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What is a tax exemption?

Tax exemption refers to the exclusion of something from taxation. Tax exemptions can apply to certain types of income, goods, or services, or to an entire organization such as a non-profit organization.

How does tax exemption work?

Tax exemption is a government exception from the tax rule. If something is tax-exempt, it means it is not subject to tax, or it is subject to a lower tax rate or only partial taxation. Tax exemption can apply in many cases.

For example, income from federal government bonds is typically exempt from local and state income taxes (while income from local and state bonds is usually exempt from federal income tax). An organization such as a charity, school, or religious institution can also be classified as tax-exempt. For instance, the Internal Revenue Service (IRS) exempts qualifying charitable organizations, among others, from federal income tax.

States may also classify an organization as tax-exempt. For example, California requires a separate application to classify an organization as exempt from income and corporate taxes. States can also classify organizations such as schools as exempt from paying sales tax on purchases.

Note: You can declare an exemption from tax withholding on your paycheck if you do not expect to be liable for federal income tax for the year, but this does not mean you are actually exempt from taxes. You may have to pay taxes when it comes time to file your tax return.

The IRS eliminated the personal tax exemption as part of the Tax Cuts and Jobs Act, and the lowest federal income tax rate is 10% on taxable income up to $10,275, or $20,550 for married couples filing jointly for the year 2022.

Examples of tax exemption

Tax exemption can apply to various taxes, such as federal or state taxes. But just because there is a tax exemption in one state, it does not mean that the tax exemption applies in another state. For example, a non-profit organization may be exempt from fees such as property taxes on buildings it owns in one state but not in another.

To be exempt from taxes at the federal level, organizations usually need to apply for tax-exempt status and meet requirements such as not operating for private interests. However, as the IRS points out, “the non-profit status is a legal concept of the state.”

Note: Tax-exempt income can vary widely. Income from investments in government bonds can be exempt from income taxes, for example.

There are many other things that are exempt from taxes. For instance, many states exempt regular groceries from sales tax.

What does tax exemption mean for individuals?

Understanding what it means to be tax-exempt can help you or your organization improve your taxes. If you know that certain types of investment income are tax-exempt, for instance, you may consider how those types of earnings fit into your portfolio to try to reduce your tax burden.

Note: Rules for tax exemption can vary significantly from state to state, so it’s important to ensure that what is exempt at the federal level also applies in your state and any other local tax authorities you may be subject to.

Individuals may also wish to understand what qualifies as tax-exempt when making decisions about their charitable donations.

Questions

Frequently Asked Questions (FAQs)

Why are churches tax exempt?

Churches and other religious institutions are exempt from taxes because Congress passed tax legislation that acknowledges the “unique status of these institutions in American society” and their prominence in the American Constitution. It should be noted that churches and religious institutions are not exempt from all taxes; some income from unrelated business activities (such as advertising in a church publication, for example, or certain types of rental income) is subject to taxation.

What does it mean to be tax exempt?

Tax exemption means that income is not subject to taxation by federal, state, or local authorities. The exempt status can apply to an individual or organization (such as a charity) whose income is not taxable, or to certain goods or services that are not subject to tax (such as groceries).

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Sources:

– Vanguard. “How Government Bonds Are Taxed.”

– IRS. “Exemption Requirements – 501(c)(3) Organizations.”

– California Tax Service Center. “Nonprofit/Exempt Organizations.”

– IRS. “IRS Provides Tax Inflation Adjustments for Tax Year 2022.”

– IRS. “Frequently Asked Questions About Applying for Tax Exemption.” Accessed Dec. 9, 2021.

– Tax Foundation. “Tax Treatment of Groceries, Candy, and Soda Can Get Tricky.”

– IRS. “Tax Guide for Churches and Religious Organizations.”

– IRS. “Exempt Organization Types.”

Source: https://www.thebalancemoney.com/what-does-it-mean-to-be-tax-exempt-5212549


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