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Highlights of 2008 federal and Kentucky income tax developments impacting

Kentucky taxpayers saw their fair share of legislative, administrative and judicial income tax developments in 2008. A comprehensive survey and in-depth analysis of these changes could very well fill the pages of a paperback novel, but here we’ll just try to hit some of the highlights.

Tax changes in the federal Emergency Economic Stabilization Act

It seems like nearly every year or two, Congress searches for a legislative vehicle to revive or keep alive a few "temporary" but popular tax provisions. This year that vehicle turned out to be the Emergency Economic Stabilization Act of 2008 (EESA).

While Congress actually enacted this massive piece of legislation in record time for the primary purpose of rescuing the financial markets, it includes dozens and dozens of tax provisions and, reportedly, makes hundreds of changes to the Internal Revenue Code. Of particular note, the House of Representative’s initial version, which did not contain the tax changes, failed to pass, but after the Senate added these tax provisions, the bailout legislation passed. So, in a sense, the tax provisions could be thought of as the sugar that made the medicine go down.

As stated, EESA included many tax provisions, but a few in particular merit mention here. EESA extended certain popular tax breaks to individual taxpayers. It authorizes individuals to take an itemized deduction for state and local sales and use taxes in lieu of income taxes for the calendar tax year 2008 and also for 2009; it also extends the above-the-line deduction for individuals for higher education tuition and the additional standard deduction for real property taxes through the end of 2009. Although not technically thought of as an "extender," the Act included a "patch" to the Alternative Minimum Tax (AMT), which was originally enacted to ensure that America’s wealthiest individuals paid at least some tax to the federal government. Among other changes, the patch raised the AMT exemption amounts to shield middle-income individuals from the AMT for 2008 only.

As to extensions of business tax incentives, EESA extended the research credit through 2009. It also extended the availability of the 15-year depreciation method (versus 39 years) to qualifying restaurant and leasehold improvements to the end of 2009. EESA also extended other tax provisions applicable to businesses and many other incentives available to individuals, energy producers and manufacturers.

Not everyone received a benefit; in fact, there were some offsets. EESA capped oil and gas companies’ domestic activities production deduction, restricted their ability to claim foreign tax credits and extended the oil spill tax. It expanded the reporting requirements of brokers on sales of publicly traded securities in future years so as to require brokers to also report the securities’ adjusted basis and to designate the gain as long or short term. It extended the federal unemployment 0.2% surtax through the end of 2009. And, it will make certain foreign deferred compensation taxable.

Tax return preparer standard

Near and dear to the hearts of those of us who provide federal tax advice, and clearly to those who prepare federal tax returns, EESA also retroactively reduced the standard that must be met for a tax return preparer to not disclose a non-abusive position (other than one as to a tax shelter or a reportable transaction) on a tax return from "more likely than not" to "substantial authority," the standard applicable to taxpayers. Thus, this change more closely aligned the tax return preparer standard with that of the taxpayer. This is good news for those who render tax advice and for their clients as well.

Kentucky tax legislation

The 2008 General Assembly made very few tax changes to Kentucky’s income tax laws. Those that it did enact were, in general, quite narrowly focused.

The change with the most far-reaching impact on Kentucky taxpayers was to the computation of interest. Prior to the change, the interest rate charged by the Commonwealth on tax assessments and that it paid on refunds was the same, (8%); however, beginning on May 1, 2008, the interest rate was set at the prime rate plus 2% (10%) on assessments and at prime minus 2% (6%) on refunds. This created a four percentage point spread that can produce inequitable results, much to the detriment of taxpayers. At least one Kentucky taxpayer has filed a judicial challenge to this law.

Not all of the changes were inherently taxpayer unfriendly. A new law was enacted to provide that the receipts factor of the three-factor formula used to apportion income to Kentucky for income tax purposes includes the overall net gain (rather than the gross receipts) from treasury function transactions involving liquid assets. Another new law provides for nonrefundable income and limited liability entity tax credits for the purchase of certain energy efficient products or construction of energy efficient homes.

Kentucky administrative developments

In July 2008, Thomas B. Miller was appointed the Commissioner of the Department of Revenue (Revenue). On the administrative front, Revenue promulgated and amended very few administrative tax regulations, particularly when compared with the dozens of regulation projects underway in 2005 and 2006, none of which were related to income tax.

Kentucky court decisions

There are many income tax cases in the pipeline. The following is a sample of a few decisions in many noteworthy cases winding their way through Kentucky’s courts.

Department of Revenue v. Davis, (S. Ct. 2008), had to be the most notable decision of 2008, if only because it was just the third Kentucky tax case considered by the U.S. Supreme Court in the past century. In that case, the Court held that Kentucky’s exemption from its income tax for interest on bonds issued by the Commonwealth or its political subdivisions, while taxing interest on bonds issued by sister states, did not violate the Commerce Clause of the U.S. Constitution.

In 2008, the Kentucky Court of Appeals decided the first modern reported case concerning a person’s domicile in the context of the Kentucky income tax – Department of Revenue v. Slagel, (Ky. App. 2008). During the course of this litigation, the Kentucky Board of Tax Appeals (KBTA) held for Revenue that Peter Slagel was domiciled in Kentucky, not Venezuela, and, thus, was subject to Kentucky individual income tax on his worldwide income. The Circuit Court reversed the KBTA, but the Court of Appeals reversed this apparently close case yet again and deferred to the KBTA’s factual determination that Slagel’s domicile was in Kentucky. This case emphasizes the fact intensive nature of a domicile issue, and a read of all three decisions is enlightening as to this issue.

In AT&T Corp. v. Department of Revenue, (Jefferson Cir. Ct. 2008), appeal pending, the Jefferson Circuit Court held in an appeal from the KBTA that the elective consolidated corporation income tax return statute [KRS 141.200 as in effect for tax years and elections made prior to 2005] did not trump the nexus provisions of KRS 141.040. In so holding, the court ordered Revenue to pay refunds to AT&T computed by not including AT&T subsidiaries without a physical presence in Kentucky in AT&T’s Kentucky consolidated income tax returns. Notably, the KBTA refused to rule on the Commerce Clause and Due Process arguments that were made on behalf of AT&T, but the court found violations of these constitutional provisions. The court also invalidated 103 KAR 16:200, the administrative regulation concerning the Kentucky consolidated income tax return method.

While change is inevitable in the field of taxes, one thing is certain—the evolution of taxes via continual developments will remain a constant.

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