At the tail-end of this spring’s tax filing season, the Kentucky General Assembly passed House Bill (HB) 5, which included a retroactive pass-through entity (PTE) tax effective for taxable years beginning on or after January 1, 2022. The Governor signed HB 5 on March 31, making it the law effective immediately.

HB 5 was actually the second version of a PTE tax enacted this year. Exactly one week before the Governor signed HB 5, he signed HB 360, which also contained a provision creating a PTE tax. HB 5 substantially overhauled the PTE tax provisions in HB 360 and made several improvements beneficial to taxpayers.

Kentucky now joins a majority of states that have enacted PTE taxes as a workaround for the cap on the federal deduction for state and local taxes. Prior to the enactment of the Tax Cuts and Jobs Act (TCJA), individuals who itemized deductions on their federal income tax return were allowed an unlimited deduction for state and local taxes paid. The TCJA imposed a $10,000 cap on the deduction for tax years beginning after December 31, 2017, and before January 1, 2026. Because of this cap, some individuals are unable to deduct the full amount of state and local taxes they pay.

State PTE taxes allow (or in rare cases, require) owners of PTEs, such as partnerships and S corporations, to pay state tax at the entity-level. Because PTEs are not subject to the $10,000 cap, the entity can deduct the state taxes paid in full, reducing the taxable income passed through to its owners. State PTE tax structures then provide a full or partial credit to the individual owners of PTEs on their state personal income tax returns equal to their share of the tax paid by the pass-through entity.

On June 5, the Kentucky Department of Revenue (DOR) published forms and instructions related to the PTE tax on its website. Form 740-PTET is used to make the election, file the return, and pay the income tax due at the entity-level. Form PTET-CR is used to report the tax paid on each owner’s behalf to each owner of the PTE. Additional guidance on the tax and credit is expected.

The Basics of Kentucky’s PTE Tax

For taxable years beginning on or after January 1, 2022, an “authorized person” may elect annually, on behalf of an “electing entity,” to pay Kentucky income tax at the entity-level. An “authorized person” is any individual with the authority from the electing entity to bind the entity or sign returns on its behalf. An “electing entity” is a PTE that makes an election to pay Kentucky income tax at the entity level. Under existing law, a “pass-through entity” includes any partnership, S corporation, limited liability company, limited liability partnership, limited partnership, or similar entity recognized by the laws of Kentucky that is not taxed for federal purposes at the entity-level, but instead passes to its owners their proportionate share of income, deductions, gains, losses, credits, and similar attributes.

Although the election is optional, once it is made for a taxable year, it is irrevocable and binding on all entity owners. For taxable years beginning on or after January 1, 2023, the election must be made by the fifteenth day of the fourth month after the close of the taxable year or the fifteenth day of the tenth month after the close of the taxable year for returns filed on extension. Thus, for calendar year 2023, the election must be made by April 15, 2024, unless the entity’s tax return is extended.

For taxable years beginning on or after January 1, 2022, but before January 1, 2023, the election may be made after March 31, 2023, but before August 31, 2024. No late payment, late filing, or similar penalty may be imposed on an electing entity that makes the election before August 31, 2024, and no interest applies to the tax paid by the electing entity.

Estimated Tax Payments

For taxable years beginning before January 1, 2024, an electing entity is not required to make estimated income tax payments, and no estimated tax penalty will be assessed. However, for taxable years beginning on or after January 1, 2024, estimated income tax payments are required, and an electing entity may be subject to penalties if the estimated tax payments are not properly made.

Credits for Entity Owners

Owners of electing entities are entitled to a refundable credit against Kentucky’s individual income tax equal to 100% of their proportionate share of the tax paid by the electing entity. The entity must report to each owner the owner’s proportionate share of tax paid for the taxable year. This provision prevents double taxation at the entity and owner level.

In addition, Kentucky residents who are owners of electing entities doing business in another state in which tax is assessed and paid at the entity-level now are allowed a credit for taxes paid to the other state. The credit is based on the owner’s distributive share of the electing entity’s items of income, loss, deduction, and credit.

An Overly Simplistic Example

To understand the operation of the PTE tax credit an example may be helpful. Assume AB Partnership has two owners, A and B, each of whom own fifty percent (50%). Further assume that the partnership has pass-through income of $100,000. Kentucky income tax on the PTE income is $5,000 ($100,000 x 5%). A and B would each receive a PTE tax credit of $2,500 ($5,000 x 50%).

Because Kentucky income tax is not deductible when calculating Kentucky taxable income, A and B’s taxable share of income from the partnership is $50,000. Kentucky income tax at the rate of five percent (5%) will be $2,500 for each partner. However, each partner will receive the PTE tax credit of $2,500, which means $0 Kentucky income tax will be paid on A and B’s distributable share from the partnership by A and B. As a result, Kentucky income tax is paid only once on the income of the partnership, that is, at the entity-level.

The benefit of the PTE tax election is the reduction of A and B’s federal individual income tax. The federal pass-through income for AB Partnership is $95,000 ($100,000 – $5,000 Kentucky tax). A and B’s individual share of that income is $47,500. Assuming a federal tax rate for both partners of 37%, A and B’s federal income tax liability is $17,575 ($47,500 x 37%) each. Without the PTE tax, their tax liability would have been $18,500 ($50,000 x 37%). Thus, the PTE tax saved each partner $925 in federal individual income tax ($18,500 – $17,575). Please bear in mind that this example is overly simplistic, as noted in the next paragraph.

Other Considerations

PTEs and their owners will need to consider several factors when deciding whether to elect to pay tax at the entity-level, including 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.

If you have questions regarding Kentucky’s PTE tax and whether it could benefit you, contact your Dean Dorton tax advisor or other professional.

For questions regarding this article, please contact Erica Horn.