How does HB 2117 exempt certain business income from Kansas tax while adding back related losses and deductions?

Plain-English summary

Kansas Notice 12-11 explains the centerpiece of 2012 House Bill 2117: new income tax modifications that exempt certain business income from Kansas tax while requiring related losses and deductions to be added back. Section 12 adds five addition modifications in K.S.A. 79-32,117(b)(xix)-(xxiii) and one subtraction modification in (c)(xx), effective for tax years beginning after December 31, 2012.

Exempt income -- subtraction modification (c)(xx). Three cumulative categories of income may be subtracted (and are thus exempt from Kansas income tax):

1. Net profit from a business -- reported on federal Schedule C and line 12 of Form 1040. (Schedule C is available only to sole proprietors, disregarded single-member LLCs, and statutory employees; ordinary W-2 employees do not qualify.)
2. Net income from certain entities and types -- rental real estate, royalties, partnerships, S corporations, estates, trusts, REMIC residual interests, and net farm rental -- reported on Schedule E and line 17.
3. Net farm profit -- reported on Schedule F and line 18.

Income must be properly reported on the correct federal schedule and line to qualify. Income from an LLC treated as a partnership qualifies (K.S.A. 17-76,138 classifies an LLC as a partnership unless classified otherwise federally). A professional corporation (K.S.A. 17-2706 et seq.) qualifies only if it has made an S corporation election.

Added-back losses and deductions -- addition modifications (b)(xix)-(xxiii). Because those categories are exempt, related losses in the same categories must be added back (b)(xix), and the following deductions must be added back:

• (b)(xx) one-half of self-employment taxes (IRC 164(f))
• (b)(xxi) self-employed retirement plan contributions (IRC 62(a)(6))
• (b)(xxii) self-employed health insurance (IRC 162(l))
• (b)(xxiii) domestic production activities deduction (IRC 199)

Overall effect. The changes exempt certain categories of business income without allowing related losses and deductions to offset other taxable income.

Date note. The notice bears no printed issue date; it is dated to mid-2012 by its position in the 2012 notice sequence (after Notice 12-01, June 11, 2012, and before Notice 12-15, July 19, 2012).

What this means for you

Sole proprietors and pass-through owners

• Net profit reported on Schedule C (line 12), Schedule E (line 17), or Schedule F (line 18) may be subtracted and is exempt from Kansas income tax, if properly reported.
• Losses in those same categories must be added back, so exempt-category losses cannot offset other Kansas income.
• Add back self-employment tax, self-employed retirement, self-employed health insurance, and domestic production deductions.

LLCs and professional corporations

• An LLC treated as a partnership for federal purposes qualifies; a professional corporation qualifies only if it elected S corporation status.

W-2 employees

• Wages reported on a W-2 (other than statutory employees) do not qualify for the business income exemption.

Common questions

What income becomes exempt? Net profit from a business (Schedule C), certain Schedule E income, and net farm profit (Schedule F), if properly reported on the correct line.

Can I still deduct losses from those businesses? No -- related losses in the exempt categories must be added back.

Does LLC income qualify? Yes if the LLC is treated as a partnership federally; a professional corporation qualifies only with an S corporation election.

Do wages qualify? No -- ordinary W-2 wages are not eligible for the business income exemption.

Citations and references

• K.S.A. 79-32,117(c)(xx) -- subtraction modification exempting Schedule C, E, and F business income (Section 12).
• K.S.A. 79-32,117(b)(xix)-(xxiii) -- addition modifications for related losses and for self-employment tax, self-employed retirement, self-employed health insurance, and domestic production deductions.
• K.S.A. 17-76,138 -- an LLC is classified as a partnership unless classified otherwise for federal income tax purposes.
• K.S.A. 17-2706 et seq. -- professional corporations; qualify only with an S corporation election.

Source

• Landing page: Kansas Department of Revenue Policy Information Library
• Original document: Notice 12-11

Original ruling text

Policy & Research Phone: 785-296-3081
915 SW Harrison St FAX: 785-296-7928
Topeka KS 66612-1588 www.ksrevenue.org
Nick Jordan, Secretary Department of Revenue Sam Brownback, Governor
Richard Cram, Director

                                      NOTICE 12-11

                                  KANSAS INCOME TAX

              CHANGES TO ADDITION AND SUBTRACTION MODIFICATIONS

                          INCOME EXEMPT FROM KANSAS TAX

Generally

  The calculation of an individual's Kansas income tax starts with federal adjusted gross

income. Certain modifications, either additions or subtractions, required by K.S.A. 79-32,117
are then made to arrive at Kansas adjusted gross income.

