North Carolina Tax Alert - SB105

North Carolina Budget Bill Revises State’s Tax Laws – Changes include phase-out of corporate income tax, pass-through entity election and conformity to the federal tax treatment of forgiven PPP loans

Governor Roy Cooper signed Senate Bill 105 (“SB105”) on November 18, 2021. SB105 contains several retroactive and prospective changes to North Carolina tax laws that companies will need to evaluate for the impact on their business.

Corporate Tax Changes

Corporate Income Tax Phase-Out

Over the course of the last 25 years, North Carolina’s corporate income tax rate has been lowered from 7.5% (tax years beginning on or after January 1, 1997) to 2.5% (tax years beginning on or after January 1, 2019).[1] SB105 fully phases out North Carolina’s corporate income tax for taxable years beginning on or after January 1, 2030.[2] The scheduled corporate income tax rate in North Carolina will phase out as follows:

Taxable Years Beginning

Corporate Income Tax Rate

In 2025

2.25%

In 2026

2%

In 2028

1%

After 2029

0%

DHG Observation – While this phase-out is well into the future, corporate taxpayers should consider the impact on any tax attributes and deferred tax assets/liabilities to ensure those items are valued appropriately for financial statement purposes. With the pending phase-out, attributes like net operating loss (NOL) carryforwards may expire unused absent further action by the North Carolina General Assembly that would allow taxpayers to utilize these attributes and avoid an unfavorable financial statement impact. While some states have taken this approach (examples include Ohio and Texas providing credits based on accumulated NOL carryforwards when those states implemented the Commercial Activity Tax and the revised franchise tax, respectively), that type of legislative fix is not a given (e.g., New York State not providing this relief for manufacturers when the New York state tax rate for manufacturers dropped to 0%). Taxpayers with long-lived, non-current deferreds that are not expected to flip until tax year 2030 should consider the North Carolina corporate income tax phase-out on those as well.

Corporate Franchise Tax – Elimination of Two Tax Bases

Prior to SB105, North Carolina required corporations to compute and pay franchise tax on the greatest of three separate bases – apportioned capital stock, investment in North Carolina tangible property or appraised value of North Carolina tangible property.[3] SB105 eliminates both property bases (investment in North Carolina tangible property and appraised value of North Carolina tangible property) from the calculation effective for franchise taxable years beginning on or after January 1, 2023 (i.e., the corporate franchise tax calculated and reported on the 2022 and later North Carolina corporate income tax return).[4]

DHG Observation – North Carolina fully phased in a single sales factor for tax years 2018 and forward. As part of this change, many taxpayers with a heavy North Carolina footprint that previously paid corporate franchise tax on the apportioned capital stock base began paying corporate franchise tax on one of the two property bases. The North Carolina General Assembly believed that the corporate franchise tax property bases inhibited capital investment in North Carolina as corporations were taxed twice on investments in North Carolina (franchise tax and personal property tax). The General Assembly’s goal is for elimination of these bases to spur additional investment in North Carolina.

Paycheck Protection Program (PPP) Conformity

SB105 amended N.C. Gen. Stat. §105-130.5(a)(32) such that North Carolina conforms to the federal corporate income tax treatment of expenses paid with a forgiven PPP loan (note that North Carolina has previously conformed to the exclusion from income of a forgiven PPP loan).[5] The prior version of §105-130.5(a)(32) had required an addback for “the amount of any expense deducted under the Code to the extent that payment of the expense results in forgiveness of a covered loan pursuant to section 1106(b) of the CARES Act and the income associated with the forgiveness is excluded from gross income pursuant to section 106(i) of the CARES Act.”[6] The updated version of §105-130.5(a)(32) states that, “For taxable years beginning on or after January 1, 2023, the amount of any expense deducted under the Code to the extent the expense is allocable to income that is either wholly excluded from gross income or wholly exempt from the taxes imposed by this Part.”[7]

DHG Observation – Nearly all taxpayers who received a PPP loan during the first round of funding have filed their 2020 North Carolina returns with an addback for the expenses deducted on the taxpayer’s corresponding federal return. This will necessitate (at minimum) an amended return for the ultimate taxpayer to claim a refund. It is not clear whether underlying filers such as flow-through entities in a tiered structure are also required to file amended returns to substantiate the amount of expenses. We will monitor administrative developments (if any) that provide guidance to taxpayers on how they should report these changes on an amended return.

