Kentucky Tax Overhaul: Guide to 2025-26 Tax Changes

Executive Summary

Kentucky's tax transformation represents one of the most significant fiscal policy shifts in the state's recent history. The individual income tax rate remains at 4% for 2025, but legislation is already in place to reduce it to 3.5% effective January 1, 2026. This systematic approach aims to eventually eliminate the state income tax entirely, positioning Kentucky among the nine states with no individual income tax.

The reform strategy involves a careful balance: reducing income taxes while expanding the sales tax base to maintain essential government services. This shift from taxing production (income) to taxing consumption (sales) reflects a broader economic philosophy designed to enhance Kentucky's competitiveness and attract businesses and residents.

Current Tax Landscape: 2025 Rates and Structure

Individual Income Tax: 4% Flat Rate Continues

For calendar year 2025, Kentucky maintains its 4% flat individual income tax rate, unchanged from 2024. This rate applies to all income levels, representing a significant simplification from the previous graduated system that peaked at 6%.

The 2022 tax reform law (House Bill 8) established a trigger-based mechanism for future rate reductions. Under this system, the income tax rate can decrease by 0.5 percentage points annually, but only when specific fiscal conditions are met:

• Budget Reserve Trust Fund Requirement: The state's rainy day fund must hold at least 10% of General Fund revenues
• Revenue Surplus Test: Actual General Fund revenues must exceed government spending, even if the tax rate had been one percentage point lower

For 2025, Kentucky missed the second trigger requirement. While FY2023 revenues were strong, they weren't sufficient to satisfy the statutory formula for automatic rate reduction. This prudent approach ensures Kentucky doesn't jeopardize its budget stability while pursuing tax cuts.

Standard Deduction and Credits

• Standard Deduction: Inflation-adjusted to $3,270 for 2025
• Family Size Tax Credit: Provides relief for lower and middle-income families
• Various Other Credits: Including education credits and other targeted relief measures

The 2026 Tax Cut: Confirmed Reduction to 3.5%

Legislative Action and Timeline

Despite the pause in 2025, Kentucky taxpayers can expect meaningful tax relief in 2026. The required revenue triggers were successfully met by the end of fiscal year 2024, clearing the path for the next scheduled reduction.

Kentucky's strong fiscal performance made this possible:

• Record Surplus: Over $2 billion surplus at the end of FY2024
• Robust Rainy Day Fund: Exceeded $5 billion, well above the required threshold
• Sustained Revenue Growth: Consistent performance across multiple fiscal years

Recognizing these favorable conditions, lawmakers acted swiftly during the 2025 legislative session. House Bill 1 passed with bipartisan support and became law in early 2025, officially setting the individual income tax rate at 3.5% effective January 1, 2026.

Economic Impact of the 2026 Cut

• Annual Savings: Estimated $718 million in additional aggregate savings for taxpayers
• Cumulative Relief: Combined with previous cuts, taxpayers will save approximately $2.5 billion annually compared to the original 5% rate
• Take-Home Pay Boost: All working Kentuckians will see increased net income starting in 2026

The Path to Zero: Long-Term Elimination Strategy

Republican Leadership's Vision

Kentucky's Republican supermajority has been explicit about their ultimate goal: complete elimination of the state individual income tax. This ambitious objective would place Kentucky among a select group of nine states with no tax on individual income, including Tennessee, Texas, and Florida.

The systematic approach outlined in House Bill 8 provides a roadmap for achieving this goal through measured 0.5% reductions, with additional flexibility built in for smaller incremental cuts (0.25% or 0.1%) as rates approach zero.

Challenges and Considerations

While supporters argue that eliminating the income tax is feasible with disciplined budgeting and continued economic growth, legislative leaders acknowledge increasing complexity as rates decline. As House Speaker David Osborne noted, "growth will not carry us beyond 3% [income tax] in the foreseeable future... every other state that has gone to zero has dramatically increased sales taxes."

This recognition underscores the need for realistic planning and potential revenue replacement strategies as the state approaches its zero-income-tax goal.

Sales Tax Expansion: Balancing the Revenue Equation

Historical Context and Strategy

Kentucky's approach to tax reform explicitly connects income tax reduction with sales tax base expansion. This strategy ensures the state can maintain essential services while transitioning to a consumption-based tax system.

