Kentucky has reciprocal tax agreements with Illinois, Indiana, Michigan, Ohio, Virginia, West Virginia, and Wisconsin. These agreements mean Kentucky residents working across state lines won’t have to file an out-of-state income tax return, unless they work in Missouri, which doesn’t have a reciprocal agreement with Kentucky, or Tennessee, which doesn’t have an income tax. The reciprocal agreements allow employers to withhold Kentucky taxes so Kentuckians can file a resident income tax return even while working out-of-state.
The reciprocal agreement covers state income taxes, but not local taxes. Local governments can impose an earnings tax on Kentucky residents who work inside their city or county limits. The local income tax doesn’t qualify for the other state income tax credit on the Kentucky return because a county, not a “state,” imposed it. It’s not deductible because Kentucky doesn’t have an itemized deduction for taxes.
For example, Sam is a Kentucky resident who works in Clark County, Indiana. Clark County has a 2% local earnings tax. Kentucky and Indiana have a reciprocal tax agreement, but the agreement doesn't cover county taxes. When Sam enters his W-2 information, TurboTax will transfer the amounts to an Indiana reciprocal nonresident return (Form IT-40RNR). The nonresident Indiana tax return shows Indiana income but no state tax liability because of the reciprocal agreement. The agreement doesn't cover Clark County tax, so Sam has a county tax liability.
Note: TurboTax asks you to enter your County of Employment. County tax is determined for the whole year, starting at the beginning of the tax year on January 1. Indiana will refund county tax if you choose another state as your County of Employment. Your County of Employment can be another state (your resident state) if you didn’t work in Indiana on January 1. For example, this would benefit Sam if he worked in Kentucky at the beginning of the year and then got a job in Indiana later in the year. All county tax would be refunded since he wasn’t employed in Indiana the entire year.