Understanding the Unique Factors Impacting Kentucky’s Tax Environment

Key Takeaways

• Kentucky’s Tax Reforms Aim to Attract Business Growth: Kentucky has modernized its tax system with market-based sourcing, broader sales tax, and phased income tax cuts to attract businesses.
• Limited Liability Entity Tax (LLET) Poses Unique Compliance Challenges: The Limited Liability Entity Tax applies broadly and uses gross receipts and profits, with strict limits on deductions and no federal income tax protections.
• Local Tax Variability Adds Complexity for Businesses: Cities and counties have separate tax rules, rates, and filing requirements — often requiring businesses to navigate multiple, non-uniform systems.

When starting a new business or expanding an existing business into a different state and/or locality, a basic understanding of the tax environment is critical in maintaining compliance and achieving business objectives. Kentucky has implemented several tax law changes since 2018 in its efforts to attract new businesses and investment. These changes include a shift to market-based receipts sourcing for income tax apportionment; expanding the sales tax to additional services; updating the IRS conformity date; implementing a gradual reduction of its income tax rate based on achievement of economic milestones; and rolling out the availability of electronic filing changes and a new website by the KY Department of Revenue.

These efforts have allowed KY to make significant progress in becoming a more tax friendly state as evidenced by improving from 37^th in 2018 to 18^th in 2021 as stated in the Kentucky Chamber’s Why Tax Reform: Kentucky’s Opportunity for Growth. However, the state-imposed limited liability entity tax (LLET) and local income tax filing requirements are two tax considerations that are distinct to KY.

Kentucky Limited Liability Entity Tax

The Kentucky Limited Liability Entity Tax is a component of the Kentucky income tax. The LLET receipts-based tax is required to be paid by all limited liability companies (LLCs), including single member limited liability companies, and corporate entities “doing business” in the state as defined below (KRS 141.0401 and KRS 141.010(13)). The activities that will qualify as “doing business” in Kentucky include any of the following:

1. Organized under the laws of KY
2. Having its commercial domicile in KY
3. Owning or leasing property in KY
4. Having one or more individuals performing services in KY
5. Maintaining an interest in a pass-through entity doing business in KY
6. Deriving income from or attributable to sources within KY, including deriving income directly or indirectly from a trust doing business in KY, or deriving income directly or indirectly from a single member limited liability company doing business in KY and is disregarded as an entity separate from its single member for federal income tax purposes
7. Directing activities at KY customers for the purpose of selling them goods or services

Single member LLCs that are treated as disregarded entities for federal income tax purposes are also disregarded for purposes of the LLET and must be included in the return filed by their single member (i.e., parent entity). KRS 141.040 and KRS 141.0401 provide a listing of LLET-exempt entities, including financial institutions, insurance companies, qualified investment partnerships (QIPs), corporations exempted by IRC Sec. 501, and religious, educational, charitable, and like corporations not conducted for profit, and limited other exceptions. (Note that financial institutions and insurance companies are both subject to KY industry specific taxes.)

For those entities subject to the KY LLET having receipts or gross profits less than $3 million, the LLET is an annual flat rate of $175. Businesses with over $3 million in receipts are subject to a tax rate of 0.095% of KY gross receipts. Businesses with gross profits exceeding $3 million are subject to a tax rate of 0.75% of gross profits. The LLET due for a particular year is the lesser of the gross receipts-based calculation and gross profits-based calculation.

For tax years beginning on or after January 1, 2018, for taxpayers applying apportionment principles, KY uses a single factor apportionment formula utilizing receipts only and requires market-based sourcing for receipts of tangible property sales, services, and intangible property. Under market-based sourcing, receipts are generally sourced to the location of a business’s customers or where the service’s benefit is received.

Businesses need to know that KY limits the cost of goods sold deduction in multiple ways.  The first limit is that only taxpayers in certain economic sectors can deduct cost of goods sold in arriving at the tax base. KY has taken the position that only taxpayers engaged in manufacturing, producing, wholesaling, retailing, and reselling of tangible products are allowed to deduct cost of goods sold from their KY gross receipts. Additionally, even if a business is engaged in one of these qualifying activities, KY restricts the cost of goods sold deduction under KRS 141.0401(1)(d)2 to amounts directly incurred for labor or materials in acquiring or producing a tangible product generating KY gross receipts. As a result, cost of goods sold for purposes of the KY LLET excludes certain indirect costs classified by the Internal Revenue Code as cost of goods sold.

KY has both a gross receipts-based tax and an income tax for all businesses subject to the KY LLET. However, this generally does not result in double taxation because KY allows a non-refundable credit for entities required to pay more than the flat annual tax of $175. The downside of this being a non-refundable credit is that the benefit is limited to entities or individual owners generating KY income. Unfortunately, this credit is not eligible for carry forward.

