The Department of Revenue (the “Department”) recently released two documents containing its “substantive” and “clarifying” requests for legislative changes to North Carolina’s revenue laws. Most of the requests include specific statutory language, while others are merely conceptual. None of the requests include proposed effective dates. The requested changes have been submitted to the General Assembly’s legislative staff and will be presented to the House and Senate Finance Committee chairs in the coming weeks.
This Alert summarizes the more significant of the requested changes, including:[1]
Corporate Income and Franchise Tax Changes
Factor Presence
The Department is requesting that the General Assembly adopt a factor presence test for corporate income tax purposes. The requested legislation would provide that (i) a corporation commercially domiciled in the state has substantial nexus with the state and (ii) a corporation commercially domiciled outside the state has substantial nexus if, in any income year, the corporation has (a) $100,000 of property in the state, (b) $100,000 or payroll in the state, (iii) $500,000 of sales into the state, or (iv) 25% of its total property, payroll and sales in the state.
Rules are included for applying these factor presence standards. For instance, the property factor would be applied by counting the average of the value of all owned or rented real and tangible personal property used in the state at the beginning and end of each year. The values used are the original cost of the property (for owned property) or eight times the rental rate (for leased property). Property under construction and property and property producing nonapportionable income would be excluded from the calculation.
For the payroll factor, payroll counting toward the threshold would be the total amount of compensation paid by the corporation in North Carolina during the year. Compensation paid to general executive officers and compensation paid in connection with nonapportionable income would be excluded. Compensation would be considered paid in the state if the payee’s service is performed entirely within the state or if out-of-state services are merely incidental to in-state services. Compensation also would be considered paid in North Carolina if some of the service is performed in the state and either (a) the base of operations or, if there is no base of operations, the place from which the service is directed or controlled is in the state, or (b) the base of operations or the place from which the service is directed or controlled is not in any state in which some part of the service is performed, but the individual's residence is in North Carolina.
For the sales factor, sales in the state would be determined under the existing sales factor apportionment rules.[2]
Notwithstanding these general rules, if a taxpayer is subject to special apportionment methods, the property, payroll, and sales for nexus threshold purposes would be defined as they are for apportionment purposes under those special apportionment methods.
Holding Company Franchise Tax Rate
Under current law, a holding company, whether organized as a C or S corporation, is subject to the franchise tax at the C corporation franchise tax rate with a maximum tax of $150,000.[3] However, S corporations pay franchise tax at a lower rate than C corporations on the first $1 million of the tax base.[4] The Department’s requested change would preserve the holding company tax cap but clarify that the tax rate would be the C corporation or S corporation rate depending on the holding company’s C or S status.
Affiliated Indebtedness
Under current law, a debtor corporation must add back affiliated indebtedness to its franchise tax base. If the creditor corporation is a North Carolina franchise taxpayer, the creditor is allowed to deduct the debt in computing its own franchise tax base.[5] Current law also provides that a debtor corporation does not have to add back affiliated indebtedness that produces “qualified interest expense” for income tax purposes. Qualified interest expense includes interest paid to an affiliate subject to North Carolina income tax.[6] The Department views these provisions as redundant and has requested the repeal of the deduction for creditor corporations.
Personal Income Tax Changes
Definition of Resident
Under current law, an individual is taxed as a resident if he is domiciled in the state. The domicile test is based on all the facts and circumstances,[7] but there is a rebuttable presumption that an individual who is present in the state for more than 183 days during the taxable year is a resident.[8]
The Department’s requested change would convert the presumption into an irrebuttable rule. Specifically, any person who has an abode in North Carolina and who spends more than 183 days in the state during the taxable year would be taxed as a resident even if the facts and circumstances test pointed to a domicile in another state.[9] The requested change would retain the provision of current law that absence from the state for more than 183 days during the taxable year raises no presumption of nonresidence.
Net Operating Losses
The federal Tax Cuts and Jobs Act added a limitation on a noncorporate taxpayer’s deduction for business losses in excess of an inflation-adjusted $250,000 ceiling ($500,000 for joint filers).[10] Such a disallowed “excess business loss” can be carried over as a net operating loss to future years for federal purposes.[11] However, a taxpayer’s state net operating loss does not include the federal net operating loss carryover. The Department’s requested change would provide that a taxpayer’s excess business loss shall be fully allowed as a State net operating loss.
S Corporation Changes
North Carolina’s S corporation income tax includes provisions that create differences between a shareholder’s basis in his S corporation stock for state and federal purposes but does not provide corresponding modifications to federal adjusted gross income to reflect these differences. The Department has proposed that the General Assembly either eliminate the basis adjustments giving rise to the state/federal differences or enact adjustments to federal AGI to reflect those differences.
Partnership Tax Changes
BBA-related Changes
The federal Bipartisan Budget Act of 2015 included provisions allowing the IRS to conduct partnership-level audits and to assess the partnership directly rather than each individual partner.[12] In some cases, the BBA allows partnership audit adjustments to be “pushed out” to the partners.