  During the 2012 Legislative Session House Bill 2117 was passed and signed into law.

Provisions in Section 12 of the Bill add five new addition modifications and one new subtraction
modification to K.S.A. 79-32,117. The overall effect of these new provisions is to exempt
certain categories of income from Kansas income tax.

Changes In The Law

                                 Addition Modifications

  K.S.A. 79-32,117(b) lists the items that are to be added in determining Kansas adjusted

gross income. Section 12 of the Bill provides 5 new addition modification in subsection (b)(xix),
(xx), (xxi), (xxii), and (xxiii). These new sections read as follows:

        (b) There shall be added to federal adjusted gross income:

       (xix) For all taxable years beginning after December 31, 2012, the amount of
 any: (1) Loss from business as determined under the federal internal revenue code
 and reported from schedule C and on line 12 of the taxpayer's form 1040 federal
 individual income tax return; (2) loss from rental real estate, royalties, partnerships,
 S corporations, estates, trusts, residual interest in real estate mortgage investment
 conduits and net farm rental as determined under the federal internal revenue code
 and reported from schedule E and on line 17 of the taxpayer's form 1040 federal
 individual income tax return; and (3) farm loss as determined under the federal
 internal revenue code and reported from schedule F and on line 18 of the taxpayer's
 form 1040 federal income tax return; all to the extent deducted or subtracted in
 determining the taxpayer's federal adjusted gross income. For purposes of this

 subsection, references to the federal form 1040 and federal schedule C, schedule E,
 and schedule F, shall be to such form and schedules as they existed for tax year 2011,
 and as revised thereafter by the internal revenue service.
       (xx) For all taxable years beginning after December 31, 2012, the amount of
 any deduction for self-employment taxes under section 164(f) of the federal internal
 revenue code as in effect on January 1, 2012, and amendments thereto, in
 determining the federal adjusted gross income of an individual taxpayer.
       (xxi) For all taxable years beginning after December 31, 2012, the amount of
 any deduction for pension, profit sharing, and annuity plans of self-employed
 individuals under section 62(a)(6) of the federal internal revenue code as in effect on
 January 1, 2012, and amendments thereto, in determining the federal adjusted gross
 income of an individual taxpayer.
       (xxii) For all taxable years beginning after December 31, 2012, the amount of
 any deduction for health insurance under section 162(l) of the federal internal
 revenue code as in effect on January 1, 2012, and amendments thereto, in
 determining the federal adjusted gross income of an individual taxpayer.
       (xxiii) For all taxable years beginning after December 31, 2012, the amount of
 any deduction for domestic production activities under section 199 of the federal
 internal revenue code as in effect on January 1, 2012, and amendments thereto, in
 determining the federal adjusted gross income of an individual taxpayer.

                                Subtraction Modification

  K.S.A. 79-32,117(c) lists the items that are to be subtracted in determining Kansas adjusted

gross income. Section 12 of the Bill provides a new subtraction modification in subsection
(c)(xx), which reads as follows:

       (c) There shall be subtracted from federal adjusted gross income:

       (xx) For all taxable years beginning after December 31, 2012, the amount of
 any: (1) Net profit from business as determined under the federal internal revenue
 code and reported from schedule C and on line 12 of the taxpayer's form 1040
 federal individual income tax return; (2) net income from rental real estate, royalties,
 partnerships, S corporations, estates, trusts, residual interest in real estate mortgage
 investment conduits and net farm rental as determined under the federal internal
 revenue code and reported from schedule E and on line 17 of the taxpayer's form
 1040 federal individual income tax return; and (3) net farm profit as determined
 under the federal internal revenue code and reported from schedule F and on line 18
 of the taxpayer's form 1040 federal income tax return; all to the extent included in
 the taxpayer's federal adjusted gross income. For purposes of this subsection,
 references to the federal form 1040 and federal schedule C, schedule E, and schedule
 F, shall be to such form and schedules as they existed for tax year 2011 and as
 revised thereafter by the internal revenue service.

Subtraction Modification - Exempt Income

 New subparagraph (c)(xx) provides a subtraction modification for three categories of

income. By allowing these three categories of income to be subtracted from federal adjusted
gross income to calculate Kansas adjusted gross income, this income is made exempt from
Kansas income tax. It should be noted the three categories of exempt income are cumulative, not
exclusive, so a taxpayer can take advantage of multiple subtraction modifications
simultaneously. These three categories are: (1) income that is net profit from a business; (2)
income from certain entities or of certain types; and (3) farm income.

