December 2, 2021
North Carolina enacts significant tax law changes for businesses and individuals
On November 18, 2021, Governor Roy Cooper (D) signed into law the 2021 Appropriations Act (2021–2022 N.C. Sess. Laws, ch. SL 2021-180, Senate Bill 105) (Bill),1 which affects various North Carolina taxes. The Bill (1) phases out the corporate income tax; (2) simplifies the franchise tax base; (3) establishes an elective tax on pass-through entities, such as partnerships, S corporations and limited liability companies (PTEs); (4) updates North Carolina's conformity to the Internal Revenue Code (IRC) and loan forgiveness under the Paycheck Protection Program (PPP); (5) reduces individual income tax rates; and (6) increases the individual standard deduction and child deduction, among other tax law changes.
The Bill enacts the state's $52.9 billion general fund budget for each year of the fiscal biennium beginning July 1, 2021 through June 30, 2023.
Tax provisions in the Bill generally are effective for tax years beginning January 1, 2022, unless otherwise noted.
Corporate income tax changes
The Bill phases out the current 2.5% corporate income tax rate over five-years starting in 2025, reaching zero by 2030. The Bill lowers the corporate tax rate to 2.25% for tax years beginning on or after January 1, 2025. The rate decreases to 2% in 2026 and 2027; and to 1% in 2028 and 2029. After 2029, the rate decreases to 0%.2
For purposes of the state's addback provision for related-party interest expense, the Bill modifies the definition of "qualified interest expense" so that the state limitation on deductions for the proportional share of interest paid to a related member does not apply to the extent that the interest paid has already been disallowed under IRC Section 163(j).3 This change applies retroactively to tax years beginning on or after January 1, 2018.
The Bill also requires the revenue secretary (Secretary) to apply the standards in the regulations under IRC Sections 381 and 382 when determining the extent a loss survives a merger or acquisition. This change applies to tax years beginning on or after January 1, 2015. For mergers and acquisitions that occurred before January 1, 2015, the secretary must apply the standards under N.C.G.S. Section 105-130.8.4
North Carolina law authorizes the Secretary to adjust net income or require a combined return. North Carolina law also requires taxpayers to provide information to the secretary upon the secretary's request. The Bill expands the scope of information that can be requested to include (1) financial or tax documents the Secretary deems necessary to determine the appropriate adjustments to net income, or (2) a combined return. If such information is not timely provided, the secretary may propose any allowable adjustment.5 This change took effect when the Bill became law on November 18, 2021.
Corporate franchise tax simplification
The Bill simplifies the franchise tax calculation. Previously, North Carolina's franchise tax was levied on the largest of three bases: (1) a corporation's North Carolina apportioned net worth; (2) 55% of the appraised value of all a corporation's real and tangible personal property in North Carolina; or (3) a corporation's total investment in tangible property in North Carolina.6 Under all three bases, the tax applied at a rate of $1.50 for every $1,000 of the tax base, with a $200 minimum and a $150,000 maximum tax.7
The Bill eliminates the second and third property tax bases, so the franchise tax will only apply to the first tax base — a taxpayer's North Carolina apportioned net worth. This change is effective for a corporation's franchise tax calculated on its 2022 income tax returns filed in 2023.8
Following similar legislation enacted by many other states this year, the Bill gives North Carolina individual taxpayers the ability to reduce the impact of the annual $10,000 limit on the IRC Section 164(b)(6) deduction for state and local tax (SALT Cap) by allowing certain PTEs to elect to pay tax at the entity level.9 The election cannot be made by a publicly traded partnership, or by a partnership that has, at any time during the tax year, a partner that is not an individual, an estate, a trust or an organization described in IRC Section 1361(c)(6).10 A PTE must elect to be taxed at the entity level on its timely filed annual return for tax periods covered by the return; the election may not be revoked after the return's due date (including extensions).11 The Bill describes (1) how electing PTEs calculate their taxable income, (2) how they pay their tax, and (3) how tax credit partners or shareholders of electing PTEs can claim their share of paid PTE tax against their North Carolina personal state income taxes.12
IRC conformity, North Carolina treatment of PPP loans and conformity to IRC Section 163(j)
The Bill updates North Carolina's conformity to the IRC of 1986, as amended, to that in effect as of April 1, 2021 (from May 1, 2020). 13 This change took effect when the Bill became law on November 18, 2021.
