North Carolina tax reform: Big, bold and controversial

INSIGHT ARTICLE  | 

Authored by RSM US LLP


A proposal in North Carolina would radically change the state’s tax system. The measure, which has already passed the state House and Senate with veto-proof majorities and is back with the House for reconciliation, will:

  • Phase out the corporate income tax over seven years (lowering the rate every year by a half a percent until it is eliminated in 2028).
  • Reduce the state’s flat personal income tax rate from 5.25 percent to 4.99 percent, increase the standard deduction from $21,500 to $25,500 for married taxpayers filing jointly and from $10,750 to $12,750 for single filers.
  • Reduce and simplify the state’s franchise tax by eliminating the two alternate property bases.
  • Create a pass through entity tax to allow partners and shareholders to avoid the federal SALT deduction limits.
  • Update federal conformity to April 1, 2021.

The proposal is estimated to reduce revenue in the state by $2.16 billion a year by 2026. If passed North Carolina would become one of seven states that does not tax corporate income.

RSM State and Local Tax Policy Experts views on North Carolina H 334.

Brian Kirkell: There’s plenty to unpack about H 334, and a good deal to love from a policy perspective if the goal is to drive growth.  However, I want to focus my comments on the elephant in the room: the phase out and repeal of North Carolina’s corporate income tax. In my opinion, there only viable way to handle the corporate income tax is to repeal it. The revenue raised is an insignificant part of the state’s overall revenue, the tax is expensive to enforce, and the current law represents a mishmash of politically expedient half-measures that hurt businesses, labor, and consumers. The only thing that would make H 334 better in this regard is outright repeal instead of a phase-out. With that said, I do have one very significant concern.

By eliminating the corporate income tax while keeping in place taxes on owners of pass-through entities, H 334 disadvantages business operating in pass-through forms. First, corporations would have the ability to keep earnings tax free by avoiding dividends, while pass-through entities could not. Second, non-resident owners of a pass-through entity would be taxed on their North Carolina sourced business income while the non-resident owners of a corporation would not be taxed at either the corporate level or the individual level because dividends would be sourced specifically to their state of domicile. While there may be a reasonable expectation that corporations will increase their investments in North Carolina as a result of the elimination of the corporate income tax, there is also a very real incentive for owners of corporations that actually distribute dividends to move to a state without a personal income tax to escape North Carolina entirely. That may not be the result North Carolina desires. Additionally, the boon on the corporate side of the equation may be offset by pass-through owners choosing to avoid the state out of frustration at unequal treatment.

Arguably, the state would be better served by either eliminating the tax on business income entirely, regardless of business form, or taxing corporate shareholders in the same manner as partners in partnerships. Either approach would level the playing field, with the first option providing a deep incentive for business owners to both invest and live in the state. And, getting the right people in the state is the real opportunity for growth.

David Brunori: I have been calling for the repeal of the state corporate income tax for 25 years. So I obviously think this measure is terrific. The corporate income tax does not work very well. It never has; it never will. That is why countries around the world have been reducing their tax on corporate income for decades. This year, several states have as well. The tax burden falls mostly on labor in the form of lower wages and consumers in the form of higher prices. Most importantly, the corporate tax deters economic growth. If this measure passes, North Carolina will have a tremendous competitive advantage. Companies will invest and create jobs in the state. That is good.

I am all for reducing personal income taxes when a state can afford it. Reducing personal income taxes is generally good for the economy as witness by the tremendous growth in Tennessee, Texas, and Florida. The last I heard, North Carolina had a $4 billion surplus. I suspect the state can afford this rate reduction.

The franchise tax simplification is also good. I continue to be amazed that 15 states still impose franchise or capital stock taxes (although Mississippi and Illinois are phasing theirs out). The tax is imposed on the value of the enterprise in the state. So companies that invest in capital and equipment – and ultimately people – are punished. You would think states would want companies to invest in property and people within their borders. If there was ever a tax to repeal, this is it.  But, simplification is a good start.

H 334 is very likely to pass the legislature, only to be vetoed by Governor Roy Cooper. However, if the interim votes are any indication, the General Assembly has the votes to override a veto. Businesses and individuals would be well served by reviewing the provisions of H 334, and preparing to respond when it takes effect.

This article was written by David Brunori , Brian Kirkell and originally appeared on 2021-06-15.
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