What Is Tax Exemption and How Does It Work?

What Is Tax Exemption – Tax exemption is a legal provision that allows certain individuals or organizations to reduce or eliminate their tax liability on some or all of their income or transactions. Tax exemption can apply at the federal, state, or local level, depending on the type and source of the income or transaction. Tax exemption can benefit various groups of people or entities, such as charities, religious organizations, educational institutions, veterans, social clubs, and political parties.

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In this article, we will explain the following topics:

The difference between tax exemption, tax deduction, and tax credit
The common types of tax-exempt income for individuals
The requirements and benefits of tax-exempt status for organizations
The process and forms for applying for tax exemption

Tax Exemption vs. Tax Deduction vs. Tax Credit

Tax exemption, tax deduction, and tax credit are three different terms that relate to how income or transactions are treated for tax purposes. They are often confused, but they have distinct meanings and effects. Here is a brief overview of each term:

Tax exemption is an amount or a type of income that is not subject to tax. For example, interest income from municipal bonds is tax-exempt at the federal level, meaning that it is not included in the taxable income of the bondholder. Tax exemption can also refer to the status of an organization that is not required to pay income tax on its revenue, such as a charity or a church.
A tax deduction is an expense or a contribution that can be subtracted from the taxable income of a taxpayer, reducing the amount of tax they owe. For example, mortgage interest, state and local taxes, medical expenses, and charitable donations are common tax deductions for individuals. Tax deductions can be claimed either by using the standard deduction (a fixed amount based on the filing status of the taxpayer) or by itemizing deductions (listing each eligible expense or contribution separately).
Tax credit is an amount that can be directly subtracted from the tax liability of a taxpayer, lowering the amount of tax they pay. For example, the child tax credit, the earned income tax credit, and the education tax credit are common tax credits for individuals. Tax credits can be either refundable or nonrefundable. Refundable tax credits can result in a tax refund if they exceed the tax liability, while nonrefundable tax credits can only reduce the tax liability to zero.

Types of Tax-Exempt Income for Individuals

While most types of income are taxable, there are some exceptions that are exempt from federal income tax. Some of these exceptions may also be exempt from state and local income taxes, depending on the tax laws of each jurisdiction. Here are some examples of tax-exempt income for individuals:

Interest income from municipal bonds. Municipal bonds are debt securities issued by state and local governments to finance public projects, such as roads, schools, or hospitals. The interest income from these bonds is exempt from federal income tax and usually from state and local income tax as well, if the bondholder resides in the same state or locality as the issuer.

Distributions from health savings accounts (HSAs)

HSAs are special savings accounts that allow individuals to set aside money for qualified medical expenses, such as doctor visits, prescriptions, or hospital bills. The contributions to HSAs are tax-deductible, the earnings in the accounts are tax-deferred, and the distributions are tax-exempt, as long as they are used for qualified medical expenses.

Qualified distributions from Roth 401(k) plans and Roth IRAs

Roth 401(k) plans and Roth IRAs are retirement savings accounts that allow individuals to make after-tax contributions and enjoy tax-free growth and withdrawals. The distributions from these accounts are tax-exempt, as long as they meet certain requirements, such as being made after the age of 59 1/2 and after holding the account for at least five years.

Foreign earned income exclusion

The foreign-earned income exclusion is a provision that allows U.S. citizens and resident aliens who live and work abroad to exclude a portion of their foreign-earned income from U.S. income tax. For 2023, the maximum exclusion amount is $109,600. To claim this exclusion, the taxpayer must have foreign-earned income, their tax home must be in a foreign country, and they must meet either the bona fide residence test or the physical presence test.

Requirements and Benefits of Tax-Exempt

Some organizations may qualify for tax-exempt status under the Internal Revenue Code, meaning that they are not required to pay federal income tax on their revenue. These organizations are usually classified under section 501© of the code, which lists various categories of exempt purposes, such as charitable, religious, educational, scientific, social welfare, political, and others. Each category has its own specific requirements and limitations for obtaining and maintaining tax-exempt status.

The benefits of tax-exempt status for organizations include:

Exemption from federal income tax on the revenue related to the exempt purpose of the organization
Eligibility to receive tax-deductible donations from individuals and corporations
Exemption from certain state and local taxes, such as sales tax, property tax, or franchise tax
Access to grants and other funding opportunities from foundations, government agencies, or other sources
Enhanced credibility and public trust in the mission and activities of the organization

Process and Forms for Applying for Tax Exemption

To apply for tax-exempt status, an organization must follow the steps outlined by the IRS, which include:

Choosing a legal structure for the organization, such as a corporation, a trust, or an association
Adopting a governing document, such as articles of incorporation, bylaws, or a trust agreement, that states the purpose, structure, and rules of the organization
Obtaining an employer identification number (EIN) from the IRS, regardless of whether the organization has employees or not
Filing the appropriate application form with the IRS, depending on the type and size of the organization. The most common forms are:
- Form 1023, Application for Recognition of Exemption Under Section 501©(3) of the Internal Revenue Code, for charitable, religious, educational, and other organizations that seek exemption under section 501©(3)
- Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501©(3) of the Internal Revenue Code, for smaller organizations that meet certain criteria and seek exemption under section 501©(3)
- Form 1024, Application for Recognition of Exemption Under Section 501(a), for organizations that seek exemption under other subsections of section 501©, such as social welfare organizations, business leagues, social clubs, and veterans’ organizations
- Form 1024-A, Application for Recognition of Exemption Under Section 501©(4) of the Internal Revenue Code, for organizations that seek exemption under section 501©(4), such as civic leagues, advocacy groups, and volunteer fire departments
Paying the required user fee, which varies depending on the type and size of the organization and the application form used
Receiving a determination letter from the IRS, which states whether the organization is recognized as tax-exempt or not

The IRS provides detailed instructions, resources, and FAQs for each type of organization and application form on its website. The IRS also offers online training courses and workshops to help organizations understand and comply with the tax-exempt rules and regulations.