North Carolina law follows the federal exclusion from gross income for indebtedness forgiven on a PPP loan issued under the Coronavirus Aid, Relief and Economic Security Act (P.L. 116-136) (CARES Act) and any subsequent federal legislation. Before the Bill's enactment, North Carolina taxpayers had to add back to federal income any expense deducted under the IRC to the extent the expense was paid with forgiven PPP loan income excluded from gross income.14
The Bill modifies this addback provision in N.C.G.S. Section 105-153.5(c2)(20) by deleting the addback language for expenses paid with forgiven PPP loans. For tax years beginning on or after January 1, 2023, the Bill requires North Carolina taxpayers to add back any expense deducted under the IRC to the extent the expense is allocable to income that is either wholly excluded from gross income or is wholly exempt from North Carolina income tax. This provision conforms North Carolina law to the treatment of PPP loans under federal tax law, which allows expenses paid with forgiven PPP loans and other federal pandemic-assistance programs to be deducted through 2022. The Bill also clarifies, for North Carolina income tax purposes, the tax treatment of expenses paid with receipts from other federal pandemic relief programs.15
North Carolina previously decoupled from the modifications to the IRC Section 163(j) limitation on business interest expense allowed under Section 2306 of the CARES Act for tax years beginning in 2019 and 2020.16 The Bill allows taxpayers to deduct the addition modification resulting from that decoupling over five years beginning with tax year 2021.17
Personal income tax rate reductions and other changes
The Bill lowers the North Carolina personal income tax rate from 5.25% to 3.99% over six years beginning on or after January 1, 2022.18
The Bill also increases the North Carolina standard deduction for personal income taxes for each of the tax years beginning on or after January 1, 2022 as follows:
In addition, the Bill increases the North Carolina child deduction by $500 for each qualifying child. The child deduction now ranges from $500 per child up to $3,000 per child based on filing status and income threshold. The Bill also expands the eligibility for the child deduction by increasing the income threshold at which taxpayers may claim the deduction.19
The Bill also creates a net operating loss (NOL) calculation for individual income tax purposes, effective for tax years beginning on or after January 1, 2022.20 Under the Bill, a taxpayer's state NOL for a tax year generally equals the amount by which yearly business deductions exceed yearly gross business income, as determined under the IRC and adjusted under N.C.G.S. Sections 105-153.5 and 105-153.6. A state NOL would not, however, include the following:
The Bill allows deductions not attributable to a taxpayer's trade or business to the extent the gross income is not derived from the trade or business.
Unused NOLs can be carried forward up to 15 years. The taxpayer's state NOL deduction cannot exceed the taxpayer's North Carolina taxable income determined without deducting the taxpayer's state NOLs. A taxpayer's federal NOL that was not used in tax years beginning before January 1, 2022, may be included in the taxpayer's state NOL in tax years beginning on or after January 1, 2022. Starting in 2022, federal NOLs carryforwards are only allowed as a state NOL to the extent they meet certain conditions.
The Bill includes other personal income tax-related provisions that:
The Bill makes other tax-related changes as follows:
The Bill also makes various changes to the state's property, sales/use, fuel and gross premiums taxes, as well as other administrative changes.
The Bill significantly changes North Carolina's personal income, corporate income and franchise and other business entity tax laws. North Carolina taxpayers should consult with their tax advisors and preparers on how the Bill's tax provisions and reporting requirements will affect past or future transactions.
The elective PTE tax effectively enables North Carolina PTE owners to exceed the SALT Cap when deducting, for federal income tax purposes, their share of North Carolina tax on their business income assigned to the state, consistent with IRS Notice 2020-75, which blessed these various state taxes imposed on PTEs (see Tax Alert 2020-2690). North Carolina becomes the latest state to enact such a "workaround" to the SALT Cap by allowing a PTE to elect to pay income tax at the entity level.24
1 The Bill is titled the North Carolina "2021 Appropriations Act."
2 Bill, Section 42.2.(a) (amending N.C. Gen. Stat. (N.C.G.S.) Section 105-130.3).
3 Bill, Section 42.13B.(d) (amending N.C.G.S. Section 105-130.7B(b)(4)).
4 Bill, Section 42.13B.(e) (amending N.C.G.S. Section 105-130.8A(c)).
5 Bill, Section 42.13B.(f) (amending N.C.G.S. Section 105-251(a)).
6 See N.C.G.S. Section 105-122(d) (prior to amendment by the Bill).
7 N.C.G.S. Section 105-120(b).
8 Bill, Sections 42.3.(c) (amending N.C.G.S. Section 105-120.2(b)) and (d) (establishing the effective date of the provision).
9 Bill, Sections 42.5.(a) - (n) (amending and adding various provisions to North Carolina tax law addressing the taxation of S corporations and partnerships including N.C.G.S. Sections 105.131.1, 105.131A (new), 105.131.7, 105.131.8, 105-153.3, 105-154.1 (new), 105-153.5, 105-153.9(a), 105.160.4, 105-163.38 and 105-163.39.)
10 Bill, Section 42.5(h) (adding new section N.C.G.S. Sections 105-154.1(a)).
11 Bill, Sections 42.5(c) (adding new subsection N.C.G.S. Sections 105-131A(a) (Taxed S Corporation Election)) and 42.5(h) (adding new subsection N.C.G.S. Sections 105-154.1(a) (Taxed Partnership Election).
12 Bill, Sections 42.5.(a) through (n).
13 Bill, Section 42.4.(a).
14 N.C.G.S. Section 105-153.5(c2)(20).
15Bill, Section 42.4.(c).
16 N.C.G.S. Section 105-153.5(c2)(17).
17 Bill, Section 42.13A.(b).
18 Bill, Section 42.1.(a) and (b). The North Carolina personal income tax rate will be 4.99% in 2022, 4.75% in 2023, 4.6% in 2024, 4.5% in 2025 and 4.25% in 2026. For years thereafter, the rate will be 3.99%.
19 Bill, Section 42.1.(c).
20 Bill, Section 42.6.(a) - (c).
21 Bill, Section 34.3A.(b).
22 Bill, Sections 34.3B.(a) and 34.3B.(b).
23 A contingent event is one that prevents the taxpayer from filing an accurate and definite refund request for an overpayment of tax within the allowed period.
24 The following states have already enacted a PTE tax as a workaround to the SALT Cap: Alabama, Arizona, Arkansas, California, Colorado, Connecticut, Georgia, Idaho, Illinois, Louisiana, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oklahoma, Oregon, Rhode Island, South Carolina and Wisconsin. Michigan, Ohio and Pennsylvania have introduced legislation that would enact a similar PTE tax.