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Kentucky’s limited liability entity tax

One of the newest taxes in Kentucky is the Limited Liability Entity Tax (LLET), and its application can affect an entity’s Kentucky income tax.

So, what is the LLET anyway? Mechanically, it is a tax on the Kentucky gross receipts or gross profits (i.e., gross receipts less cost of goods sold, as that term is statutorily defined, of certain businesses that sell tangible property) of each corporation and limited liability tax pass-through entity (LLPTE), such as a limited liability company (LLC) or an S-corporation, doing business in Kentucky. There is a “small business” exemption for each business with total gross receipts or gross profits from all sources of less than $3 million (measured on a combined group basis), which is phased out between $3 million and $6 million, so that taxable entities with gross receipts and gross profits greater than $6 million pay the full LLET. Accordingly, many “mom and pop” type businesses will most likely not be subject to the LLET.

Putting the LLET’s impact in perspective, its tax rate is $950 per $1 million of Kentucky gross receipts and $7,500 per $1 million of Kentucky gross profits. However, there is an absolute “minimum” tax of $175 on each corporation and LLPTE.

Sound familiar? In many respects the LLET is the progeny of the Alternative Minimum Calculation (often referred to as the AMC) which was in effect essentially for the 2005 and 2006 calendar tax years. One important distinguishing feature is that the LLET is creditable against LLET and the income tax – more on credits for LLET later.

There are many entities to which the LLET does not apply. For example, a general partnership does not have to pay the LLET because it is neither a corporation nor a LLPTE. Likewise, a qualified investment partnership (QIP) does not have to pay LLET. It is not uncommon to see a family limited partnership structured to qualify as a QIP.

Examples of entities exempt from the LLET include financial institutions (and like entities), insurance companies, tax exempt organizations (including religious, educational and charitable organizations), public service corporations, personal service corporations and others. See the pattern? Generally, companies subject to industry specific taxes (e.g., banking or insurance) and most non-profits do not pay LLET. There is also an exclusion from the LLET tax base of a LLPTE’s proportionate share of gross receipts or gross profits attributable to the ownership share of a qualified exempt organization, (i.e., an entity exempt from the LLET).

What about a disregarded single member limited liability company (DESMLCC)? A DESMLLC is neither a corporation nor a pass-through entity — it’s disregarded. For an individually owned DESMLLC, the Department of Revenue (Department), in its Instructions for Form 725, appears to have taken the position that a DESMLLC owned directly by an individual is a taxable entity subject to the LLET, whereas a lower-tier DESMLLC owned by another DESMLLC is disregarded. In its Instructions for Form 720, the Department appears to have taken a similar position for a DESMLLC owned by a corporation (i.e., it is disregarded).

Adhering to the federal tax treatment makes sense. From a theoretical standpoint, if a DESMLLC is “disregarded,” it would also seem to make sense that it would not be subject to LLET independent of its owner as either a corporation or a LLPTE, but rather subject to LLET only as a part of its owner.

As with the corporation income tax, a non-exempt corporation or LLPTE is subject to the LLET, provided that it is “doing business” in Kentucky. In this regard, an activity that causes a corporation or LLPTE to have nexus for income tax purposes will also cause that entity to have nexus for the LLET.

However, and importantly, the Department appears to have taken the position that Public Law 86-272, a federal law which protects taxpayers from the imposition of income-type taxes when the taxpayer solely engages in protected activities related to the solicitation of orders in a state to be filled from out-of-state, does not apply to protect a taxpayer from the imposition of LLET. Thus, it is the Department’s position that a taxpayer can be subject to LLET, but not income tax.

Regarding the LLET’s tax base, it is important to understand that Kentucky gross receipts and gross profits derive from the apportionment provisions of Kentucky’s corporation income tax, which have changed for calendar tax year 2007.

What constitutes “gross receipts” could be a big issue for some companies. On this issue, the Administrative Regulation on the Sales Factor can provide some guidance.

For calendar year 2007, and for apportionment purposes, gross receipts and, thus, gross profits, flow up from a LLPTE and certain general partnerships (those organized or formed after January 1, 2006) to their owner. This would result in multiple levels of tax on essentially the same gross receipts; however, the owner of an LLPTE receives a current year nonrefundable credit for the proportionate share of LLET paid by the lower-level LLPTE (less the $175 minimum) on gross receipts and gross profits passed through to its owner. The credit applies across multiple layers of multi-layered organizational structures.

An LLPTE owner is also allowed a non-refundable credit against the owner’s current year Kentucky income tax on income from the LLPTE for its proportionate share of the LLPTE’s LLET for the current year, after subtraction of any credits and reduced by the $175 minimum. Also, a corporation receives a nonrefundable credit for LLET (less the $175 minimum) against its current year Kentucky corporation income tax due from its activities in Kentucky. Any remaining unused LLET credit is lost and cannot be carried forward.

Bottom line, the LLET is not generally a problem for a reasonably profitable business because the LLET credit against the income tax will ordinarily be fully utilized. The LLET really becomes an issue for low margin businesses, businesses with very high levels of gross receipts, and cyclical businesses that generate profits in some years and losses in other. In these situations, the gross profits measure may provide some relief; however, a taxpayer in such a situation may end up with unused LLET credits, which unfortunately, must be used or lost. In this regard, many would like the ability to carry forward LLET credits – kind of like net operating losses.

One parting thought – the LLET rules are in their infancy. There are no administrative regulations, and as such, the rules are in flux.

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