The BBA procedures can create difficult conformity issues. For instance, where a push-out election has been made, the partners compute their adjustments for the year under review but report those adjustments as “other taxes” or as nonrefundable credits on their returns for the year of the adjustment. Under the Internal Revenue Code (the “Code”), these adjustments are generally not included in the calculation of a partner’s adjusted gross income, which is the starting point for calculating North Carolina taxable income. Consequently, partners required to pay additional federal tax under the BBA will not have a corresponding North Carolina liability, and partners due a federal refund under the BBA will not have a mechanism to claim a corresponding North Carolina tax refund.
The Multistate Tax Commission and the Council on State Taxation have produced model legislation to deal with these conformity issues and have worked with numerous states, including North Carolina to encourage its adoption.[13] The Department’s request does not include model language or specifically recommend adoption of the MTC/COST model, but does refer to Virginia’s BBA-related legislation adopted in 2020, which was based on the model legislation.
Tax Credits Earned by Taxed Partnerships
In 2021, North Carolina enacted a pass-through entity (“PTE”) tax, effective for the 2022 tax year, to help owners of PTEs reduce their federal tax liability. The original North Carolina legislation limited the availability of this provision to PTEs owned exclusively by individuals, estates, and trusts eligible to be S corporation shareholders. Legislation enacted in 2023 added partnerships and corporations to the list of persons who may be owners of a taxed partnership. The distributive share of partnership income belonging to a partner that is a partnership or corporation is not included in the partnership’s taxable income and continues to be allocated to such partners.[14]
This change created an unforeseen glitch in how a taxed partnership treats credits. A partnership that qualifies for a tax credit generally allocates the credit to its partners,[15] but if a taxed partnership qualifies for a credit, the partnership applies the credit against its own entity-level tax and may not pass the credit through to the partners.[16] Thus, a taxed partnership with a corporate or partnership partner may not pass any part of the credit through to those partners even though those partners are taxed on their distributive shares of the taxed partnership’s income. The requested legislative change would permit the taxed partnership to pass-through an allocable share of its credits to corporate and partnership partners.
Net Operating Losses pf Taxed PTEs
The Department has requested a change to clarify that net operating losses are not available to taxed partnerships and S corporations.
Trust and Estate Tax Changes
North Carolina taxes the undistributed income of an estate or trust regardless of source if the income is for the benefit of a North Carolina resident. If the undistributed income is for the benefit of a nonresident, North Carolina taxes the income only if it is derived from North Carolina sources or from a business, trade or profession carried on in the state.[17]
In North Carolina Department of Revenue v. Kimberly Rice Kaestner 1992 Family Trust,[18] the United States Supreme Court held that the law was unconstitutional as applied to a trust whose only contact with the state was the presence here of beneficiaries who have no right to demand a distribution of the income and who are uncertain ever to receive it.[19] The Court did not, however, establish a general rule of taxability and limited its decision to the facts of the case. Accordingly, the constitutionality of North Carolina’s trust and estate tax regime remains uncertain as applied to estates and trusts with different fact patterns.
The Department has requested the legislature to amend the law to limit the taxation of the undistributed income of all trusts and estates to income that is derived from North Carolina sources and is attributable to the ownership of any interest in real or tangible personal property in this State or is derived from a business, trade, profession, or occupation carried on in this State. In other words, no trusts would be taxable on undistributed income regardless of source.
Sales Tax Changes
Reliance on Tax Matrix
The Streamlined Sales and Use Tax Agreement requires signatory states, including North Carolina, to maintain a boundary and tax rate databases identifying the boundaries of each tax district within the state and the rates that apply in each such district. A taxpayer that relies on these databases is not liable for underpayments of tax attributable to incorrect information in the databases until ten days after being notified by the Department of the error.[20]
Although not required by the Streamlined Sales and Use Tax Agreement, the Department’s database provides tax rate information down to the street address level. The Department believes retailers should attempt to use the address level data provided in the database, although this is not specifically required by current law to avoid liability. The Department’s requested legislation would require taxpayers to first use address level data and only use zip code data as a second or third option.
Specifically, the requested change would provide that if the sale of an item requires a complete street address to transfer or deliver the item (as in the case of sales of tangible personal property), the retailer must obtain from the purchaser at the time of sale (or have previously obtained in the ordinary course of business) the complete street address and five-digit zip code.
If the sale of an item does not require a complete street address to transfer or deliver the item (as in the case of certain services or digital goods), the retailer would be required to request (or have previously obtained in the ordinary course of business) a complete street address, including the five-digit or nine-digit zip code.
In either case, the retailer would be required to standardize the addresses it maintains using (i) the look-up application available from the United States Postal Service, (ii) software certified by the Coding Accuracy Support System (CASS), or (iii) other software approved by the Streamlined Sales Tax Governing Board.
If the Department’s database does not provide the applicable rate for the address obtained by the seller or the seller does not obtain an address, the retailer would be required to use the tax rate assigned to the nine-digit zip code area. If the database does not provide the applicable rate for the nine-digit zip code area or the seller cannot determine the nine-digit zip code for sourcing the sale, the retailer would use the tax rate assigned to the five-digit zip code.
Oddly, the Department has proposed that these changes be incorporated into the alcoholic beverage excise tax provisions of the revenue laws[21] rather than into the sales tax law.[22] This is presumably an unintended oversight.
