What Does It Mean To Be Tax Exempt or Have Tax-Exempt Income?

Defining Tax Exempt

Tax-exempt refers to income or transactions that are free from tax at the federal, state, or local level. The reporting of tax-free items may be on a taxpayer's individual or business tax return and shown for informational purposes only. The tax-exempt article is not part of any tax calculations.

Tax-exempt may also refer to the status of a business or organization which has limits on the amount of income or gifts which are taxable. These organizations include religious and charitable institutions.

Common Tax Exempt Earnings

Not to be confused with a tax deduction, tax-exempt frees the taxpayer of any tax obligation to submit taxes on the tax-free transaction or income. Whereas, the use of a tax deduction is to reduce the tax obligation by lowering gross income.

One common type of tax-exempt income is interest earned on municipal bonds, which are bonds issued by states and cities to raise funds for general operations or a specific project. When a taxpayer makes interest income on municipal bonds issued in their state of residence, the profit is exempt from both federal and state taxes.

Taxpayers receive IRS Form 1099-INT for any investment interest they earn during the tax year. The reporting of tax-exempt interest is in box 8 of the 1099 form. This informational only data are not included in the calculation of personal income taxes.

Capital Gains Tax Exemption

A taxpayer may buy an asset and subsequently sell that asset for a profit. The profit is a capital gain, which creates a taxable event. However, several types of capital gains are exempt from taxation. 

A taxpayer can offset capital gains with other capital losses for the tax year. For example, an investor with $5,000 in profits and $3,000 in losses pays taxes on only $2,000 in capital gains. The amount of capital losses a taxpayer may claim in a given year has a cap of $3,000. When capital losses exceed this cap, the excess may be carried forward to offset gains in future years. 

The tax code also allows taxpayers to exclude from federal taxes a specific portion of capital gains from the sale of a home.

Alternative Minimum Tax and Exemptions

The alternative minimum tax (AMT) is an alternative method for determining tax liability. AMT adds back specific tax-exempt items into the personal tax calculation. Interest from private activity bonds exempt from regular tax, for example, is added to the AMT tax calculation. Individual taxpayers must include the AMT calculation with their original tax return and pay tax on the higher tax liability.

Tax-Exempt Organizations

An exempt organization that has $1,000 or more of gross income from an unrelated business must file Form 990-T. An organization must pay estimated tax if it expects its tax for the year to be $500 or more.

501(c)(3) nonprofit corporation is a charitable organization that the IRS recognizes as tax-exempt. This type of organization does not pay income tax on its earnings or on the donations it receives. Also, any taxpayer donations may reduce a taxpayer's taxable income by the donation amount. This incentive encourages private charity and makes it easier for nonprofits to raise money.

A 501(c)(3) is a charitable organization involved in religious, charitable, educational, literary, preventing cruelty to animals and children, fostering amateur local and international sports competitions, testing for public safety, and scientific activities or operations.

Article Sources
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  1. Internal Revenue Service. "Exempt Organization Types."

  2. Internal Revenue Service. "Credits and Deductions."

  3. Municipal Securities Rulemaking Board. "About Taxable Municipal Bonds."

  4. Internal Revenue Service. "Publication 550: Investment Income and Expenses," Page 11.

  5. Internal Revenue Service. "Publication 550: Investment Income and Expenses," Page 16.

  6. Internal Revenue Service. "Topic No. 409: Capital Gains and Losses."

  7. Internal Revenue Service. "Publication 523: Selling Your Home," Page 2.

  8. Internal Revenue Service. "Tax Topic No. 556: Alternative Minimum Tax."

  9. Internal Revenue Service. "Instructions for Form 6251 (2018)," Page 4.

  10. Internal Revenue Service. "Unrelated Business Tax."

  11. Internal Revenue Service. "Exemption Requirements - 501(c)(3) Organizations."

  12. Internal Revenue Service. "Publication 557: Tax-Exempt Status for Your Organization," Pages 22-23.

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