North Carolina providing broad-based tax relief

On Nov. 18, 2021, North Carolina Gov. Roy Cooper signed legislation, S.B. 105, which enacts several changes including phasing out the corporate income tax, updating conformity to the Internal Revenue Code (IRC), simplifying the franchise tax, and increasing the standard deduction for individual income taxpayers.¹

Corporate income tax

Corporate income tax phaseout

Perhaps the most notable legislative change is the phaseout of the corporate income tax, which will begin in 2025. The scheduled elimination of the corporate income tax, which is currently imposed at a 2.5% tax rate, is as follows:

The phaseout is not contingent upon other events and should be considered in the current quarter for financial statement purposes. There is no provision for a future income modification to offset any detrimental impact to the financial statements of public filers which may result from the change in deferred tax rate or valuation allowances applicable to deferred tax assets.

Federal conformity and other changes

North Carolina updated its conformity to the IRC from May 1, 2020, to April 1, 2021.³ As a result, North Carolina now conforms to the federal treatment of Paycheck Protection Program (PPP) loans, allowing the deduction for these expenses while not including the forgiveness as income. Further, the previous disallowance of deductions for expenses to the extent payment of such expenses results in forgiveness of a covered loan is retroactively rendered inapplicable by advancing the applicability date of such disallowance provision to Jan. 1, 2023.⁴ Taxpayers who added such expenses back on their originally filed 2020 returns should consider amending their return for a refund.

Under prior law, North Carolina decoupled from the changes to IRC Sec. 163(j) under the Coronavirus Aid, Relief and Economic Security (CARES) Act.⁵ As a result of decoupling, taxpayers were required to add to taxable income an amount equal to the excess of the interest deduction under the CARES Act over the amount allowed prior to the CARES Act. However, there was no mechanism to recapture such amount, resulting in a permanent disallowance of such portion of interest expense for North Carolina purposes. Taxpayers may now deduct 20% of the disallowed IRC Sec. 163(j) deductions from the 2019 and 2020 tax years for each of the first five tax years beginning in the 2021 tax year.⁶

Franchise tax

The legislation eliminates two of the three tax bases on which taxpayers determined their North Carolina franchise tax.⁷ For franchise tax periods beginning in 2023 and reported on 2022 and later corporate income tax returns, taxpayers will only report their proportionate net worth. Under prior law, taxpayers were taxed on the greater of proportionate net worth, North Carolina investment in tangible property, or 55% of the appraised value of real and personal property in the state.⁸

Pass-through entity tax election

For tax years beginning in 2022 and later, certain S corporations and partnerships may elect to be taxed at the entity level.⁹ The election to be a taxed pass-through entity may be made on a timely filed return, including extension, but may not be revoked after the due date of the return, including extensions. Partnerships may only elect to be a taxed partnership if all of the partners are individuals, estates, trusts, or certain exempt organizations.¹⁰ Further, publicly traded partnerships may not make the election.

The North Carolina taxable income of an electing pass-through entity is the sum of each non-resident shareholder’s or member’s share of income or loss attributed to the state plus each resident shareholder’s or member’s share of distributive income or loss. As a result, the entity will be subject to tax on income apportioned to North Carolina and distributable to non-residents, and on all income distributable to residents of North Carolina. Further, separately stated deductions are not included in the determination of income or loss attributed to the state. Residents and non-residents will be allowed to exclude their share of income and loss from the taxed pass-through entity in determining North Carolina taxable income.¹¹

The electing pass-through entity is taxed at the same rate as is applicable to individuals.¹² Taxed pass-through entities may elect to use North Carolina tax credits to reduce the pass-through entity tax. Installments of credits previously passed through to members must continue to be passed through and once a credit is elected to be used at the entity level, all future installments must be used at the entity level.¹³

Taxed S corporations with resident shareholders are allowed a proportionate credit for taxes paid to other states.¹⁴ Notably, it appears that while the legislative intent behind adoption of the pass-through entity tax regime was to treat partnerships and S corporations similarly, and include a similar credit mechanism for taxed partnerships, such provision is not included in the legislation. The credit includes the resident shareholder’s proportionate share of tax paid directly by the entity and any tax paid directly by the shareholder to another state but for which the income is now taxed at the entity level in North Carolina. By allowing for a credit for taxes paid at the taxed entity level, resident individuals will no longer be allowed a credit for taxes paid on their individual return related to income which is taxed at the entity level in North Carolina.¹⁵ Additionally, the credit is limited to the lesser of the tax paid to the other jurisdiction or the North Carolina tax owed on the portion of income taxed by the other jurisdiction.

