What is Tax Exempt?

A tax exemption is like a hall pass…

A hall pass means you don’t have to follow the same rules as everyone else — but there’s probably a good reason you were given one. Similarly, the government gives some types of income and some organizations a pass on being subject to taxes. But it usually has a reason; it thinks the tax exemption will incentivize behavior it wishes to encourage.

Most of the time, when people talk about tax-exempt, they are referring to federal income taxes. But tax exemptions can be found in almost any tax law. It just means that you don’t have to pay that tax because you or an organization qualifies for an exemption allowed in the law.

Being tax-exempt might mean that everything an organization does is not subject to taxation. In some cases, an individual may be exempt from certain taxes. Or, certain types of your income, or specific things that you buy, could fall into a tax-exempt category.

To become tax-exempt, there is usually a government process that ensures your organization meets the requirements outlined in the law. For federal taxes, you must file a form with the Internal Revenue Service (IRS) to become recognized as a charitable organization, non-profit, or other exempt entity. Once verified, the organization doesn’t have to pay taxes on their revenues.

The most common tax-exempt status in the Internal Revenue Code (IRC) is found in section 501(c)(3), for non-profits. The IRS also has some tax exemptions for political organizations in section 527 and a few other less common ones elsewhere in the IRC.

State and local government tax exemptions each have unique processes. It might require filing a form with the state department of revenue, county clerk, or other agency in charge of tax collections. In the case of a sales tax exemption for the elderly, the process may be as easy as showing your identification to the cashier and signing a piece of paper.

Tax-exempt organizations have one characteristic in common: They don’t distribute profits to owners.

Because that means they are not trying to turn a profit, their goals are usually more public-spirited than the pursuit of money. These groups almost always have a mission related to the improvement of society in some form or fashion. Most can be categorized into nine buckets:

1. Poverty Assistance: Food banks, homeless shelters, etc.
2. Culture: Museums, theaters, historical societies, etc.
3. Education: Universities, boy/girl scouts, etc.
4. Health: Disease research, children’s hospitals, etc.
5. Environment: The Sierra Club, etc.
6. Disaster Relief: i.e., Red Cross
7. Social Improvement: Civil rights, United Way, etc.
8. Religious: Churches, religious groups, etc.
9. Membership Groups: Unions, fraternal clubs, etc.

The Internal Revenue Service (IRS) determines if an organization meets the requirements for an exemption from federal taxes. But all tax-exempt organizations must not attempt to enrich the owners or influence political outcomes. Most of these organizations must still file a tax return, but they do not have to give part of the donations they receive to the government.

At the state and local level, each governing body with taxing authority can also create exemptions from the taxes it levies. Consult your tax professional or government official to find out if you qualify for any such exemptions.

As of November 2019, there were roughly 2.5 million tax-exempt organizations in the Internal Revenue Service (IRS) database.

In general, if you see an organization doing charitable work, they are probably tax exempt. If they are seeking profits, they aren’t.

Technically, no individual is exempt from federal income taxes. However, many people have no tax liability and do not need to file a tax return. Also, in some areas, state or local government officials may elect not to tax or may reduce taxes for certain groups of people.The most common classifications tend to be:

• Low income
• Persons with disabilities
• Military veterans
• Senior citizens
• Clergymen

Sometimes, a person must be in more than one of these categories to be tax-exempt (i.e., disabled veteran or low-income senior). For example, if your county doesn’t charge property taxes on homes owned by combat veterans with a service-connected disability, the homeowner would file proof that they meet that definition to become exempt from the property tax.

Aside from non-profit organizations being exempt from federal taxes, and certain individuals being exempt from a particular state or local taxes, several other tax exemptions can be found in various tax laws.

It is very common for sales taxes to exempt particular purchases from the tax. These usually include food, healthcare, and education. Intermediate goods (things that a business buys from another firm as part of making a final product) are exempt from sales taxes to avoid double taxation. However, they sometimes are taxed in corporate income taxes since the purchasing company can write off the costs of goods sold.

Income tax laws sometimes exclude certain types of income from taxation. For example, money received as a gift, or as compensation for a loss, might not be taxable income. Interest earned from purchasing a municipal bond is generally tax-exempt. Generally, any money raised for a public purpose by a government agency is not taxed. Sometimes, a local government might exempt a company from property taxes for some time as an economic development strategy.

These are all ways to reduce a tax liability to provide some form of public good.

A tax exemption means that the value is removed at the very beginning of a tax calculation. It never really enters the calculation at all. For example, in calculating a sales tax, only the things that are subject to the tax are added up. Exempted items are excluded from the calculation altogether. The sales tax rate is then multiplied by the total value of things that are not exempt.

A tax deduction occurs in the middle of the tax calculation. Things like the costs of goods sold are tax-deductible, which reduces the taxable income of a business - That way, the government only taxes profit rather than revenue. Home mortgage interest may be a tax-deductible item against your federal income taxes. There are several other examples of tax deductions, all of which reduce the number to which a tax rate is applied.

On the other hand, a tax credit is applied after the tax is calculated. These directly reduce the amount of taxes that are due, rather than reducing the taxable amount. Tax credits include a reduction in federal income taxes based on the number of children you take care of, buying an electric car, or doing any number of things the government wants you to do.