Tax exemption is the reduction or removal of a liability to make a compulsory payment that would otherwise be imposed by a ruling power upon persons, property, income, or transactions. Tax-exempt status may provide complete relief from taxes, reduced rates, or tax on only a portion of items. Examples include exemption of charitable organizations from property taxes and income taxes, veterans, and certain cross-border or multi-jurisdictional scenarios.
Similar terminology is used on different types of tax expenditures, such as tax exclusion and tax deduction. A tax exemption is an income stream on which no tax is levied, such as interest income from state and local bonds, which is often exempt from federal income tax. Additionally, certain qualifying non-profit organizations are exempt from federal income tax. A tax exclusion refers to a dollar amount (or proportion of taxable income) that can be legally excluded from the taxable base income prior to assessment of tax, such as the $250,000/$500,000 home sale tax exclusion in the U.S. A tax deduction is a documented amount subtracted from the adjusted gross income to compute taxable income, such as charitable contributions.
International duty free shopping may be termed "tax-free shopping". In tax-free shopping, the goods are permanently taken outside the jurisdiction, thus paying taxes is not necessary. Tax-free shopping is also found in ships, airplanes and other vessels traveling between countries (or tax areas). Tax-free shopping is usually available in dedicated duty-free shops. In such a scenario, a sum equivalent to the tax is paid, but reimbursed on exit. More common in Europe, tax-free is less frequent in the United States, with the exception of Louisiana. However, current European Union rules prohibit most intra-EU tax-free trade, with the exception of certain special territories outside the tax area.
Specific monetary exemptions Some jurisdictions allow for a specific monetary reduction of the tax base, which may be referred to as an exemption. For example, the U.S. Federal and many state tax systems allow a deduction of a specified dollar amount for each of several categories of "personal exemptions". Similar amounts may be called "personal allowances". Some systems may provide thresholds at which such exemptions or allowances are phased out or removed.26 USC 151, Allowance of deductions for personal exemptions. The amount per exemption is $3,650, subject to phase-out. UK tax free personal allowances vary.
Exempt organizations Some governments grant broad exclusions from all taxation for certain types of organization. The exclusions may be restricted to entities having various characteristics. The exclusions may be inherent in definitions or restrictions outside the tax law itself.As an example, UK charities law defines the types of organizations which may qualify as registered charities, and places limits on their actions.
Approaches for exemption There are several different approaches used in granting exemption to organizations. Different approaches may be used within a jurisdiction or especially within sub-jurisdictions.
Some jurisdictions grant an overall exemption from taxation to organizations meeting certain definitions. The United Kingdom, for example, provides an exemption from rates (property taxes), and income taxes for entities governed by the Charities Law. This overall exemption may be somewhat limited by limited scope for taxation by the jurisdiction. Some jurisdictions may levy only a single type of tax, exemption from only a particular tax.
Some jurisdictions provide for exemption only from certain taxes. The United States exempts certain organizations from Federal income taxes,26 USC 501(a). The exemption from Federal income tax is longstanding. This exemption formed part of the Revenue Act of 1894. The 1894 Act was the first broadly applicable U.S. tax on corporate income, but was soon declared unconstitutional. Since ratification of the Sixteenth Amendment to the United States Constitution in 1913, the exemption for charitable, religious, and educational organizations has been included in all subsequent Federal income tax law. See Belknap, Chauncey, "The Federal Income Tax Exemption of Charitable Organizations: Its History and Underlying Policy," 1954, reprinted (very large file) as pages 2025-2043 of the Research Papers of the Commission on Private Philanthropy and Public Needs, Volume IV, 1977. but not from various excise or most employment taxes.26 USC Subtitle D excise taxes are imposed on particular goods or services, generally without exemptions. Certain of these taxes apply primarily to tax-exempt organizations. See, e.g., 26 USC 4911, tax on excess expenditures to influence legislation. 26 USC 3101 and 3301 generally impose social security and unemployment taxes on all organizations. Note that income from certain types of services, such as services as a minister, may be exempt from the definition of income for these taxes. Employees of certain nonprofit and governmental organizations are eligible to participate in different sorts of deferred compensation plans than employees of other organizations. Compare 26 USC 401, IRS Publication 560 and others vs. 26 USC 403(b), IRS Publication 571.
Charitable, nonprofit and religious organizations Many tax systems provide complete exemption from tax for recognized charitable or nonprofit organizations. Such organizations may include religious organizations (temples, mosques, churches, etc.), fraternal organizations (including social clubs), public charities (e.g., organizations serving homeless persons), or any of a broad variety of organizations considered to serve public purposes.
