What is Tax Exemption and How to Become Tax Exempt
May 02, 2023
Not all taxpayers and organizations are required by the government to pay income taxes. These are individuals and entities that have been granted tax-exempt status by the IRS.
But what does it mean to be exempt from paying taxes, and are there any limitations to the exception?
If you are keen to learn more about what it means to be tax-exempt and check whether you are qualified, look no further. Read on and find out all about tax exemption, learn how to become tax-exempt, and more!
- Tax-exempt refers to the exclusion of an entity or individual from paying federal income taxes and other state or local tax deductions.
- Nonprofit organizations are typically granted tax exemption by the IRS as they raise funds for social welfare programs.
- Pension schemes, government entities, educational institutions, sales tax, reciprocal exemptions, and educational institutions are some examples of tax exemptions.
- One of the disadvantages of tax exemption is the prohibition against generating income for personal profit.
What Does It Mean to be Tax Exempt?
To be tax-exempt means not being subject to any federal, state, or local tax deductions. Tax exemption may also pertain to organizations or taxpayers whose taxable income is limited.
When an organization or individual has tax-exempt status, it means they gain income from voluntary contributions or donations. As such, they are not generating any revenue or profit that the IRS would deem appropriate for taxation.
Organizations may request that the Internal Revenue Service (IRS) grant them tax-exempt status. In return, organizations are required to continuously fulfill the corresponding requirements to file and report their exemption from tax obligations.
Tax Exemption Examples
In the following section, we’ll go over some common examples of tax exemptions.
#1. Pension Schemes
A pension scheme is a long-term benefit plan designed to allocate funds for retirement. It may be set up by the employees themselves, managed by a union, or regulated by the employer. Pension schemes are highly preferred by most employees since they are non-taxable and therefore allow them to have more money reserved by the time they retire.
#2. Governmental Entities
Governmental entities refer to any federal, state, or municipal entity, unit, or subdivision. Military organizations, cities, villages, boards, agencies, commissions, school districts, and bureaus are all subunits of the government.
#3. Educational Institutions
More commonly called academies, schools, universities, or colleges, educational institutions provide opportunities for bright young minds to learn, develop their skills, and expand their knowledge.
#4. Not-for-Profit Entities
The opposite of for-profit establishments, not-for-profit entities offer services to the community without expecting any payment or profit in return. Examples of not-for-profit entities are hospitals, charitable organizations, churches, museums, and volunteer groups.
#5. Reciprocal Exemptions
This type of tax exemption applies to intangible and personal assets left by citizens based in other states. The exemption granted by the law on personal properties excludes them from succession or inheritance tax.
#6. Sales Tax
Some goods and services are tax-free. These include raw materials used to manufacture goods, industrial machinery, medical services, and consumable goods.
Why are Nonprofit Organizations Tax Exempt?
With the keyword “nonprofit” it simply means that these organizations do not profit from the services and goods that they provide to the community. While they may generate earnings through fund-raising activities or invest in stock markets, the money nonprofit organizations make goes back to financing more programs.
As long as the members, trustees, and any other individuals tied to the nonprofit organization do not receive or use the income made by the organization for their personal use, they may qualify for exemption from federal income tax.
Can Tax-Exempt Organizations Make Money?
Yes, tax-exempt organizations are allowed to make money as long as the members do not benefit individually or allocate the organization’s earnings to a shareholder, a private individual, or a group.
The money generated by tax-exempt groups should be used for the purpose of maintaining the organization’s operations.
Non-Profit Organization vs. Tax-Exempt Organization
Nonprofit organizations and tax-exempt organizations are often confused as one and the same thing. It is also incorrect to assume that a nonprofit association is not permitted to generate income or that tax-exempt status means having complete freedom from paying taxes.
Here are some key factors that differentiate a tax-exempt organization from a nonprofit one:
- Definition. The term ‘nonprofit’ means that the organization is registered under state law and is recognized as a legal and independent entity. Tax-exempt denotes exemption from federal income taxes.
- Qualification. Most nonprofit organizations are tax-exempt, as elaborated under Sections 501(c)(3) and (c)(6) of the IRS code. However, qualifying for a federal income tax exemption may not always be a necessity, considering that there are still other types of state and local taxes that associations may be obligated to pay.
- Limitations. Exemption from federal taxes is not a free pass to skip all other tax obligations. Personal property taxes, SUTA, FICA, and specific state and local tax provisions limit tax exemption status to specific types of organizations only. These organizations include colleges, hospitals, and charitable groups.
How to Become Tax Exempt
If you want to be granted tax-exempt status, you must first register for an Employee Identification Number (EIN). You will need your EIN to file the tax-exempt application with the IRS.
Your organization must also be established as a legitimate entity to help determine whether the association was created for educational, charitable, medical, or religious purposes.
The IRS provides a series of steps and required documents for individuals and groups that wish to apply for federal income tax exemption status. It is important to check the specific documents required for each type of organization.
For instance, charitable, educational, and religious organizations must fulfill Form 1023-EZ and Form 1023, while social welfare organizations must fulfill Form 8976, Notice of Intent to Operate Under Section 501(c)(4) and Form 1024-A.
Are There Downsides to Being Tax-Exempt?
Exclusion from federal income tax does help lift a considerable amount of financial obligation. However, there are certain drawbacks that come with operating a nonprofit or tax-exempt organization.
First, the organization can only raise limited income or funds. Opportunities to create profitable opportunities for tax-exempt entities are also out of the question.
Second, since profitable transactions are not permitted in a tax-exempt structure, members may not distribute the organization’s income individually for personal gain.
Tax Exempt FAQ
#1. What is the meaning of tax exempted?
Tax exempted means an organization or individual is excluded from paying income taxes. Tax exemptions also vary per state, with some allowing multiple exemptions.
#2. How do I get a tax exemption?
File an application for tax exemption with the IRS. The IRS has a step-by-step guide on its website, along with information on which forms must be filled out based on the type of nonprofit organization or group.
You can also check the local or state government’s website for any additional tax exclusions for which you may be qualified.
#3. What are the two types of exemptions?
The two types of exemptions are “personal” and “dependency.” A personal exemption may be claimed by married taxpayers for their spouses as long as they are filing jointly. A dependent exemption is a deductible amount on taxpayers’ income for each of their dependents.
#4. What does fully exempt mean?
Fully exempt means an individual or entity is free from any tax obligation or liability. Fully exempt status is often granted to disabled veterans and philanthropic organizations.
Earning tax-exempt status comes with a set of responsibilities and limitations that qualified taxpayers must strictly abide by.
These responsibilities include providing relevant acts of service to the community in the form of educational resources, medical assistance, and charitable programs.
Consequently, the freedom from paying income taxes also means setting aside profitable gains and prioritizing the organization’s continued operations. If you are considering applying to be tax-exempt, it is crucial to assess whether it would benefit your association’s objectives in the long run or not.