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Tax in the Bluegrass: Kentucky's LLET

It’s tax season and so it seems appropriate to focus on this specific tax for this installment of Tax in the Bluegrass.

Perhaps the biggest changes in Kentucky income tax this upcoming filing season are that, effective for the 2007 tax year, pass-through treatment has been restored to pass-through entities and C corporations are "redefined" to solely be C corporations – just common sense really. In a nutshell, this means that a traditional C corporation will be the only type of entity subject to the Kentucky corporation income tax; likewise, a C corporation is the only type of entity (other than a disregarded single member limited liability entity [a DESMLLC for short], which is treated as a division of its C corporation owner) includable in a Kentucky consolidated return. In a sense, many might consider this to be a return to normality.

Despite this sea change reversal in the corporation income tax arena, the big buzz seems to be about one of the newest taxes in Kentucky, the Limited Liability Entity Tax, a tax that CPAs and other tax practitioners commonly refer to as the LLET and which is intertwined with Kentucky’s income tax scheme. As an aside, I try to stay away from abbreviations and acronyms, but the ones that will be used in this article are, I think, quite standard.

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 (a "LLPTE" – yes, another abbreviation/acronym), such as a limited liability company ("LLC" – we’re on a roll here) or an S corporation doing business in Kentucky. Of great importance to many, 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 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 $1,000,000 of Kentucky gross receipts and $7,500 per $1,000,000 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, nor does a qualified investment partnership (a "QIP"), a pass-through entity that, during the taxable year, holds only investments that produce income that would not be taxable to a non-resident individual if held or owned individually, for example, stocks and bonds. 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? A DESMLLC is neither a corporation nor a pass-through entity − it’s disregarded. For an individually owned DESMLLC, in its Nov. 9, 2007 draft Instructions for Form 725, the Department of Revenue 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 November 3, 2007 draft Instructions Form 720, the Department appears to have taken a similar position for a DESMLLC owned by a corporation.

Following the federal tax treatment makes sense. From a theoretical standpoint, as 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. Please note that the Department has not taken a final position on this treatment, so prudence suggests that you should check the final Instructions as it is not anticipated that the Department will promulgate an Administrative Regulation to address the LLET.

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 general, it is my observation that at least in my practice and likely in yours too, the Department has been administering the "doing business" nexus standard very broadly. 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.

Query, while concededly the LLET is imposed in a statute separate from Kentucky’s corporation and personal income taxes, with the credits it provides, the LLET functions a lot like a "floor" for Kentucky’s income taxes. Therefore, Public Law 86-272 could apply, correct? Draw your own conclusions.

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 years 2007. What constitutes "gross receipts" could be a big issue for some companies. In this regard, the Administrative Regulation on the Sales Factor can provide some guidance.

For calendar year 2007, for apportionment purposes, gross receipts, and, thus, gross profits, flow up from a LLPTE and certain general partnerships (those organized or formed after Jan. 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/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 their 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.

About the author: Mark A Loyd, Esq., CPA, is an associate in thetax and finance practice group of Greenebaum Doll & McDonald in Louisville. He is a member of the KyCPA board of directors, editorial board and industry task force; and former chair of the taxation committee. He can reached at mal@gdm.com; 502.587.3552.

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