The U.S. system exempts from Federal and many state income taxesNote that under the U.S. system each state is entitled to raise its own taxes. 43 of the states impose a [state income tax]. Some states incorporate or make reference to Federal definitions for parts of their tax laws. See, e.g.,. the income of organizations that have qualified for such exemption. Qualification requires that the organization be created and operated for one of a long list of tax-exempt purposes,26 USC 501(c) which includes more than 28 types of organizations and also requires, for most types of organizations, that the organization apply for tax-exempt status with the Internal Revenue Service,26 CFR 1.501(a)-1(a)(2). or be a religious or apostolic organization.26 USC 501(d).See IRS Publication 557. The U.S. system does not distinguish between various kinds of tax-exempt entities (such as educational versus charitable) for purposes of granting exemption, but does make such distinctions with respect to allowing a tax deduction for contributions.Tax-exempt entities with gross receipts over US$25,000 are required to file annual tax returns on Form 990. Those with less than $25,000 must file a simplified return. The IRS granted an extension of time for such organizations to file for 2009 until October 15, 2010. Charities falling under that revenue threshold have had no regular filing mandate in the past. One list of small organizations is at http://www.501exempt.com .
The UK generally exempts public charities from business rates, corporation tax, income tax, and certain other taxes.For a discussion of UK taxation of charities, see the 1999 Review of Charity Taxation Consultation Document .
Tax exemption status of nonprofit organizations can in some cases result in financial mismanagement and negative societal value.
Governmental entities Most systems exempt internal governmental units from all tax. For multi-tier jurisdictions, this exemption generally extends to lower tier units and across units. For example, state and local governments are not subject to Federal, state, or local income taxes in the U.S.26 USC 115 specifically excludes from taxable income all income of states or municipalities, as well as income of public utilities. This operates as an exemption from tax for state and municipal governments.
Pension schemes Most systems do not tax entities organized to conduct retirement investment and pension activities for employees of one or more employers or for the benefit of employees.Examples include: a) The United States taxes beneficiaries of trusts, not trusts (with exceptions), but exempts under 26 USC 402 beneficiaries of a pension trust meeting certain qualification; b) Canada; c) The United Kingdom exempts income and gains of a registered pension scheme from taxation under Income Tax Act section 186, as discussed in the Registered Pension Scheme Manual. In addition, many systems also provide tax exemption for personal pension schemes.See, e.g., 26 USC 409 providing exemption to owners of Individual Retirement Accounts until funds are distributed.
Educational institutions Some jurisdictions provide separate total or partial tax exemptions for educational institutions.See, e.g., Malaysian Ministry of Higher Education chart of exemptions and benefits for private higher education institutions. These exemptions may be limited to certain functions or income.
Sales tax
Most states and localities imposing sales and use taxes in the United States exempt resellers from sales taxes on goods held for sale and ultimately sold. In addition, most such states and localities exempt from sales taxes goods used directly in the production of other goods (i.e., raw materials).
Exempt individuals Certain classes of persons may be granted a full or partial tax exemption within a system. Common exemptions are for veterans,See, e.g., New York City's veterans property tax exemption. clergymenSee, e.g., [26 USC 107] which excludes from income the rental value of a parsonage provided by a church to a clergyman or taxpayers with children (who can take "dependency exemption" for each qualifying dependent who has lived with the taxpayer. The dependent can be a natural child, step-child, step-sibling, half-sibling, adopted child, eligible foster child, or grandchild, and is usually under age 19, a full-time student under age 24, or have special needs).Presti and Naegele Newsletter , February __, 2012. The exemption granted may depend on multiple criteria, including criteria otherwise unrelated to the particular tax. For example, a property tax exemption may be provided to certain classes of veterans earning less than a particular income level.See the New York City rule cited above. Definitions of exempt individuals tend to be complex.
Exempt income Most income tax systems exclude certain classes of income from the taxable income base. Such exclusions may be referred to as exclusions or exemptions. Systems vary highly.Contrast 26 USC 101-140 exclusions from gross income to UK non-taxable income. Among the more commonly excluded items are: Income earned outside the taxing jurisdiction.See International tax for a discussion of territorial tax systems. Most systems exclude from the tax base income of nonresidents from sources outside the taxing jurisdiction. U.S. states and Canadian provinces provide for formulary apportionment of certain business income to achieve a similar result. See, e.g., the Multi State Tax Compact, discussed in a note below. Such exclusions may be limited in amount.See, e.g., 26 USC 911, 912. Interest income earned from subsidiary jurisdictions.See, e.g., 26 USC 103, excluding from U.S. Federal taxable income certain types of interest income received on bonds issued by states or political subdivisions thereof. Income consisting of compensation for loss.See, e.g., 26 USC 104, excluding compensation for sickness or injury. The value of property inherited or acquired by gift.The transfer of such property is often taxed separately to the transferor or the transferee. See Estate tax and Gift tax.