North Carolina’s recent tax reform through S.B. 105

Editor: Mo Bell-Jacobs, J.D.

On Nov. 18, 2021, North Carolina Gov. Roy Cooper signed Senate Bill (S.B.) 105, otherwise known as the Current Operations Appropriations Act of 2021. Included in this act are significant changes to North Carolina tax law for both individuals and businesses. Many of the changes provide a reduction of overall state taxes beginning in 2022 and forward.

Personal income tax changes

S.B. 105 amends several tax provisions for North Carolina personal income taxpayers. The personal income tax rate for tax years beginning in 2021 is 5.25%. This rate will be reduced over the next several years as follows:

• 2022 — 4.99%
• 2023 — 4.75%
• 2024 — 4.6%
• 2025 — 4.5%
• 2026 — 4.25%
• 2027 and beyond — 3.99% (2021 N.C. Sess. Laws 2021-180 (S.B. 105), Part XLII., Section 42.1.(a)).

For tax years beginning on or after Jan. 1, 2022, the standard deduction will be increased. The updated standard deduction amount will be based on taxpayer filing status, with the new amounts as follows:

• Married filing jointly/surviving spouse — $25,500 (previously $21,500)
• Head of household — $19,125 (previously $16,125)
• Single — $12,750 (previously $10,750)
• Married filing separately — $12,750 (previously $10,750) (id. at Section 42.1.(b)).

North Carolina law allows a deduction for every qualifying child for whom the taxpayer is allowed a federal child tax credit under Sec. 24. The bill increases the child deduction by $500 for each income bracket, effective for tax years beginning on or after Jan. 1, 2022, while also expanding the eligibility for the deduction for each taxpayer filing type (up to $140,000 married filing jointly, $105,000 head of household, and $70,000 single or married filing separately filing status) (id. at Section 42.1.(c)).

The taxation of military pension income is also eliminated. This applies to retired military members who served at least 20 years or medically retired under 10 U.S.C. Chapter 61 (id. at Section 42.1A.(a)). The bill also creates a stand-alone state net operating loss (id., at Section 42.6.(a)). In prior years, individual taxpayers were limited to the use of their federal net operating loss.

Prior to the revised rates, North Carolina already imposed a relatively low personal income tax rate. With its eventual 3.99% tax rate, North Carolina’s rate will only be higher than the flat rates currently imposed in Indiana, North Dakota, and Pennsylvania. The reduction in the personal income tax rate as well as changes made to certain other deductions are projected to decrease tax revenue to the state by $650 million and $1.7 billion for fiscal years 2021-2022 and 2022-2023, respectively (Joint Conference Committee Report on the Current Operations Appropriations Act of 2021, p. A1).

Corporate income tax changes

S.B. 105 likewise amends several corporate tax provisions. Most notably, the state’s corporate income tax will be phased out over the next decade. North Carolina’s corporate income tax rate for 2021 is 2.5% and will be phased out under the following schedule:

• 2025 — 2.25%
• 2026 — 2%
• 2028 — 1%
• 2030 and beyond — 0% (S.B. 105 at Section 42.2.(a)).

Beginning with the 2022 tax returns of C corporations and S corporations, the calculation of the franchise tax in the state will be simplified (id. at Section 42.3.(a)). Under prior law, the franchise tax is calculated by using the highest tax base from one of three methods:

• Net worth as computed in accordance with generally accepted accounting principles;
• Book value of North Carolina real and tangible property; or
• 55% of the appraised value of North Carolina real and tangible property.

The bill removes the book value and 55% of the appraised value as a possible tax base for franchise tax purposes. Beginning with the 2022 tax returns, all franchise tax will be calculated from the company’s net worth (prior to passage of S.B. 105, most taxpayers used this base for their franchise tax calculation). The elimination of the two property bases likely will reduce the franchise tax liability for entities that have a material amount of real and personal property in North Carolina. The elimination of the two property bases is expected to reduce tax revenue to the state by $173 million in fiscal year 2022—2023, the first year of its implementation (Joint Conference Committee Report at A1).

With the phaseout of the corporate income tax, North Carolina will be one of three states that impose neither a corporate income tax nor statewide gross receipts tax. The state is projecting corporate tax revenue to be approximately $1.3 billion for both fiscal year 2021-2022 and 2022-2023 (id.).

