of which is currently under U.S. Supreme Court review in South Dakota v. Wayfair. The outcome of that litigation could overrule Kentucky’s new economic sales tax nexus law. For more information on the status of Wayfair, please read our alerts South Dakota v. Wayfair: What to know and how to prepare and U.S. Supreme Court hears argument on Quill challenge.
The changes enacted by House Bill 366 and House Bill 487 have major consequences to Kentucky taxpayers, especially entities that are subject to the Kentucky corporate income tax. Changes in apportionment methods and mandatory filing methods, the elimination of the DPAD deduction, and the decreased tax rate will all have significant impacts on corporate taxpayers going forward.
It is important to keep in mind that, similar to the TCJA, tax reform in Kentucky was introduced and passed quickly. Taxpayers should not rule out further legislative changes or corrections. RSM will continue to track any legislative action regarding tax reform in Kentucky.