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Accounting: Making the Most of Tax Reform

Kentucky is becoming more business friendly, but it takes a pro to maximize this ‘friendship’

By Mark Green

Kentucky is one of the states at the fore of tax reform, shifting from income tax to consumption tax as its revenue cornerstone. The tax reform laws now on the books aim to take the income tax to zero, a transition that will take place over time, in one-half-percentage-point annual decreases, and only when revenue and state budget surplus targets are achieved.

In contrast, when Kansas abruptly eliminated the tax on pass-through income a decade ago, the decision proved unwise both financially and politically. Swaths of businesses and individuals reclassified themselves as pass-through entities. Nine rounds of state budget and public service cuts were followed by the governor’s resignation and tax increases.

With many states in the process of adjusting their tax rates and which commercial activities are taxed, it takes expertise to comply with tax filings while aiming for lower obligations.

“We’re always looking for opportunities to apply changes in the tax law whether that be at the state or the federal level,” said Byron Largen, a partner in the Louisville office of Cherry Bekaert. Cherry Bekaert is a national professional services firm that last year acquired Louisville-based Mountjoy Chilton Medley, where Largen worked for 24 years. “The difficulty is that a lot of the laws that are getting passed become retroactive. They would pass something in 2023 that was retroactive to 2022 or they could pass something in ’24 that would have impact upon 2023 filings.”

The income tax rate reductions Kentucky has applied already and look likely to continue in coming budget years probably will bring the commonwealth recognition as a tax-haven state like Florida, Tennessee and Texas, said Chris Kramer, a tax partner with FORVIS.

And FORVIS is making recommendations to clients about how to improve their tax position.

“Tax-rate reductions in Kentucky provide for year-end tax planning opportunities, where deferral of gains and taxable income into the lower rate year produce permanent tax savings,” Kramer said. “Income deferrals may be accomplished by delaying taxable gain transactions across taxable years, use of gain recognition deferral techniques (installment sale deferrals, for example), and tax accounting method changes.”

Kramer made some criticism, though.

While Kentucky enacted small-business friendly Pass-Through Entity (PTE) legislation like most states, the state Department of Revenue is applying an interpretation of the applicable PTE tax base “that seems needlessly punitive to small-business owners living in Kentucky, because it results in more federal tax owed by Kentucky business owners while not providing Kentucky with additional revenues.”

Lisa DeVaughn Foley, managing member of Baldwin CPAs, cites the retroactive application of the pass-through tax rate as beneficial but a move that “caused quite the administrative burden.”

Overall, Foley said, the change is welcome as now businesses will be able to deduct the state income tax on the federal level. That deduction had been essentially eliminated with the Tax Cuts and Jobs Act of 2017 that limited individual tax deductions to $10,000 as an itemized deduction.

“Other states addressed this early on after 2018, but Kentucky did lag behind four years compared to other states on this change,” she said. “As of now, this limitation at the federal level is slated to expire at the end of 2025 so it will be interesting to see how long this benefit Kentucky reacted to will remain viable.”

Kentucky’s expansion in the sales-and-use tax applications has led Baldwin to work with its clients to make sure they update their systems properly to collect tax on new services and changes that have been enacted.

“I anticipate we will see more audits in the sales tax area to improve compliance with all the changes,” Foley said, “and I expect small businesses to owe more under these audits than in the past until the compliance and education about the many changes becomes more widespread.”

Tax planning continues to be more complex, she said. Most businesses now touch multiple states in their revenues, and the tax laws and rates that apply to each state are very different. Planning appropriately for state and local apportionments is a key part of what Baldwin does for clients.

“Kentucky has one of the most cumbersome local tax compliance systems in the nation,” Foley said. “We have construction companies that travel the state and end up filing 80-100 local tax returns given the 120-county make-up of Kentucky. It is hard to explain to business clients that we spend more time on 100 local returns with tax rates of 0.75% to 2.5% rather than on their federal and state compliance that normally approaches 40% rates.”

Kentucky is among the majority of states that have enacted PTE taxes as a workaround for the cap on the federal deduction for state and local taxes, said Melissa Hicks, tax director for Dean Dorton.

Hicks said pass-through entities and their owners need to consider several factors when deciding whether to elect to pay tax at the entity-level. Those factors include the state of residence of the entity’s owners, whether the PTE does business in other states, whether nonresident owners are able to claim a credit for PTE taxes paid to Kentucky, and other credits available to the PTE or its owners.

“Changes in tax law are always expected,” Hicks added, “which is why it is absolutely necessary to have a tax advisor who understands your business, your unique needs, and your industry to proactively advise you regarding your individual scenario and goals, personally or as a business.”