Internal Revenue Code Date of Conformity Updated

North Carolina is a fixed-date conformity state, which means that the state conforms to the Internal Revenue Code (IRC) as of a specified date. SB105 updated North Carolina’s date of conformity with the IRC to April 1, 2021 (previously it was May 1, 2020).[8] Along with conformity to the federal treatment of forgiven PPP loans and the related expense deduction (discussed previously), the updated conformity date means that North Carolina conforms to the Congressional responses to COVID-19 (e.g., the CARES Act, the Consolidated Appropriations Act and the American Rescue Plan Act of 2021) along with other changes to the IRC absent a specific decoupling adjustment.

Section 163(j) Modifications

North Carolina had previously decoupled from the IRC increase in Section 163(j) interest expense deductibility from 30% of adjusted taxable income to 50% of adjusted taxable income (tax years 2019 and 2020 only).[9] SB105 clarified that while taxpayers are required to addback to federal taxable income “the amount by which the taxpayer’s interest expense deduction under Section 163(j) of the Code exceeds the interest expense deduction that would have been allowed under the Internal Revenue Code as enacted as of January 1, 2020, calculated on a separate company basis,” an addback under 105-130.5(a)(31) is not required “to the extent the amount was required to be added back under another provision of this subsection.”[10] “Another provision” is a reference to North Carolina’s addback for interest expense paid to a related party in 105-130.7B.

SB105 does allow taxpayers who have made an addition to federal taxable income described in the previous paragraph to take a deduction of 20% of the addition that was not otherwise disallowed by G.S. 105-130.7B in each of the first five taxable years beginning tax year 2021.”[11]

DHG Observation – Taxpayers who elected to use 50% of adjusted taxable income as their base for interest expense deductibility for federal income tax purposes (as opposed to 30% of adjusted taxable income) will need to track the difference for North Carolina purposes to take the subtraction from federal taxable income beginning in tax year 2021.

Pass-Through Entity Election

Following the lead of several other states, North Carolina enacted a pass-through entity (PTE) election as part of SB105 to help shareholders/partners who may be limited by the federal SALT cap.[12] Key elements of North Carolina’s PTE election are as follows:

  • Optional election – The election for an S Corporation or partnership to be taxed at the entity level is an optional election.[13]
  • Method of making the election – The election must be made on a timely filed, annual return.[14]
  • Revocation of the election – The PTE election cannot be revoked by the S Corporation or partnership after the due date of the return (including extensions) where the election was made.[15]
  • Eligible entities – S Corporations are eligible to make the North Carolina PTE election, but partnerships that have partners other than individuals, estates, trusts described in IRC Section 1361(c)(2) or certain exempt organizations described in IRC Section 1361(c)(2) cannot make the election.[16]
  • Tax rate – The tax rate imposed for election of S Corporations or partnerships will be the same as North Carolina’s personal income tax rate (5.25% for tax year 2021, though scheduled to drop – see later in this alert).[17]
  • Taxable income – The taxable income for the electing S Corporation or partnership will be the sum of each shareholder or partner’s pro rata/distributive share of the PTE’s income or loss, after state modifications, that is apportioned to North Carolina plus each resident shareholder’s or resident partner’s pro rata/distributive share of the PTE’s income or loss, after state modifications, that is not attributable to North Carolina.[18]
  • Individual income deduction – North Carolina allows taxpayers who are shareholders/partners of an entity that made a PTE election to deduct the shareholder’s/partner’s pro-rata/distributive share of income from the taxpayer’s North Carolina individual income tax filing.[19] Likewise, any loss attributable to an entity that made a PTE election would be added back to a shareholder’s/partner’s individual income tax return.[20]
  • Payment of the tax – The PTE itself is responsible for payment of the tax. If tax is not paid by the PTE within 60 days of notice by the Secretary of Revenue, the shareholders/partners may not take the individual income deduction described in the previous bullet.[21]
  • Basis – The basis of both North Carolina residents and non-North Carolina residents in the S corporation or partnership is determined as though no PTE election was made.[22]