Remote Seller Threshold
Under current law a remote seller must collect sales tax if it makes gross sales into North Carolina in excess of $100,000 in the current or previous year.[23] Once the threshold is reached, tax must be collected on the next sale. This requires remote sellers to continuously monitor their gross sales into the state. The Department’s request would provide that collection is not required until the first day of the first calendar month beginning at least 30 days after the threshold is met.
Administrative Changes
Frivolous Returns
Current law imposes a $500 penalty for filing a frivolous return and defines such a return as one that (i) fails to provide sufficient information to permit a determination that the return is correct or that contains information which indicates the return is incorrect and (ii) evidences an intention to delay, impede or negate the revenue laws of this State or that purports to adopt a position that is lacking in seriousness.[24]
The Department’s requested change would increase the penalty to $2,000, although the Department describes this amount as merely a placeholder and notes that the corresponding federal penalty is $5,000.
The requested change would also change the definition of a frivolous return to include one that both (i) fails to provide sufficient information to permit a determination that the return is correct or that contains information which indicates the return is incorrect (as under current law), and (ii) is based on a position which the Department has identified as a frivolous position. To carry out this new definition, the change would direct the Department (like the Internal Revenue Service pursuant to Code Section 6702(c)) to prescribe (and periodically revise) a list of positions which the Department determines to be frivolous.
Incorporation of Federal Law
The Department requests that any reference to an Internal Revenue Code section in the Revenue Act be deemed to include “all federal rulings and regulations interpreting those sections.” Further, any term used in a Code section referenced by the Revenue Act “shall have the same meaning as when used in a comparable context in the Code, or in any statute relating to federal income taxes, in effect during the taxable period.” This change, if adopted, would incorporate into North Carolina law a vast, indeterminate and ever-changing body of federal tax law. Its adoption would also lead to disputes over such issues as exactly what federal subregulatory guidance is included in “rulings,” whether that term includes judicial opinions, what contexts are “comparable” and what federal statutes other than the Code are “related” to federal income taxes. Such a provision also would arguably violate the prohibition in the state constitution against contracting away the power of taxation.[25]
Written Determination Database
Current law requires the Department to publish written determinations on its website within 90 days of being issued.[26] The Department requests “for administrative purposes” that it be allowed to remove written determinations from its website after ten years. What these “administrative purposes” are is undisclosed. Removing older rulings from the database would deprive the taxpayer community of a valuable source of guidance while preserving it for the Department itself.
Next Steps
Lawmakers will review these requests in the coming weeks, and taxpayers should be prepared to monitor any legislation ultimately introduced and make their voices heard.
[1] In addition to the matters discussed in this Alert, the Department’s requested changes include changes to the Motor Fuels, Alternative Fuels, Sports Wagering, Tobacco Products, Motor Carrier and Alcohol Excise Taxes, changes to the Personal Income Tax withholding requirements, changes to the penalty for making tax payments in the wrong form, changes to the Department’s authority to close inactive withholding accounts, clarifications to the scope of the property tax exemption for burial property and corrections to incorrect or outdates statutory references.
[2] See N.C. Gen. Stat. §105-130.4(l).
[3] See N.C. Gen. Stat. §105-120.2(b).
[4] See N.C. Gen. Stat. §105-122(d2).
[5] See N.C. Gen. Stat. §105-122(b)(2a).
[6] See N.C. Gen. Stat. §§105-122(b)(2) and 105-130.7B(b)(4).
[7] See Department of Revenue, 2023 Personal Income Tax Bulletin, §IV.1.
[8] N.C. Gen. Stat. §105-153.3(15).
[9] Under existing law, a taxpayer may have multiple abodes. Department of Revenue, 2023 Personal Income Tax Bulletin, §IV.1. Thus, under the requested change, a taxpayer with a vacation home in North Carolina would be taxed as a resident if he was present in the state for more than 183 days.
[10] Internal Revenue Code §461(l).
[11] Internal Revenue Code §461(l)(2).
[12] See Internal Revenue Code §6221 et seq.
[13] See Multistate Tax Commission, Report of the Hearing Officer to the Multistate Tax Commission on the Proposed Model Uniform Statute for Reporting Adjustments to Federal Taxable Income and Federal Partnership Audit Adjustments (October 26, 2018).
[14] N.C. Gen. Stat. §105-154.1(b)(1).
[15] N.C. Gen. Stat. §105-269.15.
[16] N.C. Gen. Stat. §105-154.1(c).
[17] N.C. Gen. Stat. §105-160.2.
[18] 139 S. Ct. 2213 (2019).
[19] 139 S. Ct., 2221 (2019).
[20] N.C. Gen. Stat. §105-164.42L.
[21] Specifically, N.C. Gen. Stat. §105-113.84.
[22] Specifically, N.C. Gen. Stat. §105-164.42L.
[23] N.C. Gen. Stat. §105-164.8.
[24] N.C. Gen. Stat. §105-236(10a).
[25] N.C. Const., Art. V, §2(1).
[26] N.C. Gen. Stat. §105-264.2(b).
