Tax-exempt means not being required to pay taxes on certain types of income. Individuals can qualify for tax exemptions. Entire organizations can be completely tax-exempt.
Tax-exempt does not mean you don’t have to report the income on your tax return. However, it will not be added to your taxable income on your return.
Tax-Exempt: At a Glance
- Tax-exempt status depends on how income or funds are earned and used.
- Tax-exempt income must still be reported on your tax return, and may be included in taxable income calculations.
- Some investments generate tax-exempt earnings.
- Entire organizations can operate as tax-exempt entities.
Tax-Exempt vs. Other Tax Terms
The term “tax-exempt” has a very specific meaning, but is sometimes confused with other tax terms.
| Term | Definition |
|---|---|
| Tax-exempt | Means some (or all) income is exempt from taxes at the local, federal or state level. |
| Tax-deferred | Income is not taxed in the year you earn it — but rather deferred until later. For example, if you contribute to a traditional individual retirement account (IRA), you can defer income taxes until you start withdrawing from the account in retirement. |
| Tax-free | Can apply to goods and investments, such as when a state offers a tax-free weekend on certain goods, such as school supplies or tax-free Roth IRA withdrawals. |
Common Types of Tax-Exempt Income for Individuals
Certain types of income may be exempt from income taxes.
Gifts and Estates
If you give a gift (money or otherwise), there is an exemption of up to $19,000 per year, per individual. You can also give more than that, as there’s a lifetime gift tax exemption of $15 million, per individual.
Scholarships
Scholarships are only tax-exempt if the following conditions are met:
- You are pursuing a degree at an educational institution that has a standard curriculum, regular instructors and enrolled students who attend classes on site.
- The money you receive is applied toward required tuition and fees, or mandatory course expenses like books, supplies and equipment.
Disability Benefits
Not all disability benefits are taxable. Although Veterans Affairs (VA) disability benefits aren’t taxable, military disability retirement pay could be. Social Security disability benefits aren’t taxable unless you have more than $25,000 in income for individuals or $32,000 for married people.
Here are a few other examples of tax-exempt income:
- Workers’ compensation
- Supplemental security income
- Child support
- Welfare payments
Tax-Exempt Investments and Accounts
There are several ways to earn tax-exempt income through investing. There are also different investments and accounts that allow you to avoid paying income taxes.
- Municipal bonds: These pay interest that is exempt from federal taxes — and may also be exempt from state and local taxes as long as you purchase them in the state or municipality where you reside.
- Roth IRAs: This account allows your contributions to grow tax-free. Once you’re retired, your withdrawals are also tax-free.
Other examples of tax-exempt investments include Roth 401(k)s and some mutual funds and exchange-traded funds (ETFs).
What It Means To Be a Tax-Exempt Organization
Tax-exempt entities are organizations that don’t have to pay income tax on any income. These organizations don’t report a profit. Instead, they use funds for organizational purposes.
Types of Tax-Exempt Entities
Non-Profit Organizations
Non-profit organizations are charities and other organizations that receive income in the form of donations. These charitable donations could be cash or other assets. The donations are then given to those in need or are used for other charitable purposes.
Non-profit organizations don’t have excess contributions. All funds are used to pay for organization expenses and are used for the purposes of the organization.
For example, Goodwill stores receive donated goods, resell these goods and use the funds to help with job training and placement.
This means income in a non-profit is tax-exempt when being used for the purposes of the organization in compliance with IRS regulations.
Government Entities
Government agencies are typically funded by taxes, but can also earn money in other ways. The funds received by these organizations are tax-exempt.
Whether it’s the police force, public schools or another government organization, there are no taxes levied on the income collected for use in government agencies.
Religious Groups
Religious groups and churches are typically tax-exempt organizations. Most are required to file as a 501(c)(3) to receive tax-exempt status.
The donations collected by religious organizations are used for the mission and operation of the organization itself. Income from donations is considered tax-exempt, and these organizations do not need to pay income tax.
How Organizations Get Tax-Exempt Status
Organizations must apply for recognition of exemption and meet IRS requirements related to purpose, structure and use of funds.
Do Employees of Tax-Exempt Organizations Pay Taxes?
You will still have to pay income tax if you are an employee at a tax-exempt organization.
Your employer is generally required by law to withhold federal income tax from employees’ wages.
If you work for a nonprofit that doesn’t participate in the Social Security program, you must pay Social Security and Medicare taxes on any earnings above $108.28.
Rules That Can Revoke Tax-Exempt Status
Tax-exempt status isn’t permanent — it comes with strict rules. The IRS can revoke an organization’s exemption if it fails to operate within legal and regulatory guidelines.
Common reasons for losing tax-exempt status include:
- Engaging in political or lobbying activities beyond what’s allowed under IRS rules, especially for 501(c)(3) charities.
- Using funds for illegal or non-charitable purposes, including personal benefit or private interests.
- Failure to file required annual returns, like Form 990, for three consecutive years.
- Lack of transparency, including not making governing documents or filings available to the public when required.
Losing tax-exempt status means the organization becomes subject to federal income tax and may face penalties or reputational damage.
To avoid issues, it’s key to maintain compliance, keep thorough records and stay up to date on IRS requirements.
Common Myths About Being Tax-Exempt
Tax-exempt status is often misunderstood. Here are two common myths — and what the rules actually say.
- Many people assume “tax-exempt” means income doesn’t have to be disclosed to the IRS, but most tax-exempt income still does even if no tax is owed.
- Another misconception is that individuals can have tax-exempt status. They can have tax-exempt income, but only organizations can be tax-exempt.
Key Takeaways
Understanding how tax exemption works can help you make tax-smart decisions that can help you or your organization save money on your income taxes. Here are some key points to keep in mind:
- Tax-exempt status limits certain taxes but does not remove all tax obligations.
- Tax-exempt income is often still reported, even when it is not taxed.
- Whether income or an organization qualifies depends on specific IRS rules and usage requirements.
Tax-Exempt FAQ
These frequently asked questions explain what tax-exempt status means, how it works and what obligations still apply.- Is tax-exempt the same as tax-deductible?
- No. Tax-exempt income is not taxed at all, while tax-deductible expenses reduce how much of your income is taxed. Tax-exempt income may still be reported on your return even though it is excluded from taxable income.
- Can a charity lose tax-exempt status?
- Yes. A charity can lose its tax-exempt status if it violates IRS rules, such as engaging in prohibited political activity, misusing funds or failing to file required returns like Form 990 for three consecutive years.
- Do tax-exempt organizations still file tax forms?
- Yes. Most tax-exempt organizations are still required to file annual informational returns with the IRS, even though they do not pay federal income tax.
- What does it mean if you are tax-exempt?
- Being tax-exempt means certain income is not subject to federal income tax, but it does not mean the income is hidden from the IRS or exempt from reporting requirements.
Cynthia Measom contributed to the reporting for this article.