The North Carolina PTE election is effective for taxable years beginning on or after January 1, 2022.[23]

DHG Observations – As with many other states, a qualifying PTE has many different things to consider when deciding whether to make the PTE election. The particulars of the North Carolina election are straightforward, but its application to qualifying PTEs that have residents in multiple states is not as clear. Prior to making the election, taxpayers should model the impact to their qualifying PTE to determine whether it makes sense in North Carolina.

Personal Income Tax Changes

SB105 makes several changes to North Carolina’s personal income tax structure, including a reduction in the personal income tax rate, an increase in the standard deduction and an additional child deduction.

North Carolina’s personal income tax rate currently is 5.25%.[24] SB105’s schedule for personal income tax rate reductions are as follows:

Taxable Years Beginning [25]

Tax

In 2022

4.99%

In 2023

4.75%

In 2024

4.6%

In 2025

4.5%

In 2026

4.25%

After 2026

3.99%

Effective for tax years beginning on or after January 1, 2022, the standard deduction is increased for the following filing statuses:

Filing Status [26]

Current Standard Deduction

New Standard Deduction

Married, filing jointly/surviving spouse

$21,500

$25,500

Head of Household

$16,125

$19,125

Single

$10,750

$12,750

Married, filing separately

$10,750

$12,750

In addition, North Carolina created a deduction from adjusted gross income for specified military pensions.[27] This provision is retroactive to tax years beginning on or after January 1, 2021.[28]

Paycheck Protection Program (“PPP”) Conformity

SB105 amended N.C. Gen. Stat. §105-153.5(c2) such that North Carolina conforms to the federal income tax treatment of the PPP (i.e., exclusion of income from the forgiven PPP loan and deductibility of expenses paid for with the forgiven PPP loan) for individuals.[29] The prior version of §105-153.5(c2)(20) had required an addback for “the amount of any expense deducted under the Code to the extent that payment of the expense results in forgiveness of a covered loan pursuant to section 1106(b) of the CARES Act and the income associated with the forgiveness is excluded from gross income pursuant to section 106(i) of the CARES Act.”[30] The updated version of §105-153.5(c2)(20) states that, “For taxable years beginning on or after January 1, 2023, the amount of any expense deducted under the Code to the extent the expense is allocable to income that is either wholly excluded from gross income or wholly exempt from the taxes imposed by this Part.”[31]

DHG Observation – Nearly all taxpayers who received a PPP loan during the first round of funding have filed their 2020 North Carolina returns with an addback for the expenses deducted on the taxpayer’s corresponding federal return. This will necessitate (at minimum) an amended return for the ultimate taxpayer to claim a refund. It is not clear whether underlying filers such as flow-through entities in a tiered structure are also required to file amended returns to substantiate the amount of expenses. We will monitor administrative developments (if any) that provide guidance to taxpayers on how they should report these changes on an amended return.

State Net Operating Loss (NOL)

Effective for tax years beginning on or after January 1, 2022, North Carolina requires individual taxpayers to calculate a state-specific NOLs.[32] The state NOL is calculated as the amount “business deductions for the year exceed gross business income for the year as determined under the Code” and adjusted by North Carolina law, including both the standard individual modifications in 105-153.5 and 105-153.6 and new modifications such as losses from the sale of capital assets cannot exceed gains from the sale of capital assets.[33] The state net loss can be carried forward for a period of 15 tax years.[34] Taxpayers with federal NOL carryfowards may continue to offset North Carolina income for the next 15 years.[35]

