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Kentucky Mandatory Nexus Consolidated Corporation Income Tax Returns

Corporate taxpayers grapple each tax filing season with the rules governing Kentucky mandatory nexus consolidated corporation income tax returns.  Scant official administrative guidance is out there.  The Department’s Regulation, 103 KAR 16:200, has not been updated for the statutes now in effect.  What corporations should be included in such a consolidated return?  What corporations should be excluded?  The rules can be confusing and are quite unique to Kentucky.   

History of Consolidated Returns in Kentucky

Before the 2005 General Assembly enacted legislation that is sometimes still referred to as “Tax Modernization,” corporations had the option to elect to file a Kentucky consolidated income tax return, an option the 1996 General Assembly put in place in the wake of the Kentucky Supreme Court’s GTE decision. The composition of the elective consolidated return group remains an open question, although the pending AT&T case may provide the answer. [Editor’s Note:  The author’s law firm represents the taxpayer in AT&T Corp. v. Dep’t of Revenue, No. 2008-CA-1888 (Ky. App.)].  The law has, however, morphed since that version of consolidated returns. 

Tax Modernization ushered in the era of the mandatory nexus consolidated income tax return, the second version of the consolidated return.  You may recall that during that era (essentially, tax years 2005 and 2006) pass-through entities with the characteristic of limited liability were defined to be corporations.  This treatment of pass-through entities made Kentucky an outlier among its sister States. 

The 2006 General Assembly brought Kentucky back into line by again treating pass-through entities as pass-through entities, but the mandatory nexus consolidated income tax return provisions were kept in place.  They were, however, modified to apply only to corporations.  This, the third version, remains in effect today. 

Corporations Includible in an Affiliated Group

An affiliated group, regardless of whether it files a federal consolidated return, is mandated to file a consolidated return which includes all includible corporations, i.e., those doing business in the Commonwealth not otherwise excluded – to wit, a mandatory nexus consolidated return.  See KRS 141.200(9) & (11)(a).  In determining the composition of any given mandatory nexus consolidated return group, two things are critical:  what constitutes an includible corporation; and, what makes up an affiliated group. 

An includible corporation is one that is doing business in Kentucky, i.e., one with Kentucky nexus, which is not otherwise excluded.  See KRS 141.200(9)(e).  For this purpose, a corporation is the same as a corporation for federal income tax purposes.  See KRS 141.010(24)(a).

An in depth discussion of nexus is beyond the scope of this writing.  That said.  What constitutes doing business is statutorily defined in KRS 141.010(25), and includes those corporations: organized in Kentucky; having a Kentucky commercial domicile; owning or renting property in Kentucky; having at least one individual performing services in Kentucky; maintaining an interest in a pass-through entity doing business in Kentucky; deriving income from Kentucky sources including a disregarded single member limited liability company doing business in Kentucky; and, directing activities at Kentucky customers for the purpose of selling them goods and services.  Take a look at the Kentucky Department of Revenue’s Administrative Regulation regarding nexus, 103 KAR 16:240, for additional insight regarding Kentucky income tax nexus. 

An affiliated group is one or more chains of includible corporations connected through stock ownership with a common parent corporation which is itself an includible corporation, provided that: the common parent owns stock constituting at least 80% of the voting power in at least one other includible corporation; and, each includible corporation, excluding the common parent, is owned by one or more of the other corporations.  See KRS 141.200(9)(b).  In its simplest form, a nexus consolidated return is comprised of a common parent corporation that owns at least eighty percent (80%) of the stock of another corporation, its subsidiary, where both corporations are includible corporations. 

Excepted Entities

Not all corporations are includible corporations.  For example, corporations not doing business in Kentucky are not included in the first place.  See KRS 141.200(e). 

Corporations exempt from Kentucky corporation income tax are carved out from the scope of what constitutes an includible corporation.  Exempt corporations include: certain financial institutions; savings and loan associations; banks for cooperatives; production credit associations; insurance companies; corporations exempt under section 501 of the Internal Revenue Code; corporations not organized or conducted for pecuniary profit (i.e., religious, educational, charitable, or like corporations); and, corporations whose only owned or leased property located in Kentucky is located at the premises of a printer with which it has contracted for printing.  See KRS 141.200(9)(e)(1) (referencing KRS 141.040(1)). 

Other corporations excepted include: foreign (i.e., non-U.S.) corporations; possessions corporations; REITs; RICs; and, DISCs.  See KRS 141.200(9)(e)(2)-(6).  Other corporations excepted are: any corporation that realizes a net operating loss with de minimis property, payroll, and sales factors (“de minimis factor loss corporation”); and, any corporation for which the sum of its property, payroll, and sales factors is zero (“zero-factor corporation”).  See KRS 141.200(9)(e)(7) & (8).  These last two exceptions can present interesting quandaries. 

An Example Provides More Clarity

A visual example can somewhat illuminate the affiliated group rules. 

In the Example, assume that Parent has Kentucky nexus and, except for A, so do all of the other corporations.  A cannot be included in the affiliated group because it has no nexus and thus is not an includible corporation.  If A were a corporation excepted from the includible corporation rules (e.g., if A were an exempt corporation), it would likewise not be includible.   

Because E has no parent corporation, E must file its own separate company return.  If E owned 100% of a corporation with Kentucky nexus that was not otherwise excepted, E and that corporation would comprise an affiliated group that would together file a consolidated return. 

In the Example, Parent, along with B, C, D and F form an affiliated group.  F is included in the affiliated group because F is more than 80% owned by one or more of the includible corporations (C & D) in the affiliated group.  

The Bad and Good of the Single Corporation Concept

An affiliated group filing a Kentucky mandatory nexus consolidated corporation income tax return is treated as a single corporation.  See KRS 141.200(11)(b).  All transactions are eliminated in computing net income and apportionment factors.  Id.  Determinations and computations are made in accordance with the federal rules, except as required by differences between the Kentucky and federal rules.  See KRS 141.200(9)(g). 

One glaring negative to the filing of a consolidated return is that, “Includible corporations that have incurred a net operating loss shall not deduct an amount that exceeds, in the aggregate, fifty percent (50%) of the income realized by the remaining includible corporations that did not realize a net operating loss.”  KRS 141.200(11)(b).  It is difficult to find a rational explanation for the loss disallowance here, particularly given the single corporation concept; however, this provision has the potential to be managed.  Moreover, the net operating loss can be carried forward.  Id. 

The filing of a consolidated return is not without benefits.  For example, the disallowance of deductions for intangible expenses, intangible interest expenses, and management fees, provided for by KRS 141.205 does not apply to corporations included in the same Kentucky consolidated return.  It would also seem that the single corporation concept would provide the same result. 

Options and Alternatives

The rules for de minimis factor loss corporations and zero-factor corporations can pose challenges for corporate groups.  Even so, these types of corporations can also pose opportunities, particularly when breaking up a group of corporations into multiple affiliated groups is advantageous. 

Inserting a non-includible corporation into a corporate group can split the group into multiple affiliated groups.  And, removing such a corporation can combine affiliated groups.  Options like these can be considered and explored. 

Other alternatives can produce a similar single corporation effect.  For example, the use of disregarded single member LLCs can result in multiple entities being considered as one entity for both federal and state income tax purposes. 

“Why don’t we have a game of riddles and if I win, you show me the way out of here?”  Bilbo Baggins in The Hobbit: An Unexpected Journey (2012). 

The Kentucky mandatory nexus consolidated return rules can pose both challenges and opportunities for corporate groups.  Better understanding the rules is the first step in overcoming the former and taking advantage of the latter.  



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