The taxed pass-through entity is required to pay tax when the return is due. If the taxed pass-through entity does not pay the tax shown due on the return, the North Carolina Department of Revenue must issue a notice of tax collection. If the tax is not paid within 60 days of the notice of collection, the members of the taxed pass-through entity may not exclude the income or loss attributable to them and will be issued a notice of proposed assessment.¹⁶

Individual income tax

For tax years beginning on or after Jan. 1, 2022, the legislation increases the standard deduction to the following amounts based on the taxpayer’s filing status:

The personal income tax rate is reduced from 5.25% as follows:

Additionally, the budget legislation increases the child deduction by $500 for the 2022 tax year and beyond, and slightly increases the adjusted gross income threshold at which the deduction is no longer available.¹⁹ Finally, the legislation also creates a new deduction to exclude military pension income from the North Carolina personal income tax base beginning in the 2021 tax year.²⁰

For the 2022 tax year and thereafter, individuals may generate and claim a state net operating loss.²¹ The state net operating loss replaces the deduction of the federal loss and is the amount by which business deductions exceed business income. The state net loss does not include the child deduction, the IRC Sec. 199A deduction, deductions not attributable to the taxpayer’s business and other adjustments. The state net loss may be carried forward for up to 15 years.²² Federal net operating losses not absorbed fully in the 2021 tax period may be converted to a state net operating loss in 2022.²³

Similar to the corporate income tax change, taxpayers who added back additional IRC Sec. 163(j) interest due to non-conformity with the CARES Act may deduct 20% of the disallowed IRC Sec. 163(j) deductions from the 2019 and 2020 tax years for each of the first five tax years beginning in the 2021 tax year.²⁴

Finally, the failure to pay tax when due penalty was changed to be 2% per month up to a maximum of 10%, rather than 10% at the date tax was deemed to be not paid.²⁵

Commentary

The enactment of this legislation marked the end of a very lengthy legislative session and is the first comprehensive budget bill passed and approved by the governor in several years. The agreement comes after detailed negotiations between the House and the Senate followed by negotiations between the legislature and the governor. The outcome is contrary to recent years when the governor has vetoed much legislation, as there was incentive to reach a resolution to allow for an agreed-upon plan to utilize federal appropriations from the American Rescue Plan Act (ARPA).

S.B. 105, as passed, does not contain previously proposed changes to lower the franchise tax rate or to leave in place the corporate income tax regime which were considered in various proposed bills. The move to eliminate North Carolina’s comparatively low corporate income tax rate of 2.5% signals a continued mindset to build a business-friendly environment and to fund expenditures through increasing employment and direct and indirect taxes on those individuals. Based upon the most recently available statistics from the 2018 tax year, corporate income and franchise taxes accounted for only 2.9% and 2.6% of state tax revenues respectively, while individual income and sales and use taxes comprised 45.2% and 28.9% respectively.²⁶ Accordingly, the repeal of the corporate income tax leaves a relatively small gap to fill, relative to total tax collections. Further, more than 70% of franchise taxes collected were computed using the net worth base which remains in effect, so the relief from simplifying the franchise tax will be more administrative than financial for most taxpayers.²⁷

Additionally, the inclusion of a pass-through entity tax election follows approximately 20 other states in allowing for a workaround to the current SALT cap of $10,000 for federal individual income tax purposes. While the legislature sought to provide more substantial relief to North Carolina resident owners of multistate pass-throughs by taxing 100% of their distributable income rather than on an apportioned basis, the result is a very rigid, cumbersome, and complicated regime which may limit adoption by many taxpayers. Taxpayers and practitioners should exercise caution when considering such elections due to the potential for adverse tax implications of one or more shareholders or members.

1 S.L. 2021-180 (S.B. 105), Laws 2021.
2 N.C. GEN. STAT. § 105-130.3.
3 N.C. GEN. STAT. § 105-228.90(b)(7).
4 N.C. GEN. STAT. § 105-130.5(a)(32).
5 P.L. 116-136 (2020).
6 N.C. GEN. STAT. § 105-130.5(b)(32).
7 N.C. GEN. STAT. § 105-122(d).
8 Id.
9 N.C. GEN. STAT. §§ 105-131.1A; 105-154.1.
10 N.C. GEN. STAT. § 105-154.1(a).
11 N.C. GEN. STAT. § 105-153.5(c3).
12 N.C. GEN. STAT. §§ 105-131.1A(b); 105-154.1(b).
13 N.C. GEN. STAT. §§ 105-131.1A(c); 105-154.1(c).
14 N.C. GEN. STAT. § 105-131.1A(d).
15 N.C. GEN. STAT. § 105-153.9(a)(4), (5).
16 N.C. GEN. STAT. §§ 105-131.1A(g); 105-154.1(f).
17 N.C. GEN. STAT. § 105-153.5(a)(1). The increases range from $2,000 to $4,000 over the 2021 tax year amounts.
18 N.C. GEN. STAT. § 105-153.7(a).
19 N.C. GEN. STAT. § 105-153.5(a1). The adjusted gross income threshold is $140,000 for taxpayers that are married filing jointly or surviving spouses, $105,000 for heads of household, and $70,000 for taxpayers that are married filing separately or single.
20 N.C. GEN. STAT. § 105-153.5(b)(5a).
21 N.C. GEN. STAT. § 105-153.5A.
22 N.C. GEN. STAT. § 105-153.5A(b).
23 N.C. GEN. STAT. § 105-153.5A(f).
24 N.C. GEN. STAT. § 105-153.5(c2)(17a).
25 N.C. GEN. STAT. § 105-236(a)(4).
26 North Carolina Corporation Income and Business Franchise Taxes Statistics and Trends, Tax Year 2018, Feb. 2021.
27 Id.

Contacts: