As part of the effort to phase out the Kentucky individual income tax, in April 2022, Kentucky House Bill 8 (“HB 8”) passed – over the Governor’s veto – and expanded the sales and use tax base to include over 30 consumer and business-to-business services, with an emphasis on short-term services. The new taxes take effect on January 1, 2023. These changes follow the nationwide trends to expand consumer taxes, often by taxing services, and cut income taxes. The Kentucky Department of Revenue (“KDOR”) has provided some informal guidance on the substantial changes made by HB 8; however, many questions remain unanswered, including practical issues in compliance.
SERVICES NOW SUBJECT TO KENTUCKY’S SALES AND USE TAX
The newly taxable services are:
- non-medical and nondental health photography and photofinishing services;
- marketing services;
- telemarketing services;
- public opinion and research polling services;
- lobbying services;
- executive employee recruitment services;
- website design and development services;
- website hosting services;
- facsimile transmission services (currently taxable as communication services);
- private mailroom services;
- bodyguard services;
- residential and non-residential security system monitoring services;
- private investigation services;
- process server services;
- repossession of tangible personal property services;
- personal background check services;
- parking services that are not located at an educational institution;
- road and travel services provided by automobile clubs;
- condominium time-sharing exchange services;
- rental of space for short-term business uses, entertainment events, and short-term social events (i.e., a rental for less than 30 days);
- social event planning and coordination services;
- leisure, recreational, and athletic instructional services;
- recreational camp tuition and fees;
- personal fitness training services;
- nonmedical massage services;
- cosmetic surgery services;
- body modification services;
- non-medical, non-educational, and non-veterinarian testing services;
- interior decorating and design services;
- household moving services;
- specialized design services;
- lapidary services;
- labor and services to repair or maintain commercial refrigeration equipment and systems when no tangible personal property is sold in that transaction;
- labor to repair or alter apparel, footwear, watches, or jewelry when no tangible personal property is sold in that transaction;
- and prewritten computer software access services.
The $6,000 de minimis threshold in KRS 139.470(23) applies to these newly taxable services.
Businesses selling these high growth, high consumption services must now register with KDOR and collect the 6% sales tax from their customers. Taxable service providers are required to file monthly or annual returns and remit the tax.
Businesses should be careful to understand which charges associated with a taxable service are the responsibility of the service provider versus those charges that are passed on to the customer. Service providers may, in some instances, issue a resale certificate for the purchase of tangible personal property that transfers to the customer. For example, an interior designer may issue a resale certificate for the purchase of tangible personal property that transfers to the customer, e.g., drapes, blinds, and wallpaper. However, if the interior decorating and design provider performs a turn-key project and bills for all project charges, then the bill is subject to the 6% sales and use tax. For example, improvements to real property performed by or on behalf of the interior decorator, that is billed to the customer, is considered the taxable retail sale of the interior decorator’s services.
Following the trend in expanding taxable transactions, HB 8 changed the definition of “extended warranty services” to include warranty contracts for real property and all contracts for tangible personal property and digital property—regardless of whether the property is taxable or exempt. For example, a separately charged extended warranty on farm equipment (an exempt property) will no longer be exempt from sales and use tax. However, if the extended warranty was purchased by a tax-exempt purchaser, then it may still be exempt from the sales and use tax. HB 8 also amended the exemption from sales and use tax for residential electricity, natural gas, fuels, water, and sewer services to require the service be declared by the resident as used in the resident’s domicile.
THE TREND TOWARD TAXING SERVICES
There are a few notable trends among the newly taxable services.
Internet-related services appear to be a target among the newly taxable services. These include telemarketing services; website design and development services; website hosting services; and prewritten computer software access services.
Kentucky’s changes are in line with the recent nationwide tax trends. According to the Tax Foundation (available at 2023 State Tax Changes, Effective January 1, 2023, | Tax Foundation), Kentucky is among thirty-eight states that had noteworthy tax changes take effect on January 1, 2023. However, while it follows the recent nationwide trend of income tax rate deductions, Kentucky’s recent tax changes break from the pack in a few ways. Specifically, of the eleven states that had individual income tax rate reductions take effect, Kentucky is the only one to pay for the reductions by expanding its sales tax to select services.
These changes allow Kentucky to obtain revenue from previously unavailable sources of tax revenue. Take for example the newly taxable lobbying services. According to KDOR, the sales and use tax on lobbying services is based on where the customer receives the service. [KDOR Tax Answers, Lobbying Services (available at Lobbying Services – TAXANSWERS (ky.gov))]. Accordingly, a lobbying provider located in Washington, D.C. lobbying on behalf of a Kentucky client would charge the Kentucky sales and use tax because the client is receiving or making first use of the service in Kentucky. Previously, Kentucky likely could not obtain tax revenue from such a transaction unless it could show the D.C. based lobbying provider owed Kentucky income taxes.