                        (1) Income that is Net Profit From a Business

 New subsection (c)(xx) provides a subtraction modification for income that is net profit

from a business. Specifically, the new language states:

       (c) There shall be subtracted from federal adjusted gross income:

      (xx) For all taxable years beginning after December 31, 2012, the amount of
 any: (1) Net profit from business as determined under the federal internal revenue
 code and reported from schedule C and on line 12 of the taxpayer's form 1040
 federal individual income tax return;

 In order to qualify for the exemption, income must meet two requirements. First, the

income must be properly reported on Schedule C of federal Form 1040. Second, the income
must be properly reported on Line 12 of federal Form 1040. Income not properly reported in
accordance with federal income tax law and instructions on Schedule C and line 12 of the federal
Form 1040 is outside the scope of the subtraction modification language in paragraph (c)(xx).

  Under federal law, Schedule C is available only to sole proprietors, to single member

limited liability companies not treated as separate entities for federal income tax purposes, and to
individuals considered statutory employees for federal income tax purposes. Statutory
employees include full-time life insurance agents, certain agent or commission drivers and
traveling sales persons, and certain homeworkers. A statutory employee receives a Form W-2
with the "statutory employee" designation box checked on the form. Schedule C is not available
to employees. Therefore, employees who receive wages reported on federal form W-2 (other
than statutory employees) will not qualify for the business income exemption.

                  (2) Income from Certain Entities and Certain Income

 New subsection (c)(xx) provides a subtraction modification for income from certain entities

and for certain types of income. Specifically, the new language states:

       (c) There shall be subtracted from federal adjusted gross income:

      (xx) For all taxable years beginning after December 31, 2012, the amount of
 any: (2) net income from rental real estate, royalties, partnerships, S corporations,

 estates, trusts, residual interest in real estate mortgage investment conduits and net
 farm rental as determined under the federal internal revenue code and reported from
 schedule E and on line 17 of the taxpayer's form 1040 federal individual income tax
 return;

Entities

  Certain income from any of the following entities may qualify under new subsection

(c)(xx) and be exempt from Kansas income tax:

 Partnerships
 S Corporations
 Estates
 Trusts

  In order to qualify for the exemption, income must meet three requirements. First, the

income must be allocated to an individual as pass-through income from a partnership, S
corporation, or conduit income from an estate or trust. Second, the income must be properly
reported on Schedule E of federal Form 1040. Third, the income must be properly reported on
line 17 of federal Form 1040. Income not properly reported in accordance with federal income
tax law and instructions on Schedule E and on line 17 of the federal Form 1040 is outside the
scope of the subtraction modification language of paragraph (c)(xx). See Revenue Ruling 19-
2012-02 regarding certain income that does or does not qualify for exemption.

  Taxpayers with ownership interests in partnerships or S corporations, and beneficiaries of

trusts and estates should receive a Form K-1. The Form K-1 instructions should designate the
line, schedule, and/or form on which income from the partnership, S corporation, trust or estate
should be reported. That information is needed to determine whether such income is includable
in the exemption provided by new subsection (c)(xx).

  Income from limited liability companies is not specifically included in the new subtraction

modification language. However, K.S.A. 17-76,138, which is part of the statutes dealing with
limited liability companies, provides that for all purposes of Kansas taxes, a limited liability
company "shall be classified as a partnership unless classified otherwise for federal income tax
purposes." As a result, certain pass-through income from a limited liability company that is
treated as a partnership for federal income tax purposes will qualify for the exemption provided
by new subparagraph (c)(xx).

 A professional corporation may be formed in accordance with K.S.A. 17-2706 et seq. A

professional corporation formed under these provisions will not qualify for the exemption
provided by new subparagraph (c)(xx) unless an S corporation election is made for federal
income tax purposes.

 In order to qualify a partnership, limited liability company, or S corporation must be a pass-

through entity for federal income tax purposes under the federal "check the box" provisions.

Types of Income

The following types of income qualify under new subsection (c)(xx) and are therefore

exempt from Kansas income tax:

 Rental real estate
 Royalties
 Residual interests in real estate mortgage investment conduits
 Net farm rental

  In order to qualify for the exemption, income must meet two requirements. First, the

income must be properly reported on Schedule E of federal Form 1040. Second, the income
must be properly reported on Line 17 of federal Form 1040. Income not properly reported in
accordance with federal income tax law and instructions on Schedule E and on line 17 of the
federal Form 1040 is outside the scope of the subtraction modification language of paragraph
(c)(xx).

