Local sales and use taxes are an important revenue source for North Carolina counties and municipalities. But a portion of the sales and use tax revenues may legally belong to a local unit’s special taxing district(s). As I detailed in a previous post, when a county uses the ad valorem method to distribute certain local sales and use taxes among the county and its eligible municipalities, the county's and municipalities' special taxing districts—including rural fire districts, county service districts, municipal service districts, and school districts or areas with voted supplemental taxes—also are entitled to a proportional share.
Understanding when that happens requires separating two concepts that are easy to confuse: sales and use tax allocation and distribution. Allocation determines how sales and use tax proceeds are divided among counties. Distribution determines how a particular county's allocation is then divided within that county, among the county and its eligible municipalities.
This post first explains those allocation and distribution rules for the general local sales and use taxes under Articles 39, 40, and 42 of Chapter 105. It then focuses on what happens when a county uses the ad valorem distribution method, including how to calculate the share attributable to a special taxing district, how that share should be handled in practice, and what a unit should do if it discovers that it has not been making the required district allocations. It also briefly distinguishes the sales and use tax provisions in Articles 43, 44, and 46, which do not follow this same general framework.
Overview of Local Sales and Use Taxes
North Carolina does not have a single local sales and use tax. Instead, Chapter 105 authorizes several local sales and use taxes in separate Articles, each with its own rules for how the revenue is allocated and distributed.
The three that matter for this discussion are Articles 39, 40, and 42. Article 39 authorizes a 1% local sales and use tax. Article 40 authorizes an additional ½% tax, and Article 42 authorizes another ½% tax. The taxes are imposed locally but administered and collected by the North Carolina Department of Revenue.
[Other Articles address different local sales and use taxes. Article 43 authorizes certain transportation-related sales taxes. Article 46 authorizes an additional ¼% county sales and use tax if approved by the voters. Article 44 is somewhat different; it now primarily contains hold-harmless and redistribution provisions rather than a separate general local-option sales tax. The requirement that sales and use tax proceeds distributed on an ad valorem basis be shared with special taxing districts does not apply to these articles.]
The distinction among the Articles matters because the revenue is not all divided in the same way. To understand how Articles 39, 40, and 42 work—and when special taxing districts must eceive a share—it helps to separate two steps: allocation and distribution.
Allocation Comes First; Distribution Comes Second
Allocation determines how much sales and use tax revenue goes to each county. Distribution determines how a county's allocation is then divided between the county and the eligible municipalities within that county. The same method does not apply at both steps.
Article 40 provides a good example. Article 40 proceeds are generally allocated among counties based on population (per capita), subject to the adjustments in G.S. 105-486. That determines how much each county receives. But the calculation does not end there. Once a county's Article 40 allocation is determined, that amount must be distributed within the county. For this second step, Article 40 uses the distribution method the county has selected under Article 39. G.S. 105-486(c).
A county chooses between two Article 39 distribution methods: per capita or ad valorem. G.S. 105-472(b). To continue with the example, Article 40 proceeds are allocated among counties based on population and then may be distributed within a particular county using the ad valorem method. Those are not competing rules. They apply at different stages.
How Articles 39, 40, and 42 Fit Together
Each of these Articles has its own allocation rule, but all three ultimately use the Article 39 rules to distribute the county's allocation within the county.
- Article 39. Proceeds are generally allocated based on where the tax was collected. The county's allocation is then distributed between the county and its municipalities using the county's chosen method—per capita or ad valorem. G.S. 105-472(a), (b).
- Article 40. Proceeds are generally allocated among counties based on population, subject to statutory adjustments. Each county's allocation is then distributed using that county's Article 39 distribution method. G.S. 105-486.
- Article 42. Proceeds are generally allocated based on where the tax was collected. Each county's allocation is then distributed using the county's Article 39 distribution method. G.S. 105-501.
That is what brings special taxing districts into the picture. If a county uses the ad valorem distribution method, the property tax levies of certain special taxing districts are included in the calculation, and those districts are entitled to their proportional share of the resulting sales tax proceeds. (Remember that the allocation method does not matter.)
A county is not permanently locked into its existing distribution method. The board of county commissioners may change from per capita to ad valorem, or from ad valorem to per capita, but G.S. 105-472(b) establishes a specific process and timetable. To change methods, the board must adopt a resolution during the month of April selecting the new distribution method. A certified copy of the resolution must be delivered to the Secretary of Revenue within 15 calendar days after adoption. The change does not take effect immediately. The new method applies beginning July 1 of the fiscal year following the succeeding fiscal year. For example, if the commissioners adopt the required resolution in April 2027, the new distribution method takes effect July 1, 2028. If the board does not adopt a resolution changing the method, the county's existing method continues. The existing method also continues if the county does not timely deliver the certified resolution to the Secretary of Revenue.
And if a county is considering a change to or from the ad valorem distribution method, there is a consequence to consider: the treatment of special taxing districts.
What Is a Special Taxing District?
For purposes of this discussion, a special taxing district is an area in which an additional property tax is levied to fund a particular service or purpose. Unlike the countywide or municipal property tax, the additional tax applies only to property within the district or tax area. North Carolina law authorizes several types of special taxing districts.
Rural fire protection districts may be established under Article 3A of Chapter 69. Voters within the district approve an additional property tax to fund fire protection, and the county levies and collects the tax. G.S. 69-25.1.
Counties also may establish county service districts under Article 16 of Chapter 153A. These districts allow a county to provide and fund specified services within a defined area of the county. Authorized services applicable to all counties include fire protection, recreation, water, sewer, solid waste, ambulance and rescue services, beach erosion control and flood and hurricane protection, cemeteries, and watershed improvement projects. G.S. 153A-301. Fire protection is one of the most common uses of county service districts.