The expansion of Kentucky's 6% sales tax has occurred in phases:

• 2018 Reform: When the income tax was flattened to 5%, the state extended sales tax to numerous services previously exempt, including landscaping and janitorial services, entertainment events, and various professional services
• 2022 House Bill 8: This major overhaul accelerated the shift with substantial changes to service taxation. Effective 2023, more than 30 additional service categories became subject to the 6% sales tax.

Newly Taxable Services

• Personal fitness training
• Marketing and advertising services
• Website design and hosting
• Professional photography
• Telemarketing services
• Courier and delivery services
• Event planning
• Pet grooming
• Home repair services

Additional Revenue Measures

• Peer-to-Peer Car Sharing: New excise tax on short-term vehicle rentals
• Electric Vehicle Provisions:
  • Annual ownership fees ($140 for fully electric, $70 for hybrids)
  • Tax on electric vehicle charging to ensure EV drivers contribute to road funding
• Expanded Excise Taxes: Various fees designed to broaden the tax base

Business Tax Implications and Opportunities

Pass-Through Entity Tax Election

• Business elects to pay Kentucky tax at the entity level (4% rate)
• Entity-level tax payment is fully deductible for federal purposes
• Owners receive refundable credit on Kentucky returns, preventing double taxation

Sales Tax Compliance Requirements

• Register for Kentucky sales tax permit
• Collect 6% sales tax from customers
• File periodic returns and remit taxes
• Update billing and point-of-sale systems
• Maintain proper documentation
• Compliance Risks: Failure to collect tax on newly taxable services can result in audits, back taxes, penalties, and interest charges

Corporate Income Tax

Kentucky's corporate income tax remains at 5% for C-corporations, unchanged by the individual tax overhaul. However, C-corporations may benefit indirectly from economic growth spurred by individual tax reductions.

Strategic Tax Planning Opportunities

Individual Taxpayer Strategies

• Deferring bonuses or capital gains into 2026 when possible
• Accelerating deductible expenses into 2025 (higher rate years provide greater deductions)
• Reviewing retirement account contribution timing
• Withholding Adjustments: Taxpayers should review withholding once the new rate takes effect
• Estate Planning: The changing tax environment may affect estate planning strategies

Business Planning Considerations

• Evaluate pass-through entity structure given changing tax rates and PTET opportunities
• Consider expansion timing to leverage lower individual tax rates
• Plan for sales tax collection and remittance requirements to ensure adequate cash flow

Practical Implementation Guidelines

For Individuals

• No change in withholding or estimated payments for 2025
• Standard deduction increases to $3,270
• Same 4% flat rate applies
• Take advantage of available credits and deductions

For Businesses

• Assess services for sales tax requirements
• Register for sales tax permit if needed
• Update billing systems and customer communications
• Implement tax collection procedures
• File required sales tax returns and maintain detailed records
• Monitor legislative changes for additional requirements
• Consider PTET election for pass-through entities

Economic and Policy Implications

Competitive Positioning

• Lower income taxes make Kentucky more attractive to high-income individuals and retirees
• Reduced tax burden can influence location decisions for businesses and entrepreneurs
• Kentucky competes with Tennessee and other southeastern states for economic development

Revenue Sustainability

• Continued economic expansion must offset reduced income tax revenue
• State government must maintain fiscal responsibility while providing essential services
• Expansion of sales tax base and other revenue sources must adequately replace income tax revenue

Future Considerations

As Kentucky progresses toward potential income tax elimination, each additional rate cut becomes more challenging to offset with economic growth alone. Further broadening of the sales tax or implementation of new revenue sources may be necessary, and the strategy must remain viable during economic downturns when revenue growth slows.

Conclusion

The confirmed reduction to 3.5% in 2026, combined with the long-term vision of income tax elimination, creates both opportunities and challenges for taxpayers.

For individuals, the changes mean more take-home pay and simplified tax calculations, but also the need for careful planning around income timing and withholding adjustments. Businesses face new compliance requirements for sales tax collection while gaining opportunities through the PTET election and potential economic growth benefits.

Success in navigating these changes requires staying informed, planning ahead, and working with qualified tax professionals. As Kentucky continues its ambitious tax reform journey, taxpayers who understand and adapt to these changes will be best positioned to benefit from the state's evolving fiscal landscape.

Plan Confidently in a Changing Tax Environment

With Kentucky’s tax code in transition, proactive planning is more important than ever. Baldwin CPAs is here to help you understand the new rules, adjust your strategies, and ensure full compliance with both income and sales tax requirements. Contact us today to prepare for 2025 and beyond.

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