The long-awaited 2021-2023 biennial North Carolina budget was passed by the General Assembly and signed by Governor Roy Cooper on November 18, 2021. Media outlets have focused on high-profile provisions, such as raises for teachers and other state employees. Other provisions – including historic tax cuts – immediately impact all North Carolina taxpayers.
Full Deduction of Paycheck Protection Program Loan Expenses
Federal law prescribes that income from PPP loans is tax-exempt and the expenses paid with PPP funds are tax-deductible. North Carolina has also held that the income is tax-exempt, but did not allow expenses to be deducted. The budget bill now permits the deductions through 2022.
Taxpayers who deducted PPP expenses on their 2020 federal returns were required to add the deductions back to income, for calculating North Carolina taxable income. Those 2020 state tax returns will need to be amended and taxpayers will receive refunds. We expect the NC Department of Revenue to issue guidance quickly for amending returns. The state may be able to process the corrections automatically. More likely, PPP recipients should expect to work with their tax advisors to claim refunds.
Individual Tax Cuts
North Carolina’s individual tax rate is currently a 5.25% flat rate. Starting in 2022, the individual tax rate will decrease in each of the next six years. In 2022, it will decrease to 4.99%. By 2026, it will reach 3.99%.
In addition to lower rates, North Carolina taxpayers who do not itemize deductions will have less income subject to taxation. Starting in 2022, standard deductions for married couples filing jointly increase from $21,500 to $25,500. Single taxpayers get a bump from $10,750 to $12,750, and Head of Household filers see their standard deductions increase from $16,125 to $19,125.
Families with children receive an additional benefit. State deductions for children who qualify for the federal child tax credit increase from a maximum of $2,500 to $3,000, with lesser amounts for higher earners.
Military retirement pay will now be exempt from state income tax. Men and women who served in the nation’s Armed Forces for at least 20 years, or who were medically retired, may deduct all retirement pay from state taxable income.
Business Tax Cuts
North Carolina imposes both an income tax and a franchise tax on state business entities. The income tax is currently 2.5%. Beginning in 2025, it will gradually be reduced until it reaches 0% in 2029.
The franchise tax will not see a rate change, but the budget simplifies the administration of the tax. Currently, taxpayers must calculate the tax based on the greatest of three calculations: the company’s net worth, a percentage of the appraised value of the company’s real and tangible property in the state, or the company’s actual investment in real and tangible property reduced by depreciation and acquisition indebtedness.
The revised calculation will eliminate the need to calculate the appraised value and the actual investments in real and tangible property. The tax will be based on the company’s net worth only. Besides the accounting simplification, the change will remove the disincentive for investing in North Carolina real and tangible assets.
Business Recovery Grant Program
The budget establishes a Business Recovery Grant Program to provide one-time, state-tax-exempt grants to businesses that suffered substantial economic damage from the COVID-19 pandemic. To qualify, a business will need to demonstrate a 20% decrease in gross receipts for the period of March 1, 2020 to February 28, 2021, compared to the same period in 2019-2020. Prior awards from the state COVID-19 Job Retention Program, the federal Economic Injury Disaster Loan (EIDL) Advance, Paycheck Protection Program, Restaurant Revitalization Fund, or Shuttered Venue Operators Grant Program disqualifies a business — except for businesses in hospitality industries. (The federal Employee Retention Tax Credit is not a disqualifying award.)
The amount of the grant is 20% of the economic loss, up to $500,000. The grant is reduced to 10% of the economic loss, up to $500,000, for businesses which have previously received funds from the programs listed above.
The law sets out an application timeline of 60-90 days. Allocated funds will likely be claimed quickly. Eligible businesses should work with their PBMares advisor to prepare applications as soon as they become available.
Pass-Through Entity Election to Work Around SALT Cap
The 2017 Tax Cuts and Jobs Act created a $10,000 limit for individuals to deduct state and local taxes (SALT) among their itemized deductions. North Carolina joins a growing list of states to enact a workaround for owners of pass-through businesses (S Corporations, Partnerships, LLCs).
The workaround operates by allowing the business entity to pay the individual state income tax that would normally be reported on the shareholder’s or partner’s state tax return for the income derived from the business. The individuals will reduce their state taxable income by the amount of business income already taxed at the entity level. They thereby reduce the amount of state tax they pay, and reduce the amount of SALT deduction disallowed on the federal return.
The workaround is available to businesses whose owners comprise only individuals, estates, and trusts. It becomes available in tax years starting on or after January 1, 2022. The election for the pass-through entity tax is made annually.
The usefulness of the workaround hinges on the ongoing Congressional negotiations regarding the SALT cap. Congress may increase the cap or eliminate it for incomes under $400,000. Owners of pass-through entities will need careful tax planning, after Congress concludes its negotiations, to determine the best course for their circumstances.
The budget bill aligns North Carolina tax procedures with federal law through April 1, 2021. It writes into North Carolina law federal COVID relief measures, with some exceptions:
- Charitable contributions may only be deducted up to 60% of the taxpayer’s modified adjusted gross income, as under previous law. Federal law has temporarily suspended that limitation.
- The federal $300 ($600 for married filing jointly) charitable deduction for non-itemizers is not permitted for North Carolina.
- North Carolina does not permit exclusion of unemployment income, income received as student loan payments by one’s employer, or income from the discharge of a student loan, as allowed under federal law.
- North Carolina maintains the rule that only 50% of business meals may be deducted. Federal law temporarily increased the deduction to 100%.
- The state continues its normal requirement to include income from discharge of qualified principal residence indebtedness and its normal practice not to allow mortgage interest premiums to be treated as interest by itemizers.
Individuals’ Net Operating Losses
Individual taxpayers who generate business net operating losses (NOLs) will calculate state NOLs differently beginning in 2022. Previously, individuals merely used NOLs as they were included in federal adjusted gross income. The new procedure will require NC taxpayers to calculate the NOL separately for state business interests, and to adjust their income for the difference between federal and state calculations. Nonresident taxpayers will only include NC income and losses in their calculations.
Current law results in some situations where taxpayers can lose NOLs that ought to carry over from one year to the next. The revised process corrects those situations.
Combined with important federal tax changes, as detailed in our previous tax alerts, the large tax cuts and the accompanying tax law changes present significant tax planning opportunities for North Carolina taxpayers. We recommend that you consult with your tax advisor before December 31. Your PBMares CPA will help ensure that your tax plans for 2022 and beyond are in place.