IRC conformity

S.B. 105 updates the state’s IRC conformity from May 1, 2020, to April 1, 2021, with certain modifications (S.B. 105 at Section 42.4.(a)). This amendment changes a number of the state’s prior positions, including the treatment of Paycheck Protection Program (PPP)-related loan expenses as well as excess business interest expense under Sec. 163(j). Taxpayers who deducted PPP-related expenses on their 2020 federal income tax return were required to add these expenses back as a separate state modification on their North Carolina income tax return. A state modification will no longer be required for the 2020, 2021, and 2022 tax years. As the 2020 tax returns have already been filed, an amended return will likely be required (pending N.C. Department of Revenue guidance) to realize the benefit for this period. Deduction of PPP-related expenses is estimated to reduce tax revenue by approximately $610 million and $50 million for fiscal years 2021-2022 and 2022-2023, respectively (Joint Conference Committee Report at A1).

Due to the prior conformity date, North Carolina conformed to the law known as the Tax Cuts and Jobs Act of 2017 (TCJA), P.L. 115-97, but not the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136. Therefore, the state conformed to the 30% excess business interest limitation of Sec. 163(j) mandated by the TCJA but not the 50% limitation adopted by the CARES Act. Because of the state’s nonconformity to the CARES Act, a separate state addition modification was required in 2019 for C corporations and in 2020 for all entity types. S.B. 105 now allows for any taxpayer who made a state addition for CARES Act nonconformity to deduct 20% of the addition ratably for the first five tax years beginning with the 2021 tax period (S.B. 105 at Section 42.13A.(b)).

Passthrough entity tax

S.B. 105 creates a passthrough entity election for S corporations, partnerships, and LLCs treated as partnerships for federal income tax purposes to be taxed at the entity level, becoming at least the 20th state to do so. Any S corporation is eligible to make this election in the state. However, publicly traded partnerships and partnerships that at any point during the tax year have a partner that is not one of the following are not eligible to make the election: an individual, an estate, a trust described in Sec. 1361(c)(2), or an organization described in Sec. 1361(c)(6) (id. at Sections 42.5.(a) and 42.5.(h)).

A resident of North Carolina historically was allowed a credit for taxes paid to another state. If a passthrough entity election is made, the North Carolina resident shareholder/partner will not be entitled to a credit for taxes paid to another state on income that is taxed to the passthrough entity. However, the shareholder/partner will be allowed to deduct the pro rata share of distributive income taxed to the passthrough entity (id. at Section 42.5.(j)). The net effect of these changes will depend on the states in which the passthrough entity election has been made.

Cigar tax increases

Most changes made in S.B. 105 are favorable to taxpayers. However, the state will begin subjecting remote sales of cigars to the current excise tax, which is 12.8% of the cost of each cigar, with a cap of 30 cents per cigar (id. at Sections 42.9.(a) and 42.9.(g)). This increase is likely to affect premium cigars only. The increase is effective July 1, 2022, and is projected to raise revenue in the fiscal year 2022-2023 by $25 million (Joint Conference Committee Report at A1).

Large fiscal effects

S.B. 105 includes significant state tax law changes for both business entities and individuals in North Carolina. The net changes are projected to result in tax cuts for both businesses and individuals in the state. Before the bill was enacted, North Carolina was projected to add an additional $6.5 billion to the state’s general fund through fiscal year 2022-2023 (Office of Gov. Roy Cooper, news release, “New Revenue Forecast Projects Additional $6.5 Billion Surplus by 2023” (June 15, 2021)). New revenue projections after Senate Bill 105 was passed estimate that fiscal year 2021-2022 revenue will decrease from $29,705,400,000 to $28,379,700,000, and fiscal year 2022-2023 revenue will decrease from $30,707,200,000 to $28,716,900,000 (Joint Conference Committee Report at A1). North Carolina follows almost a dozen other states that cut personal or corporate income tax rates throughout 2021 legislative sessions on the heels of increased tax revenue and federal support.

EditorNotes

Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP.

For additional information about these items, contact Breen.Parry@rsmus.com and Charles.Britt@rsmus.com.

Unless otherwise noted, contributors are members of or associated with RSM US LLP.