                                   (3) Farm Income

  New subsection (c)(xx) provides a subtraction modification for farm income. Specifically,

the new language states:

       (c) There shall be subtracted from federal adjusted gross income:

       (xx) For all taxable years beginning after December 31, 2012, the amount of
 any: (3)net farm profit as determined under the federal internal revenue code and
 reported from schedule F and on line 18 of the taxpayer's form 1040 federal income
 tax return;

 In order to qualify for the exemption, income must meet two requirements. First, the

income must be properly reported on Schedule F of federal Form 1040. Second, the income
must be properly reported on Line 18 of federal Form 1040. Pursuant to Schedule F instructions,
a farmer who is a single member limited liability company not treated as a separate entity for
federal income tax purposes may use Schedule F. Income not properly reported in accordance
with federal income tax law and instructions on Schedule F and on line 18 of the federal Form
1040 is outside the scope of the subtraction modification language of paragraph (c)(xx)(3).

 It should also be noted that "farm rental" income qualifies for exemption under (c)(xx)(2),

mentioned above.

Addition Modifications - Inclusion of Losses and Deductions

  Because the categories of income explained above will no longer be subject to tax, the Act

includes provisions in new subsection (b)(xix) which prohibit individuals from deducting losses
or claiming certain deductions associated with these categories of income.

                                   (1) Loss from Business

 New subsection (b)(xix) provides an addition modification for loss from business.

Specifically, the new language states:

       (b) There shall be added to federal adjusted gross income:

       (xix) For all taxable years beginning after December 31, 2012, the amount of
 any: (1) Loss from business as determined under the federal internal revenue code
 and reported from schedule C and on line 12 of the taxpayer's form 1040 federal
 individual income tax return;

  In order to be included as an add-back, the loss must meet two requirements. First, the loss

must be properly reported on Schedule C of federal Form 1040. Second, the loss must be
properly reported on Line 12 of federal Form 1040. Loss not properly reported in accordance
with federal income tax law and instructions on Schedule C and line 12 of the federal Form 1040
is outside the scope of the addition modification language in paragraph (b)(xix)(1).

               (2) Loss from Certain Entities and Certain Types of Losses

  New subsection (b)(xix) provides an addition modification for loss certain entities and

certain types of losses. Specifically, the new language states:

       (b) There shall be added to federal adjusted gross income:

       (xix) For all taxable years beginning after December 31, 2012, the amount of
 any: (2) loss from rental real estate, royalties, partnerships, S corporations, estates,
 trusts, residual interest in real estate mortgage investment conduits and net farm
 rental as determined under the federal internal revenue code and reported from
 schedule E and on line 17 of the taxpayer's form 1040 federal individual income tax
 return;

Entities

 Certain losses from any of the following entities may be included as an add-back under

new subsection (b)(xix):

 Partnerships
 S Corporations
 Estates
 Trusts

  In order to be included as an add-back, the loss must meet three requirements. First, the

loss must be received by an individual as pass-through loss from a partnership, S corporation,
estate or trust. Second, the loss must be properly reported on Schedule E of federal Form 1040.

Third, the loss must be properly reported on Line 17 of federal Form 1040. Loss not properly
reported in accordance with federal income tax law and instructions on Schedule E and line 17 of
the federal Form 1040 is outside the scope of the addition modification language in paragraph
(b)(xix).

  Loss from limited liability companies is not specifically included in the new addition

modification language. However, K.S.A. 17-76,138, which is part of the statutes dealing with
limited liability companies, provides that for all purposes of Kansas taxes, a limited liability
company "shall be classified as a partnership unless classified otherwise for federal income tax
purposes." As a result, certain pass-through loss from a limited liability company that is treated
as a partnership for federal income tax purposes will be considered an add-back under the
addition modification provided by new subparagraph (b)(xix).

  A professional corporation may be formed in accordance with K.S.A. 17-2706 et seq. A

professional corporation formed under these provisions will not be subject to the add-back
requirement provided by new subparagraph (b)(xix) unless an S corporation election is made for
federal income tax purposes.

  In order to be subject to the add-back requirement a partnership, limited liability company,

or S corporation must be a pass-through entity for federal income tax purposes under the federal
"check the box" provisions.