Business Grant Recovery Program

SB105 established a Business Grant Recovery Program (“Grant”) that will provide a one-time grant to businesses that suffered economic damage from COVID-19.[36] Businesses are eligible for the Grant if they meet one of the following conditions:

“Economic loss” is defined as the “economic damage experienced in connection with the COVID-19 pandemic, determined as the difference between the business’s gross receipts for “the COVID period” and its gross receipts for the equivalent time frame in the preceding 12-month period.”[38] The COVID period is defined as the “period beginning March 1, 2020 and ending February 29, 2021.”[39] “Gross receipts” is defined as the “sum of (i) the North Carolina gross receipts listed on line 1 of Form E-500, Sales and Use Tax Return, for sales occurring during a specified time period and (ii) gross receipts not listed on Form E-500 if any, provided the gross receipts are for transactions apportionable to the State.”[40]Although the definition of gross receipts only refers to receipts reported on North Carolina Sales and Use Tax Returns as well as Federal Partnership returns, the grant appears to be eligible to all businesses subject to North Carolina income tax, which would include C Corporations and S Corporations. Although not explicitly stated, businesses that are C Corporations or S Corporations would presumably consider gross receipts reported on line 1a of Form 1120 and 1120S respectively for federal returns, provided the gross receipts are apportioned to North Carolina.

North Carolina also allows a state modification (subtraction) from federal taxable income for both individuals and corporations to the extent the Grant is included in federal taxable income.[41]

The Grant amount is the lesser of $500,000 or a percentage of the economic loss equal to 20% for businesses that have not previously received an award, and 10% for all other businesses.[42] Total funding for the Grant program is no more than $500 million.[43]

Program specifics will be handled by the North Carolina Department of Revenue. Be on the lookout for future alerts as to the program particulars.

Other Tax Changes

SB105 contained several other tax provisions:

  • North Carolina’s child deduction amount increased across all filing statuses effective for taxable years beginning on or after January 1, 2022.[44]
  • Individuals who made certain charitable contributions during tax years 2020 and 2021 are allowed to a claim in excess of the federal limitations contained in the CARES Act.[45]
  • Individuals are required to add back to North Carolina taxable income the amount of the increase in meals and entertainment expenses in IRC Section 274(n) enacted by the Consolidated Appropriations Act.[46]
  • North Carolina eliminated most of its statutory credits available to offset individual/corporate income and franchise tax. However, it extended the sunset date for both the credit for rehabilitated mill property and the credit for rehabilitating historic structures.[47]
  • SB105 clarifies that North Carolina does not apply the standards of IRC Sections 381 and 382 (survivability of a corporate loss following a merger or acquisition) for North Carolina loss carryforwards generated in tax years beginning prior to January 1, 2015.[48]

If you have any questions about SB105 or its impact on your business, please reach out to one of our tax professionals.

REFERENCES:

[1] See https://www.ncdor.gov/taxes-forms/corporate-income-franchise-tax/tax-rate-and-basis-tax.

[2] S.L. 2021-180, Part XLII (Finance), Section 42.2(a).

[3] See N.C. Gen. Stat. §105-122(d).

[4] S.L. 2021-180, Part XLII (Finance), Sections 42.3(a) to (d).

[5] S.L. 2021-180, Part XLII (Finance), Sections 42.4(d).

[6] N.C. Gen. Stat. §105-130.5(a)(32) (effective until November 18, 2021).

[7] N.C. Gen. Stat. §105-130.5(a)(32) (effective after November 18, 2021).

[8] S.L. 2021-180, Part XLII (Finance), Section 42.4(a).

[9] N.C. Gen. Stat. §105-130.5(a)(31).

[10] N.C. Gen. Stat. §105-130.5(a)(31) as amended by SB105.

[11] S.L. 2021-180, Part XLII (Finance), Section 42.13B(c) (new N.C. Gen. Stat. §105-130.5(b)(32)).

[12] The federal SALT cap was enacted as part of the Tax Cuts and Jobs Act in December 2017 and limits taxpayers who itemize deductions to no more than $10,000 of deductions for state and local taxes.