Finally, note that as a gross receipts-based tax, the protections provided by federal Public Law 86-272 to certain sellers of tangible personal property do not apply to the LLET. (Among other restrictions, Public Law 86-272 protections apply only to a state tax measured by income, not by gross receipts.)

KY Local Taxes

While KY’s income tax rate of 4% is relatively low compared to many states, it is important to also consider the local tax rates for any local jurisdictions in which a business is required to file. Most KY cities and counties administer their own tax schemes and apply various tax rates.

Louisville Metro’s tax rate of 2.2% is one of the highest in the state. Since these local taxes are administered by separate tax departments, there are numerous differences in how these taxes are interpreted and applied across local jurisdictions.

Many localities also have minimum and/or maximum tax liabilities. In addition to having their own tax rates, some of KY’s localities have a gross receipts-based tax as opposed to a net profits tax. To further increase complexity, some jurisdictions will require taxpayers to report the same income to both the city and county.

Whether your business is domiciled in Kentucky or headquartered in a different state, it is critical to evaluate the footprint of your business within KY to determine the cities and/or counties where you have created a filing obligation (unless you meet the requirements of an exempt activity or entity).

To determine if your business has a filing obligation with a specified city or county, the first step is to evaluate (i) the personnel working permanently within that location as well as those entering a locality temporarily, and (ii) the services being performed by those personnel. As an example, based on Louisville Metro’s regulations, engaging in any of the activities below can create nexus:

1. Any office, store, location, or place of any nature at which any activity in furtherance of any business in Louisville Metro is conducted
2. The delivery or shipment to addresses within Louisville Metro, whether by employees, agents, or contractors, other than through mail or common carrier
3. Contracting to sell or provide goods or services within Louisville Metro
4. Advertising, solicitation, negotiation, or any other activity in Louisville Metro that leads to a contract for the sale of goods or services
5. The lease or rental of real or tangible personal property located in Louisville Metro or to a person located in Louisville Metro
6. The presence of employees, independent contractors, agents, representatives, or other persons acting on the taxpayer’s behalf in Louisville Metro

In addition to the physical presence activities listed above, Louisville Metro established a “brightline” economic nexus threshold, which can trigger a filing requirement for entities that exceed a designated threshold of (i) engaging in 200 or more transactions within that jurisdiction or (ii) generating receipts of $25,000 or more. These brightline thresholds were added via updates to Louisville Metro’s regulations that were issued November 11, 2011, effective beginning January 1, 2022 (see Sec 1.02(H)(2)(d)).

Because these locally imposed taxes are income-based, Public Law 86-272 may provide some protection for taxpayers whose revenue is generated through the sale of tangible personal property.  For more information regarding nexus, check out my previous article entitled What Is Nexus and Why You Should Care.

Even though the taxes are administered by their respective city and county tax departments, many of the regulations are similar. This is due in part to KY’s years-long ongoing efforts working towards additional uniformity. For example, in 2008, the KY legislature implemented revenue statutes KRS 67.750 to KRS 67.790 to seek uniformity in state income tax regulations. In 2012, the KY Secretary of State created a centralized repository requiring localities to provide copies of their tax forms and ordinances.

In 2016, the KY Department of Revenue launched Form OL-S which creates some efficiencies due to the fact that many tax preparation platforms now include this form in their software packages. It would be beneficial for additional cities and counties to follow Louisville’s lead in creating an electronic filing platform.

Despite KY’s efforts to increase uniformity over the past 17 years, the changes being implemented at the state level have not yet been adopted for local tax purposes. As a result, KY localities continue to use a two-factor apportionment formula which weighs payroll and revenue equally. In addition, revenue from services continues to be sourced based on cost of performance as opposed to market-based sourcing. As a result, taxable income sourced to KY localities may be significantly different from revenue sourced for KY LLET purposes.

If you are currently navigating the ramifications of your KY business activities for 2024 and/or 2025, it is important to note that the widespread flooding and resulting damage during February 2024 resulted in a declaration of a Federal Declared Disaster for all of KY during 2024, which is applicable to business and individuals domiciled in KY.  See KY’s announcement here and Louisville Metro’s announcement here.

Navigating Kentucky’s Unique Tax Landscape: Expert Guidance for Businesses Operating or Expanding in the State

Whether you are already operating within KY or are considering expanding into the state, LBMC tax advisors can provide significant value in assessing potential tax ramifications and help with navigating the unique factors of KY’s tax environment such as the LLET and its multitude of local taxing jurisdictions. We can also assist you in understanding how the disaster declarations impact you and your business for 2024 and 2025.

LBMC’s State and Local Tax (SALT) team provides clients with proactive and strategic multi-state tax services to mitigate risk, defend positions and improve cash flow. Our SALT experts are ready to provide you with planning and solutions to your state tax issues whether you are conducting business in one, several or all 50 states.

Content provided by Joe Guelda, LBMC Senior Tax Manager. He can be reached at joe.guelda@lbmc.com.

LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.