Tax-Exempt: Meaning & Definition

KEY TAKEAWAYS

• The federal standard deduction is the most well-known tax exemption.
• State and local exemptions are the other types of tax exemptions.
• Tax exemptions are mostly intended to support or shelter a certain group of individuals.
• Interest income that is tax-exempt is not taxed in any way, especially not at the federal level.

What Is Tax Exempt?

Tax-exempt is a term that refers to any transactions or income that is not subject to taxation. This is at the local, state, or federal level. Tax-free items may be reported and shown for informational purposes solely on a taxpayer’s corporate or individual tax return. The tax-exempt item is not taken into account when calculating taxes.

A firm or organization that has restrictions on the amount of income or gifts that are taxable is said to be tax-exempt. Religious and benevolent institutions are among these organizations.

How Does Tax-Exempt Work?

Tax-exempt works by having certain incomes or transactions that aren’t taxed at any level. Tax-exempt absolves the taxpayer of any duty to pay taxes on the tax-free gain or transaction.

How to Become Tax Exempt

You can check for the requirements for tax exemption & apply for tax-exempt status via the Internal Revenue Service (IRS) website. You will need to figure out what type of tax-exempt status you want. The choices are:

• Charitable, Educational, and Religious Organizations (501(c)(3))
• Social Welfare Organizations (501(c)(4))
• Other Nonprofit or Tax-Exempt Organizations (501(a))

How to Fill Out a Tax-Exempt Form

Filling out a tax-exempt form is quite a long and complicated process. Fortunately, the IRS has detailed instructions for each type of form. The types of forms that you need to fill out for each choice are listed as follows:

• Charitable, Educational, and Religious Organizations (501(c)(3))
  • Form 1023-EZ
  • Form 1023

• Social Welfare Organizations (501(c)(4))
  • Form 8976, Notice of Intent to Operate Under Section (501(c)(4))
  • Form 1024-A

• Other Nonprofit or Tax-Exempt Organizations (501(a))
  • Form 1024

What Is Tax-Exempt Interest?

Tax-exempt interest is interest income exempt from federal income taxes. In rare circumstances, a taxpayer’s eligibility for certain other tax advantages may be restricted by the amount of tax-exempt interest the person earns. 

Municipal bonds and income-producing investments held within Roth retirement accounts are the most frequent sources of tax-exempt interest.

How Long Can You Claim Exemption on Your Taxes?

You can claim an exemption on your taxes as a tax-exempt organization as long as the organization is in operation. However, you may need to re-file your forms on a yearly basis in order to keep the IRS up to date on your operations.

Summary

Tax exemptions allow charitable, educational, welfare, and religious organizations to reduce or eliminate their tax obligations. This means that they can focus more of their capital on their operations rather than on their tax bill. 

If your organization fits the criteria of a tax-exempt organization, make sure to fill out the relevant forms with the IRS so that you can legally claim tax exemption.

Written by Jami Gong, MPAcc, CPA

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.

Written by Jami Gong, MPAcc, CPA

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.