[13] N.C. Gen. Stat. §§ 105-131.1A(a) and 105-154.1(a).

[14]Id.

[15]Id.

[16] N.C. Gen. Stat. §105-154.1(a)(1) to (4).

[17] N.C. Gen. Stat. §§ 105-131.1A(b) and 105-154.1(b).

[18] N.C. Gen. Stat. §§ 105-131.1A(b)(1)(a) and (b) and 105-154.1(b)(1)(a) and (b).

[19] N.C. Gen. Stat. §105-153.5(c3)(1) to (4).

[20]Id.

[21] N.C. Gen. Stat. §§ 105-131.1A(g) and 105-154.1(f).

[22] N.C. Gen. Stat. §§ 105-131.1A(h) and 105-154.1(g).

[23] S.L. 2021-180, Part XLII (Finance), Section 42.5(n).

[24] N.C. Gen. Stat. §105-153.7(a).

[25] S.L. 2021-180, Part XLII (Finance), Section 42.1(a).

[26] S.L. 2021-180, Part XLII (Finance), Section 42.1(b).

[27] S.L. 2021-180, Part XLII (Finance), Section 42.1A(a) and N.C. Gen. Stat. §105-153.5(b)(5a).

[28] S.L. 2021-180, Part XLII (Finance), Section 42.1A(b).

[29] S.L. 2021-180, Part XLII (Finance), Sections 42.4(c) and N.C. Gen. Stat. §105-153(c2)(20).

[30] N.C. Gen. Stat. §105-130.5(a)(32) (effective until November 18, 2021).

[31] N.C. Gen. Stat. §105-130.5(a)(32) (effective after November 18, 2021).

[32] S.L. 2021-180, Part XLII (Finance), Section 42.6(c).

[33] N.C. Gen. Stat. §105-153.5A(a).

[34] N.C. Gen. Stat. §105-153.5A(b)(1).

[35] N.C. Gen. Stat. §105-153.5A(f).

[36] S.L. 2021-180, Part XXXIV (Revenue), Section 34.3A(b).

[37] S.L. 2021-180, Part XXXIV (Revenue), Section 34.3A(c). Note that award amounts include PPP, Economic Injury Disaster Loan Advances, Restaurant Revitalization Fund, Shuttered Venue Operators Grant Program and the North Carolina COVID-19 Job Retention Program.

[38] S.L. 2021-180, Part XXXIV (Revenue), Section 34.3A(h)(6).

[39] S.L. 2021-180, Part XXXIV (Revenue), Section 34.3A(h)(5).

[40] S.L. 2021-180, Part XXXIV (Revenue), Section 34.3A(h)(7).

[41] S.L. 2021-180, Part XXXIV (Revenue), Section 34.3B(a) and (b) and N.C. Gen. Stat. §§ 105-130.5(b)(31a) and 105-153.5(b)(14a).

[42] S.L. 2021-180, Part XXXIV (Revenue), Section 34.3A(e).

[43] S.L. 2021-180, Part XXXIV (Revenue), Section 34.3A(f).

[44] S.L. 2021-180, Part XLII (Finance), Section 42.1(c) and N.C. Gen. Stat. §105-153.5(a1).

[45] S.L. 2021-180, Part XLII (Finance), Section 42.4(b) and N.C. Gen. Stat. §105-153.5(a)(2).

[46] S.L. 2021-180, Part XLII (Finance), Section 42.14(c) and N.C. Gen. Stat. §105-153.5(c2)(21).

[47] S.L. 2021-180, Part XLII (Finance), Sections 42.7 and 42.7A.

[48] INSERT FINAL BILL NUMBER, Part XLII (Finance), Section 42.13B(e) and N.C. Gen. Stat. §105-130.8A(c).

ABOUT THE AUTHORS

Matt Gentile, JD
Director, State & Local Tax

Matt Howell, CPA
Senior Consultant, State & Local Tax

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