Losses

  The following losses are subject to the add-back requirement of new subsection (b)(xix)

and therefore may be subject to Kansas income tax:

 Loss from rental real estate
 Loss from royalties
 Loss from residual interests in real estate mortgage investment conduits
 Loss from farm rental

  In order to be included as an add-back, the loss must meet two requirements. First, the loss

must be properly reported on Schedule E of federal Form 1040. Second, the loss must be
properly reported on Line 17 of federal Form 1040. Loss not properly reported in accordance
with federal income tax law and instructions on Schedule E and line 17 of the federal Form 1040
is outside the scope of the addition modification language in paragraph (b)(xix)(2).

                                       Farm Loss

 New subsection (b)(xix) provides an addition modification for farm loss. Specifically, the

new language states:

       (b) There shall be added to federal adjusted gross income:

      (xix) For all taxable years beginning after December 31, 2012, the amount of
 any: (3) farm loss as determined under the federal internal revenue code and
 reported from schedule F and on line 18 of the taxpayer's form 1040 federal income
 tax return; all to the extent deducted or subtracted in determining the taxpayer's
 federal adjusted gross income.

  In order to be included as an add-back, the loss must meet two requirements. First, the loss

must be properly reported on Schedule F of federal Form 1040. Second, the loss must be
properly reported on Line 18 of federal Form 1040. Loss not properly reported in accordance
with federal income tax law and instructions on Schedule f and line 18 of the federal Form 1040
is outside the scope of the addition modification language in paragraph (b)(xix)(3).

                                       Deductions

  Certain federal deductions must be added to federal adjusted gross income to calculate

Kansas adjusted gross income. These deductions are not shown on federal Schedule C, E, or F,
but are instead shown separately on a line of the federal Form 1040. These include:

 A.    One-half of self-employment taxes. Line 27, IRC §164(f)

 B.    Contributions to retirement plans by self-employed. Line 28, IRC §62(a)(6)

 C.    Purchases of health insurance by self-employed. Line 29, IRC §162(l)

 D.    Deduction for domestic production activities. Line 35, IRC §199

  New subsection (b)(xx) provides an addition modification for one-half of self-employment

taxes. Specifically, the new language states:

       (b) There shall be added to federal adjusted gross income:

      (xx) For all taxable years beginning after December 31, 2012, the amount of
 any deduction for self-employment taxes under section 164(f) of the federal internal
 revenue code as in effect on January 1, 2012, and amendments thereto, in
 determining the federal adjusted gross income of an individual taxpayer.

  New subparagraph (b)(xxi) provides an addition modification for contributions to

retirement plans by self-employed. Specifically, the new language states:

       (b) There shall be added to federal adjusted gross income:

       (xxi) For all taxable years beginning after December 31, 2012, the amount of
 any deduction for pension, profit sharing, and annuity plans of self-employed
 individuals under section 62(a)(6) of the federal internal revenue code as in effect on

 January 1, 2012, and amendments thereto, in determining the federal adjusted gross
 income of an individual taxpayer.

  New subparagraph (b)(xxii) provides an addition modification for purchases of health

insurance by self-employed. Specifically, the new language states:

       (b) There shall be added to federal adjusted gross income:

      (xxii) For all taxable years beginning after December 31, 2012, the amount of
 any deduction for health insurance under section 162(l) of the federal internal
 revenue code as in effect on January 1, 2012, and amendments thereto, in
 determining the federal adjusted gross income of an individual taxpayer.

New subparagraph (b)(xxiii) provides an addition modification for any deduction for

domestic production activities. Specifically, the new language states:

       (b) There shall be added to federal adjusted gross income:

       (xxiii) For all taxable years beginning after December 31, 2012, the amount of
 any deduction for domestic production activities under section 199 of the federal
 internal revenue code as in effect on January 1, 2012, and amendments thereto, in
 determining the federal adjusted gross income of an individual taxpayer.

Overall Effect of Changes

  The changes made by Section 12 of HB2117 to K.S.A. 79-32,117 allow certain categories

of income to be subtracted from federal adjusted gross income in calculating Kansas adjusted
gross income, while at the same time requiring certain losses and deductions to be added. The
overall effect is to exempt certain categories of income from tax, without allowing related losses
and deductions to be offset against other taxable income.

                                 Taxpayer Assistance

Additional copies of this notice, forms or publications are available from our web site,
www.ksrevenue.org. If you have questions about income tax, please contact:

                              Taxpayer Assistance Center
                             Kansas Department of Revenue
                             915 SW Harrison St., 1st Floor
                               Topeka, KS 66612-1588
                                 Phone: 785-368-8222
                                  Fax: 785-291-3614