How To Take Advantage of Pass-Through Entity Tax in North Carolina

KATHY STANTON: Welcome, everyone, to today's tax podcast, where we will discuss the North Carolina pass-through entity tax election. I'm Kathy Stanton. I'm a partner with Cherry Bekaert and lead the State and Local Tax (SALT) Practice.

KATHY STANTON: With me today is Tony Konkol, an attorney and manager in our SALT Practice, who knows practically everything about pass-through entity tax elections.


TONY KONKOL: Thank you.


KATHY STANTON: There have been many pass-through entity tax elections enacted over the past one to two years. A little background: the Tax Cuts and Jobs Act (TCJA) limited the state and local tax deduction that individuals can take, capping it at $10,000.

KATHY STANTON: If you are an owner of a flow-through entity that is highly profitable, you could be severely limited in deducting state income taxes at the individual level. If organized as a C corporation, state income taxes would be deductible for federal purposes.

KATHY STANTON: The pass-through entity tax elections convert state income tax that is non-deductible at the individual level into a deductible expense at the federal level by imposing tax at the entity level. The top federal individual rate is 37 percent, so this can produce meaningful savings.

KATHY STANTON: The IRS issued a notice near the end of 2020 that generally sanctioned this approach, noting it generally works but stopping short of authoritative guidance. The IRS indicated regulations would be forthcoming, but none have been issued and none are expected soon.

KATHY STANTON: That IRS notice opened the door for numerous states and New York City to pass legislation allowing owners of pass-through entities to elect to impose income tax at the entity level rather than at the individual level. There are now 29 states and New York City with a PTE election, with several other states considering legislation.

KATHY STANTON: Today we'll dive deeper into the North Carolina pass-through entity election. Tony, please share your viewpoint on how the North Carolina PTE election generally works.


TONY KONKOL: Thank you, Kathy. A bit of background: North Carolina established its PTE election under Senate Bill 105, enacted in November 2021. The election is first available for tax year 2022. For calendar-year taxpayers, that means the tax year beginning January 1, 2022; for fiscal-year taxpayers, any tax year beginning on or after January 1, 2022.

TONY KONKOL: Since then, North Carolina passed one technical bill in June 2022 that included a tweak to estimated payments for electing PTEs. Those two measures create the framework for North Carolina's PTE regime, bringing the total to roughly 30 jurisdictions when counting New York City.


KATHY STANTON: So this was effective for tax year 2022, which means that tax year has just ended and the 2022 extensions and returns are the first year the election can apply.


TONY KONKOL: Correct.

TONY KONKOL: Eligible entities are partnerships and S corporations, generally following federal filing treatment for Forms 1065 and 1120S. North Carolina, however, imposes strict ownership requirements for both partnerships and S corporations. The state references S corporation shareholder eligibility statutes, so partnerships must be 100 percent owned by individuals, estates, or limited categories of trusts described in IRC Section 1361(c)(2) or (c)(6).

TONY KONKOL: That means tiered structures or any partnership with a corporate owner will be disqualified. If a partnership has a 1 percent owner that is a C corporation or another pass-through entity, the entire partnership cannot make the election. In tiered structures, you may need to analyze each level to find an eligible owner, and restructuring opportunities may exist but can be challenging.


KATHY STANTON: Even with restructuring, you need unanimous owner agreement and attorney involvement, so it is not always simple.


TONY KONKOL: Exactly. On the income base, North Carolina uses a resident/nonresident distinction. For nonresidents, tax is computed on North Carolina apportioned income. For residents, the base is unapportioned and includes the entire distributive share of income that a resident would be subject to tax on in North Carolina.


KATHY STANTON: That creates a potential mismatch. If two owners each have 50 percent ownership but only 10 percent of the income is apportioned to North Carolina, one owner could have the full 50 percent of income taxed while the other only has 5 percent in the North Carolina tax base.


TONY KONKOL: Yes. Some states use apportioned income for both residents and nonresidents, but North Carolina chose the unapportioned approach for residents. That provides more benefit to residents because it increases the income base that can be taxed at the entity level, reducing federal taxable income for those residents who are taxed on their entire distributive share.


KATHY STANTON: What about owners who are 100 percent North Carolina residents? If both partners are residents, what happens with other states where they have income and pay tax?


