Instrumentality

What Is an Instrumentality?

An instrumentality is a non-governmental agency that acts independently but whose obligations are backed by the government because of its role in providing a public service.

In the U.S., the Federal National Mortgage Association, known as Fannie Mae, is an example of an instrumentality. Created during the Great Depression to enable more Americans to buy their own homes, Fannie Mae is both a government-sponsored entity and a publicly-traded company under the symbol FNMA.

Key Takeaways

  • An instrumentality is an independent agency or entity that provides an essential service to the public.
  • An instrumentality is subject to government overview but has no government powers.
  • Fannie Mae, Freddie Mac, Ginnie Mae, and Sallie Mae, are all federal instrumentalities created to promote homeownership and higher education.
  • State universities are instrumentalities of the state.
  • Instrumentalities cannot be taxed by another level of government.

Understanding an Instrumentality

An instrumentality may exist at the federal, state, or local level. It is created to fill a specific need that is deemed by the government to be in the public's interest.

The legal groundwork for instrumentality is based on the necessary and proper clause of the U.S. Constitution (Article 1, Section 8), which precludes federal and state governments from taxing each other's governmental operations.

This means that a state university, for example, may be an instrumentality of the state and therefore is not subject to taxation by the federal government.

The concept of instrumentality also extends the backing of the federal government for the entity's financial obligations based on the full faith and credit of the federal government.

The IRS Defines Instrumentality

The U.S. Internal Revenue Service (IRS) defines instrumentality:

"An instrumentality is an organization created by or pursuant to state statute and operated for public purposes. Generally, an instrumentality performs governmental functions but does not have the full powers of a government, such as police authority, taxation, and eminent domain. A wholly-owned instrumentality of one or more states or political subdivisions is treated as a state or local government employer for purposes of the mandatory social security and Medicare provisions and also applies to entities covered under Section 218 of the Social Security Act."

Examples of Instrumentality

The concept of instrumentality may be applied to a number of functions. For example, government-sponsored enterprises (GSE) including Fannie Mae (Federal National Mortgage Association), Ginnie Mae (Government National Mortgage Association), Freddie Mac (Federal Home Loan Mortgage Corporation), and Sallie Mae (Student Loan Marketing Association), are all federal instrumentalities.

These entities were created to provide a service that is in the public interest. Fannie Mae, Ginnie Mae, and Freddie Mac have roles in keeping the U.S. mortgage system stable and making mortgages available to more Americans by guaranteeing them. Sallie Mae provides a similar function for student loans.

Libraries, schools, hospitals, and fire departments may be instrumentalities, along with other associations formed for public purposes, depending on the circumstances. To determine if an organization is an instrumentality, a number of factors must be considered, including state regulations, state sponsorship requirements, and whether employees participate in a state-sponsored retirement system.

An instrumentality may be interstate in its reach. For example, an entity that is authorized by two or more states to provide a service in the public interest, such as an interstate transit authority or port authority, water district, or planning authority, is an instrumentality.

Benefits of an Instrumentality

Organizations that perform a public service obtain substantial tax benefits if they qualify as instrumentalities. The benefits include exemption from federal taxes of any income that derives from performing an essential governmental or public utility function.

Such organizations include libraries, hospital districts, state colleges, and fire departments.

How to Set Up an Instrumentality

A number of tests are used to determine whether an organization qualifies as an instrumentality:

  • The organization performs a government function.
  • It functions on behalf of a state or other government entity.
  • If it is forced to liquidate its assets, a government entity will have the interest of an owner in the process.
  • A government entity is represented on the governing board of the entity.
  • A government entity authorized the creation of the entity.
  • A government entity receives regular financial reports on the entity.

Federal instrumentalities are used to ensure greater access to mortgages and student loans.

The History of Instrumentalities

The necessary and proper clause provided Congress with the power to create a key federal instrumentality—a national bank.

Since this first, pivotal assertion of the role of the federal government, America's national banking system has grown into the Federal Reserve System (FRS) and developed a national network of commercial banks, thrifts, credit unions, and insurance companies.

McCulloch v. Maryland (1819), which provided the legal groundwork for the necessary and proper clause, was a landmark court challenge to an attempt by the state of Maryland to tax a national bank branch in Baltimore. At its essence, the Constitution forbids states from taxing federal instrumentalities and vice versa. This is the doctrine of intergovernmental immunity.

What Does Instrumentality of the State Mean?

An entity such as a public university may be an instrumentality of the state. That is, it is performing a necessary public service but it is not a public agency. It is independent of state control but permits state oversight.

Such entities are instrumentalities of the state. The Constitution exempts them from taxation by other levels of government, notably the federal government.

What Is a Government Instrumentality?

A government instrumentality, according to the IRS, is an organization that was created to provide a necessary public service but does not have the full power of a public agency such as the police powers or the power to tax. Like a government agency, its financial obligations are backed by the full faith and credit of the United States.

What Are Some Examples of Instrumentalities?

A state, county, or city hospital may be an instrumentality. An entity with an interstate role, such as a port authority, may be an instrumentality. An agency with a national role, such as Freddie Mac, the mortgage guarantee association, may be an instrumentality.

In any of these cases, the entity may or may not be an instrumentality. Because they are performing an essential public service, and because they have substantial tax benefits, there are strict rules for approval of instrumentality status.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Congress. "Constitution of the United States."

  2. Internal Revenue Service. "Government Entities and Their Federal Tax Obligations."

  3. The Public Finance Tax Blog. "Who Wants to be an Instrumentality?"

  4. Internal Revenue Service. "State Institutions - Instrumentalilties."

  5. Our Documents. "McCulloch v. Maryland (1819)."

  6. Internal Revenue Service. "What Are Government Entities and Their Tax Obligations?"

  7. The Public Finance Tax Blog. "Who Wants to be an Instrumentality?"

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