The advantages and disadvantages of tax exemption

Tax exemption can have both advantages and disadvantages, depending on the type, source, and purpose of the income or transaction. Here are some of the main pros and cons of tax exemption:

Advantages of tax exemption:

Tax exemption can lower the tax burden for taxpayers who have certain types of income or transactions that are deemed to be beneficial for the public interest, such as charitable donations, educational expenses, or foreign-earned income.
Tax exemption can also encourage or incentivize certain behaviors or activities that are considered to be socially desirable, such as saving for retirement, investing in municipal bonds, or supporting nonprofit organizations.
Tax exemption can also enhance the credibility and public trust of nonprofit organizations that are recognized as tax-exempt by the government, as they are subject to certain rules and regulations that ensure their accountability and transparency.
Tax exemption can also provide access to grants and other funding opportunities from foundations, government agencies, or other sources that are restricted to tax-exempt entities.

Disadvantages of tax exemption:

Tax exemption can also create complexity and confusion for taxpayers who have to determine whether their income or transactions qualify for tax exemption, and how to report them on their tax returns. Tax exemption can also vary by jurisdiction, so taxpayers may have to comply with different tax laws at the federal, state, and local levels.
Tax exemption can also result in revenue loss for the government, which may affect the provision of public goods and services, or require higher taxes on other sources of income or transactions to compensate for the shortfall.
Tax exemption can also create unfairness or inequality among taxpayers who have similar income or transactions, but are treated differently for tax purposes, depending on their eligibility for tax exemption. Tax exemption can also create loopholes or opportunities for tax avoidance or evasion by some taxpayers who abuse the system.
Tax exemption can also impose certain restrictions or limitations on the activities or operations of tax-exempt entities, such as nonprofit organizations, which may affect their autonomy, flexibility, or efficiency. Tax-exempt entities may also face public scrutiny or criticism for their use of funds or their alignment with their mission.

What Is Tax Exemption: Frequently Asked Questions (F&Qs)

How do I get a tax exemption certificate in the US?

To get a tax exemption certificate in the US, you need to follow the steps outlined by the Internal Revenue Service (IRS) and the state tax authorities where you operate. The process and the requirements may vary depending on the type and the purpose of your organization, but generally, you need to:

Choose a legal structure for your organization, such as a corporation, a trust, or an association
Adopt a governing document, such as articles of incorporation, bylaws, or a trust agreement, that states the purpose, structure, and rules of your organization
Obtain an employer identification number (EIN) from the IRS, regardless of whether your organization has employees or not
File the appropriate application form with the IRS, depending on the type and size of your organization.
Pay the required user fee, which varies depending on the type and size of the organization and the application form used
Receive a determination letter from the IRS, which states whether your organization is recognized as tax-exempt or not
File the appropriate application form with the state tax authorities, depending on the state and the type of exemption you seek. Some states may accept the IRS determination letter as proof of exemption, while others may have their own forms and criteria. You may also need to apply for exemption from state and local sales tax, property tax, or franchise tax, depending on the state and the nature of your activities.

What organizations are exempt from tax in the US?

There are various types of organizations that are exempt from federal income tax in the US, depending on their purpose, structure, and activities. According to the Internal Revenue Service (IRS), the major classifications of organizations that might qualify for tax exemption are:

Organizations exempt from income tax under Internal Revenue Code Section (IRC) 501 (including charities, private foundations, and other types of exempt organizations, such as business leagues, labor unions, and veterans’ organizations)
Political organizations described in IRC 527
Federal, state, and local governments
Indian tribal governments

Each classification has its own specific requirements and limitations for obtaining and maintaining tax-exempt status. Some of these organizations may also be exempt from state and local taxes, depending on the tax laws of each jurisdiction.

Some examples of tax-exempt organizations under IRC 501 are:

Charitable organizations, such as churches, synagogues, universities, hospitals, the Red Cross, homeless shelters, and other groups that seek to improve our society
Social welfare organizations, such as civic leagues, advocacy groups, and volunteer fire departments
Agricultural or horticultural organizations, such as farmers’ cooperatives, agricultural research organizations, and plant societies
Labor organizations, such as unions, trade associations, and professional societies
Social clubs, such as country clubs, hobby clubs, and sports clubs
Fraternal societies, such as lodges, fraternal orders, and benevolent associations
Employee benefit associations or funds, such as health savings accounts, pension plans, and welfare funds
Veterans’ organizations, such as veterans’ associations, posts, and auxiliaries