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Beware of the Kentucky NOL Apportionment Flip-Flop

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Inicio Perspectivas Beware of the Kentucky NOL Apportionment Flip-Flop
Kentucky’s 2019 adoption of mandatory unitary combined reporting was not the state’s first major corporate tax reform in the 21st century. In 2005, Kentucky overhauled its corporate tax regime to switch from separate-company reporting to mandatory nexus consolidated reporting. This alert focuses on that 2005 overhaul and highlights a potential problem for taxpayers that carried separate-company NOLs into nexus-consolidated tax years.

For separate-company filers, Kentucky NOLs were computed and carried forward on a post-apportionment basis. In contrast, for nexus-consolidated filers, NOL computations were done on a pre-apportionment basis. In 2006, the Department of Revenue amended its NOL regulation (103 KAR 16:250) to establish rules for how a separate-company NOL could offset income on a consolidated return. Those new rules applied “if a corporation that previously filed a separate return and incurred net operating losses as a separate entity, will now be filing as part of a consolidated nexus return.”1

Specifically, to transition from a separate-company, post-apportionment, NOL regime to a nexus-consolidated, pre-apportionment, NOL regime, the Department’s regulation provided that “[t]he net operating loss carryforward shall be adjusted to a pre-apportionment amount unless an election has been made to utilize the net operating loss carryforward as an apportioned amount.”2 So, under the regulation, the default rule was that separate-company post-apportionment NOLs were converted to pre-apportionment NOL amounts, unless the taxpayer elected out of that conversion. This is where a problem arises.

Despite the availability of the election to continue to “utilize the net operating loss carryover as an apportioned amount,” the Department’s implementation of the rule (in tax return forms, etc.) did not make any provision for this election. Instead, the Department prohibited corporations filing mandatory nexus returns from deducting any post-apportionment NOLs from the net income apportioned to Kentucky.3 As a result, the Department required that a taxpayer who elected to retain post-apportionment NOLs must nonetheless still deduct those NOLs from pre-apportionment income.

This begs the question—why did the Department offer this election at all? If the NOL was to be deducted from pre-apportionment income of a nexus consolidated filing group, why would any taxpayer elect to deduct the post-apportionment NOL amount? After all, the default rule would have resulted in a larger (i.e., pre-apportionment) NOL deduction.

We do not think taxpayers should be required to deduct post-apportionment NOLs from pre-apportionment income. Otherwise, the NOL deduction will fail to achieve its intended purpose.4 If you have encountered this problem, we would be happy to discuss this with you further.

  1. 103 KAR 16:250 Section 2(3) (2006).
  2. 103 KAR 16:250 Section 2(3)(b) (2006).
  3. See, e.g., Instructions to Kentucky Corporation Income Tax Return, p. 10 (“Line 21—If the corporation is filing a mandatory nexus consolidated return, enter zero (-0-).”), available at revenue.ky.gov.
  4. See, e.g., Libson Shops, Inc. v. Koehler, 353 U.S. 382, 386 (1957) (NOL provisions “were enacted to ameliorate the unduly drastic consequences of taxing income strictly on an annual basis. They were designed to permit a taxpayer to set off its lean years against its lush years, and to strike something like an average taxable income computed over a period longer than one year.”); Commonwealth v. Southwire Co., 777 S.W.2d 598, 601 (Ky. App. Ct. 1989) (“The obvious reason for allowing a net operating loss deduction is to afford a corporation the opportunity to average income.”). 

Client Alert 2021-123