Municipalities may establish municipal service districts under Article 23 of Chapter 160A. These districts fund additional services or improvements within a defined part of the municipality. They are commonly used for downtown or urban area revitalization, although the statutes authorize a number of other purposes, including beach erosion control and flood and hurricane protection works, drainage, sewer, transit, off-street parking, watershed improvement projects, historic district projects, and conversion of private residential streets to public streets. G.S. 160A-536.
There also may be special school tax districts or areas. Under Article 36 of Chapter 115C, voters may approve an additional property tax within a local school administrative unit, school district, or other school tax area to supplement State and county school funding. G.S. 115C-501.
These districts differ in how they are created, what services they provide, and how their revenues may be spent. But they share one feature that matters for the sales and use tax calculation: a county or municipality levies and collects property taxes on behalf of the district or special tax area.
What Happens Under the Ad Valorem Distribution Method for Sales and Use Taxes?
Under G.S. 105-472(b)(2), the ad valorem method distributes sales and use tax proceeds based on the relative property tax levies of the county and its municipalities. There is a two-step calculation. First, the county and municipalities receive their respective shares based on their total qualifying property tax levies. Second, each county or municipality shares the appropriate portion of its distribution with the special taxing districts whose levies were included within its total.
The first step is to determine the property tax levy for each unit. For this purpose, a county's or municipality's levy includes both its general property tax levy and the property tax levies of its special taxing districts. (The statute also specifically includes in a county's levy property taxes levied for a merged school administrative unit described in G.S. 115C-513 on property located within that county.) The district levies are included within the county's or municipality's total levy. They are not treated as separate levies when the sales tax proceeds are initially divided among the county and municipalities.
An example helps illustrate the calculation.
Suppose County A has two municipalities, Town X and Town Y. Their property tax levies are:
- County A: $60 million, consisting of $54 million in countywide taxes and $6 million levied for Fire Tax District A
- Town X: $25 million
- Town Y: $15 million
The total property tax levy used to distribute the sales tax proceeds is $100 million. Fire Tax District A's $6 million levy is already included in County A's $60 million total.
Assume there is $10 million in Articles 39, 40, and 42 sales and use tax proceeds to distribute within the county. County A's $60 million levy represents 60 percent of the $100 million total levy, so County A receives $6 million. Town X receives $2.5 million, and Town Y receives $1.5 million.
There is then a second calculation for any special taxing district levy included within a county's or municipality's total levy. G.S. 105-472(b)(2) requires the county or municipality to immediately share its sales tax proceeds with each district on behalf of which it levied property taxes, in proportion to the district's share of the unit's total levy.
Here, Fire Tax District A's $6 million property tax levy represents 10 percent of County A's $60 million total levy. The district therefore receives 10 percent of County A's $6 million sales tax distribution, or $600,000. The remaining $5.4 million belongs to the county.
The same calculation applies when a municipality levies property taxes for a special taxing district. Suppose $5 million of Town X's $25 million levy is for a downtown municipal service district. That $5 million is included within Town X's $25 million levy when Town X's share of the sales tax proceeds is calculated. Because the district levy represents 20 percent of Town X's total levy, 20 percent of Town X's $2.5 million sales tax distribution—or $500,000—is belongs to the municipal service district.
To repeat the basic rule: when a special taxing district levy is included in determining a county's or municipality's share of the sales and use tax distribution for Articles 39, 40, and 42 using the ad valorem method, the district receives the corresponding proportional share of that distribution. (A special taxing district does not get a share of the sales and use taxes if the county has selected the per capita distribution method for Articles 39, 40, and 42.)
The District's Share Is Legally Restricted
The district's share of the sales and use tax proceeds does not just need to be accounted for as district revenue. Once sales and use tax proceeds are allocated to a special taxing district fund under G.S. 105-472(b)(2), those proceeds are legally restricted to the purposes for which that district was created.
This applies to all special taxing districts included in the ad valorem distribution calculation. The particular purposes will vary depending on the statutory authority for the district. A fire district's sales and use tax share must be used for its authorized fire protection purposes. A county or municipal service district's sales and use tax share must be used for the services or purposes for which that district was established. A school supplemental tax district's sales and use tax share must be used for the authorized supplemental school purposes.
The governing board cannot allocate the sales and use tax proceeds to a district fund and later transfer them to the general fund or use them for an unrelated purpose. The district's share of the sales and use tax proceeds is legally restricted to the authorized purposes of that district and cannot be diverted by the governing board to other purposes.
What If a Unit Has Not Been Doing This?
A county or municipality may discover that the Department of Revenue has been including special district property tax levies in calculating the relevant shares of the ad valorem sales and use tax distribution but has not been giving the districts their proportional shares of the resulting proceeds. The local unit must correct this going forward. Current and future sales and use tax proceeds should be properly allocated to the affected districts and accounted for in the appropriate district funds.
What to do about prior years is more complicated. G.S. 105-472(b)(2) requires the sharing of the proceeds but does not specifically address how a county or municipality should correct a historical failure to make those distributions. There also may be statute-of-limitations issues affecting how far back a correction must extend. See G.S. 1-52(2) (providing a three-year limitations period for an action upon a liability created by statute). A local government that discovers a historical problem should consult its attorney about whether and how prior years must be addressed. The finance officer and auditor also should be involved in determining the appropriate budget and accounting treatment.
The uncertainty about prior years does not change the obligation going forward. If a special district's property tax levy is being counted in the ad valorem calculation, the unit must properly identify, account for, and restrict the district's share of the resulting sales and use tax proceeds.
