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Tax Issues Faced by Small Businesses

The Kentucky CPA Journal / Issue 3 2010

Tax in the Bluegrass


July 2010


All Kentucky businesses face state and local tax issues, even small businesses. While the term “small business” might suggest a sole proprietorship or a “mom and pop” retail store, it can encompass retailers, wholesalers, manufacturers and service providers with millions of dollars of gross receipts and assets. And, while a business might be “small,” issues resulting from tax law changes, tax compliance and tax administration can potentially have a significant impact on such a business. Following are a few tax issues among others that, in the author’s view, are now faced by Kentucky small businesses as a whole.

Potential sales tax on services 

The 2010 Kentucky General Assembly seriously considered the option of expanding Kentucky’s sales and use tax to impose tax on nearly all services. For example, though not enacted, HB78 would have expanded the sales tax to nearly all services and, along the same lines but more narrowly, HB13 would have expanded the sales tax to janitorial, security, landscaping, garment alteration and pest control services. 

Aside from the obvious increase in costs to purchasers of services that a tax thereon would create, Kentucky small businesses that provide services will face multiple issues if the Commonwealth expands the sales tax to encompass services sometime in the future. For example, small service businesses with simple point-of-sale systems will need to upgrade or modify these in order to compute and collect sales tax on their sales of taxable services. Another issue will be the almost inevitable uncertainty as to whether certain services would be subject to sales tax or whether sales tax exemptions would apply. Small businesses would also need to put systems in place to document exempt sales and to keep this documentation. 

Although the General Assembly chose not to expand the sales tax to services during the Regular Session, this issue may resurface, perhaps even later this year. If it does, small businesses, and service businesses in particular, should consider contacting their legislators to let them know what their thoughts are on this issue. They might also keep this possibility in mind when purchasing point-of-sale systems in the upcoming year. 

Lack of detailed administrative tax regulations with examples 

Small businesses need clear guidance to comply with Kentucky’s tax laws in addition to the tax statutes themselves. While this need exists for every tax - whether it be income, property, sales tax, etc. - it is particularly important for a Kentucky small business to have accessible and extensive guidance that can be relied upon from the Kentucky Department of Revenue regarding sales tax exemptions. This is because many small businesses sell to consumers; so, if a small business does not collect sales tax when the sale is made and the Department later determines on audit that the sale was not exempt, it is then often either impossible or impractical for the small business to go back to its customers and collect sales tax. 

Up until the early 2000s, the Department published Revenue Policies and Circulars that somewhat met this need. Since it stopped this practice, however, there have been quite a few law changes in Kentucky’s tax laws. Of particular note, Kentucky’s income tax was “modernized” in 2005 and underwent another extensive round of revisions, effective in 2007. The 2003 General Assembly also enacted legislation, which went into effect on July 1, 2004, that implemented the Streamlined Sales and Use Tax Agreement (SSUTA) - a multi-state agreement with sales tax uniformity among the States as one of its goals. Kentucky continues to “tweak” its sales tax laws to remain in compliance with SSUTA. Numerous other tax law changes have been enacted. 

It has been my observation that issues often arise on audit in the area of sales and use tax exemptions related to manufacturing, many of which have been part of Kentucky’s sales tax law since its inception. For example, German Cuisine, LLC v. Finance and Administration Cabinet, No. K07-R-03 (KBTA), on appeal, Civil Action No. 09-CI-372 (Franklin Cir. Ct. Div. II), concerns the question of whether a butcher shop’s purchases of meat processing equipment are exempt from sales and use tax pursuant to the machinery for new and expanded industry exemption of KRS 139.480(10). It is also not uncommon for small businesses engaged in manufacturing and the Department to disagree on the application of the exemptions for manufacturing and industrial materials, supplies and industrial tools provided by KRS 139.470(11). 

When the General Assembly amends Kentucky’s tax laws, disputes often arise between small businesses and the Department. Changes in the sales tax exemptions for medical items provided by KRS 139.472 have sparked quite a bit of litigation in recent years.King Drugs, Inc. v. Department of Revenue, 250 S.W.3d 643 (Ky. 2008) is but one case example. Disputes regarding KRS 139.472 continue to arise. 

Another area to watch is the exemption for food provided by KRS 139.485, which was amended in conjunction with Kentucky’s adoption of SSUTA. Small grocers and food sellers have no administrative tax regulation on which to rely for this exemption, and this can cause tremendous problems for these businesses when the Department and the small business taxpayer come to different conclusions as to the food exemption’s application. 

The KyCPA and its Tax Committee has been particularly concerned with the absence of examples in recent administrative tax regulations. In part, through the KyCPA Tax Committee’s efforts, the 2010 General Assembly recently enacted S.B. 158, which amends KRS 131.130(1) to include examples in administrative tax regulations including demonstrative, non-exclusive lists of items to assist taxpayers in understanding and interpreting tax laws. Hopefully, the Department will act to promulgate tax regulations with helpful examples in the near future. Watch out for these. 

Retroactive tax legislation 

In recent years, the General Assembly has enacted legislation that retroactively changes tax laws. For example, 2008 H.B. 704 and 2009 H.B. 216, which repealed and reenacted H.B. 704, retroactively changed the date on which interest accrues on tax refunds (see KRS 131.183) which resulted in a retroactive loss of interest to taxpayers with outstanding refund claims. The retroactive effect of this legislation has been judicially challenged. 

Miller v. Johnson Controls, Inc., 296 S.W.3d 392 (Ky. 2009) is another example of a judicial challenge to retroactive legislation. The subject of the challenge in Johnson Controls is Kentucky corporate tax legislation enacted by the 2000 General Assembly which barred the issuance of corporate income tax refunds related to combined tax returns filed under the unitary business concept for years prior to 1995. A divided Kentucky Supreme Court rejected the challenge, but the involved taxpayers have petitioned the United States Supreme Court to hear the case. 

Some states, like Ohio, have a constitutional amendment that bars retroactive legislation. Kentucky has no explicit ban, and although it would seem that certain provisions of the Kentucky Constitution should operate against it, taxpayers have, so far, unsuccessfully argued against this practice. 

The problem that retroactive tax legislation like this poses to small businesses is that it changes the rules after the fact. It makes it difficult for small businesses to make informed decisions about tax positions. Moreover, the prospect of retroactive tax legislation that extinguishes pending tax refunds incentivizes small business taxpayers to not pay tax on an uncertain position and defend it on audit rather than to pay the tax and request a refund. 

Concluding thoughts 

“The hardest thing in the world to understand is the income tax.” Albert Einstein. 

From this quote, one can infer that understanding taxes was a struggle, even for one of the smartest human beings who ever lived. The quote is a bit vague. Was Einstein referring to newly enacted tax laws, the application of tax laws to the myriad of factual situations or to the reasoning behind retroactive tax law changes? Regardless, Einstein’s observation could just as easily have been made by a Kentucky small business taxpayer. 

About the author: Mark A Loyd, Esq., CPA, is a member of Greenebaum Doll & McDonald in Louisville and chairs its State and Local Tax Team. He is a member of the KyCPA board of directors; chair of the editorial board; member of the industry task force; and former chair of the taxation committee. He can reached at mal@gdm.com; 502.587.3552

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