North Carolina Enacts Budget Bill That Phases Out Corporate Income Tax

December 2021

BY

Angela AcostaPartner, State & Local Tax

North Carolina Governor Roy Cooper on November 18, 2021 signed a two-year budget into law. The legislation—Senate Bill 105 (S.B. 105)—contains numerous tax law changes, including a phaseout of the corporate income tax, a simplification of the franchise tax and enactment of a new elective pass-through entity (PTE) tax regime.
 

Corporate Income and Franchise Tax Changes

Corporate Income Tax Phase-Out: The North Carolina corporate income tax will be phased out over a five-year period for tax years beginning on or after January 1, 2025. The current tax rate of 2.5% will drop to 2.25% in 2025, 2% in 2026, 1% in 2028 and 0% in 2030.
 
Simplified Franchise Tax Base: S.B. 105 simplifies the calculation of the franchise tax by eliminating two of the three tax bases on which the tax may be levied—the “Investment in N.C. Tangible Property” and “Appraised Value of N.C. Tangible Property” bases. This change will apply for tax years beginning on or after January 1, 2023 and will be applicable to the calculation of franchise tax reported on the 2022 and later corporate income tax returns. Once effective, taxpayers will calculate their franchise tax by using only the North Carolina net worth base.
 
IRC Conformity: S.B. 105 updates North Carolina’s reference date for conformity to the Internal Revenue Code (IRC) by changing the definition of the Code to the IRC “as enacted as of April 1, 2021, including any provisions enacted as of that date that become effective either before or after that date.”
 
Paycheck Protection Program (PPP) Loans: Before this new law was enacted, North Carolina did not allow taxpayers to deduct covered expenses on forgiven PPP loans. North Carolina will now conform to the federal tax treatment of PPP loans, Economic Injury Disaster Loans or Shuttered Venue and Restaurant Revitalization Grants, so that taxpayers will be allowed an income tax deduction for covered expenses paid using forgiven pandemic-related loans. However, North Carolina will conform to the federal treatment only for tax years beginning before January 1, 2023.
 
Business Interest Expense: North Carolina already decoupled from the CARES Act temporary increase of the IRC Section 163(j) limitation from 30% to 50% of a taxpayer’s adjusted taxable income for tax years 2019 and 2020. As a result, North Carolina taxpayers were required to add back the additional federal business interest expense deduction allowed for 2019 and 2020 by the CARES Act. S.B. 105 provides that the add-back is not required to the extent the amount was added back under another provision of state law, such as the addition modification for related-party interest expense, to avoid a double add-back.
 
If a taxpayer had an add-back for such interest expense in 2019 or 2020, S.B. 105 also allows taxpayers to deduct 20% of the addition each year for the first five taxable years beginning with tax year 2021.
 
Certain Administrative Provisions: The Secretary of Revenue has historically exercised broad authority in adjusting net income or requiring combined reporting of certain entities. S.B. 105 provides the Secretary the ability to request any tax or financial documents that he or she deems necessary for the examination of a tax return. If the taxpayer is not able to produce the requested information, the Secretary is authorized to propose any allowable adjustment.
 

PTE Tax Election

In an effort to sidestep the $10,000 federal cap on individual income tax deductions for state and local taxes, North Carolina will allow certain pass-through entities (partnerships, S corporations and LLCs taxed as partnerships) to elect to be taxed at the entity level for tax years beginning on or after January 1, 2022. The elective PTE tax rate is the same as the personal income tax rate. The irrevocable PTE tax election must be made annually on the PTE’s timely filed tax return. The PTE’s taxable income is each nonresident owner’s pro rata or distributive share of income attributable to the state plus the entire distributive share of income regardless of source for residents of North Carolina, subject to North Carolina adjustments.
 
Individual PTE owners can reduce their North Carolina adjusted gross income by their pro rata share or distributive share of the PTE’s income. Similarly, individual owners must add back the amount of their pro rata or distributive share of loss from the taxed PTE, to the extent it was included in the taxed PTE’s North Carolina taxable income and the individual’s adjusted gross income.
 
The new law makes clear that tax paid by an electing PTE does not change the outside basis of ownership interests.
 

Personal Income Tax Changes

Personal Income Tax Rate Reduction, Increased Standard Deduction and Child Deduction: North Carolina will begin lowering the personal income tax rate from 5.25% to 3.99% over a period of six years, effective for tax years beginning on or after January 1, 2022. The rate will drop to 4.99% in 2022, 4.75% in 2023, 4.6% in 2024, 4.5% in 2025, 4.25% in 2026 and 3.99% for all tax years thereafter. Additionally, the standard deduction amount and the child deduction both will increase beginning in 2022.

IRC Conformity: S.B. 105 updates North Carolina’s reference date for conformity to the IRC by changing the definition of the Code to the IRC “as enacted as of April 1, 2021, including any provisions enacted as of that date that become effective either before or after that date.”
 
PPP Loans: Similar to the corporate income tax conformity discussion above, North Carolina will now conform to the federal tax treatment of PPP loans, Economic Injury Disaster Loans, or Shuttered Venue and Restaurant Revitalization Grants as applied to personal income tax.
 
Business Interest Expense: As noted above, S.B. 105 provides that the add-back is not required to the extent the amount was added back under another provision of state law, such as the addition modification for related-party interest expense, to avoid a double add-back.
 
State NOL Calculation: For tax years beginning on or after January 1, 2022, North Carolina creates a separate net operating loss (NOL) deduction calculation for individual income tax, subject to a 15-year carryforward limitation. Individual taxpayers are required to add back the NOL amount allowed under IRC Section 172 and deduct the North Carolina NOL. The new law includes transition rules that should be taken into consideration.
 
S.B. 105 makes various other changes that impact the North Carolina personal income tax, including decoupling from the charitable contribution limitation modification, decoupling from the increased deduction for business-related meal expenses, and allowing a deduction for military pension income.