Now, these tax changes allow Kentucky to tax the money leaving the state in this scenario by shifting the source from where the service is performed to where the benefit is received. The new taxes thus bring up thorny questions of nexus and other constitutional concerns.
The wedding industry is among the industries that are most heavily impacted by these changes. Specifically, by expanding the sales and use tax base to include lapidary services, social event planning services, specialized design services, photography services, and rental of space for weddings (and other short-term uses), the sales tax now applies to transactions for services concerning the purchase of engagement and wedding rings, wedding planners, the designing of wedding dresses, engagement and wedding photographs, and rental for the wedding reception, respectively. As with many of the newly taxable services, these wedding-related services often also involve the sale of tangible personal property, and service providers will need to be circumspect in creating correct invoices and charging the proper sales tax.
DESPITE AVAILABLE ADMINISTRATIVE GUIDANCE, QUESTIONS REMAIN
KDOR has provided guidance on the new taxes in Kentucky Sales Tax Facts (June 2022) and Kentucky Sales Tax Facts (September 2022). [KDOR New Tax Facts (available at Sales Tax Facts – Department of Revenue (ky.gov))]. Additional guidance may be found at TaxAnswers.k-y.gov. The guidance tackles some of the specific services included in HB 8, but it does not address them all.
In its guidance, KDOR states that apparel, footwear, watches, or jewelry repair or alteration service charges—where the material used for the repair or alteration is less than 10% of the total charges—are taxable because the transaction is no longer bundled (i.e., both the materials used and the labor charges are taxable). Similarly, repair or maintenance charges on commercial refrigeration equipment and systems—even if the installed parts are less than 10% of the total charge—are taxable.
The commercial refrigeration tax only applies to the repair and maintenance; it does not apply to the sale and installation of new commercial refrigeration equipment. The tax treatment of an original installation is dependent on whether the equipment and system will be fixtures to real property or will be free standing tangible personal property post-installation.
KDOR also specified that charges for street parking and parking provided by city, county, and state governments or nonprofit entities are subject to the new parking services sales and use tax. If the customer receives a receipt, then the parking service provider must display the amount of sales tax collected on the transaction. If receipts are not available or the parking service is coin-only meters or cash-only lots, then the tax may be added to the sales price as one charge. Lastly, although parking services at educational institutions are exempt from the tax, parking services for athletic events occurring off of the campus is subject to the tax.
However, many questions remain unanswered. HB 8 includes specific statutory definitions for only some of the additional services, thus leaving several of the newly taxed services undefined. In such instances, KDOR appears to endorse dictionary definitions. [See, e.g., KDOR Tax Answers, Lobbying Services (explaining that while there is no definition of lobbying services in KRS Chapter 139, “Webster’s Dictionary provides helpful guidance.”) (Available at Lobbying Services – TAXANSWERS (ky.gov))]. While the guidance sheds light on compliance issues for some of the newly taxable services, taxpayers will likely have to wait for fulsome regulations in order for all of their questions to be addressed.
These changes will likely increase the challenges of managing a business’s sales and use tax in the post-Wayfair world. The United States Supreme Court’s decision in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080; 201 L. Ed. 2d 403 (2018) eliminated the physical presence safe harbor for sales taxes, after which most states adopted a sales tax economic nexus standard similar to that of South Dakota, i.e., $100,000 in sales or 200 transactions in a year.
Retailers that sell tangible personal property must already constantly review their obligations for registration, collection, and filing; Kentucky now expands that reach to retailers selling taxable services.
The lack of clear answers to questions like those mentioned above emphasizes the likelihood of practical issues in compliance. For example, there are several services which are taxable, unless they are necessary for medical or dental health. Specifically, these services include photography and photo finishing services; massage services; cosmetic surgery services; body modification services; and testing services. However, HB 8 does not provide a definition or standard of when any of these services are “medically necessary”. The medical necessity of these services may not always be clear and will likely require a fact intensive analysis. In these situations, such service providers will find themselves in uncharted territory with minimal guidance for determining when these services are medically necessary, and what information could be required to prove so in an audit.
A business does not want to be in the position of having under-collected sales tax so that it is left bearing the burden of under-collected sales tax on audit. Conversely, a business does not want to over collect sales and use tax on purchases so that its customers are paying more than what is owed.
HB 8 creates significant changes to Kentucky’s Sales and Use Tax by expanding the sales and use tax base to include over thirty (30) additional consumer and business-to-business services. While it remains to be seen whether these changes will help or hurt Kentucky’s economy, it is clear that this next evolution of Kentucky’s tax laws brings with it new challenges for Kentucky taxpayers to navigate. Taxpayers with questions about how HB 8 may affect their tax obligations in Kentucky should consult with their tax advisors.
January 26, 2023