TONY KONKOL: That is handled through the credit for taxes paid to other states mechanism. One interesting North Carolina approach, uncommon among other states, is how it treats credits when other states also have PTE elections. If an entity elects North Carolina and also has elections in other states, North Carolina allows the entity itself to claim the credit for taxes paid to other states on the resident portion of income. In practice, the entity computes the tax on the owner's share and can offset that tax by claiming credits for taxes paid to other states.

TONY KONKOL: From a compliance standpoint, North Carolina is effectively an income-reduction method state. Instead of an individual owner claiming a credit for taxes paid to other states, a resident owner will take a subtraction from income on their individual return for income that was taxed at the entity level. That means the individual does not need to claim a credit for taxes paid to other states on that pass-through income.


KATHY STANTON: That makes things easier for the individual, provided the entity makes PTE elections in all other states where it has income.


TONY KONKOL: Right. If the entity does not make elections in other states, the individual may still need to file nonresident returns in those states and claim credits as usual. North Carolina's approach shifts some compliance burden to the entity, which must substantiate and attach returns to claim credits on the entity return.

TONY KONKOL: North Carolina computes the tax using the North Carolina individual rates in effect for the tax year. For example, the North Carolina rate changed from 4.99 percent to 4.75 percent for 2023, and is scheduled to reduce further in future years.


KATHY STANTON: The credit an owner or entity receives will not exceed the North Carolina tax rate, so if an owner is subject to a 10 percent rate in another state, they would only get credit up to the North Carolina rate.


TONY KONKOL: Correct. Most states cap the credit at their own rate. States differ in approach: many use a credit method, where the entity pays the tax and owners receive a pro rata credit on their individual return; others, like North Carolina, use an income-reduction method, where owners subtract the income taxed at the entity level from their taxable income.

TONY KONKOL: In a credit-method state, the individual computes tax and offsets it with the credit. In an income-reduction state, the individual reduces taxable income by the amount of pass-through income taxed at the entity level. With no other sources of income, both methods can produce the same bottom-line tax after credits or subtractions, but the administrative mechanisms differ.


KATHY STANTON: Why don't states adopt a model-act approach so rules are uniform across states?

KATHY STANTON: I have built a 37-year career in state tax, and while uniformity would simplify matters, most states have chosen different qualification rules, different computation methods, and different treatments of credits and subtractions. That variability creates complexity and requires state-by-state analysis.

KATHY STANTON: We have a couple of minutes left. Tony, when would you not want to make a PTE election? It sounds attractive to convert state tax to a federal deduction, but are there situations where the election could harm taxpayers?


TONY KONKOL: One of the biggest issues is owner mix and residency. You must evaluate who the owners are and in what states they reside to see if they can claim credits for taxes paid to other states. Complications arise when the individual owner is no longer directly paying the income tax because it was paid at the entity level.

TONY KONKOL: North Carolina issued guidance taking a position for partnerships that, if the partnership does not elect the North Carolina PTE tax but elects in other states, a North Carolina resident cannot claim a credit for taxes paid to other states on that other-state entity-level PTE tax. That position does not apply to S corporations because North Carolina already had statutory authority for S corporation treatment in prior law.

TONY KONKOL: The guidance effectively funnels the credit through the entity when the entity elects the North Carolina PTE tax and limits a resident owner's ability to claim that credit when the entity did not elect North Carolina. That is a complex area and raises questions about statutory authority and interpretation.


KATHY STANTON: We believe there may still be statutory basis for an owner to claim the credit, so that North Carolina position is somewhat questionable and confusing. Even tax departments can get confused by these interactions.

KATHY STANTON: The key point is to ensure owners either get the income removed from their individual return if it was taxed at the entity level or receive a credit for tax paid at the entity level. If neither happens, owners could end up paying tax twice on the same income, which is the biggest pitfall.


TONY KONKOL: We do not want the election to increase tax liability; the goal is to save money.


KATHY STANTON: That covers the main complexities and mechanics of pass-through entity tax elections. We hope this discussion provides useful information on North Carolina's specific election, particularly for taxpayers with significant pass-through income or business sales.

KATHY STANTON: Contact your representative at Cherry Bekaert in the tax department or the SALT group if you would like assistance with state PTE elections across jurisdictions to ensure you receive the maximum federal benefit.


TONY KONKOL: Especially if you are in a state where residents can include the full distributive share for entity-level tax, it can be advantageous.


KATHY STANTON: Thank you, Tony, for your time and expertise today.