Tax Exempt

Updated on April 8, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Tax Exempt Meaning

Tax exempt refers to earnings excluded (partly or wholly) from tax collection at the federal, state, or local level. It helps ease off the tax liability and improve organizational transparency. For example, the government provides the tax exempt certificate to eligible entities for specific professional advancement or for encouraging charitable foundations. 

Tax Exempt

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Tax exempt income is subtracted from the total earnings to calculate the taxable incomeCalculate The Taxable IncomeThe taxable income formula calculates the total income taxable under the income tax. It differs based on whether you are calculating the taxable income for an individual or a business corporation.read more. Moreover, maximum taxpayersTaxpayersA taxpayer is a person or a corporation who has to pay tax to the government based on their income, and in the technical sense, they are liable for, or subject to or obligated to pay tax to the government based on the country’s tax laws.read more are subject to definite exemptions for taxable salary cutback. At the same time, some individuals and companies relish total income tax exemption.

Key Takeaways

  • Tax exempt denotes the wholly or partially non-taxable income at the local, state, or federal level. Moreover, a common tax exempt example is the interest earned through municipal or US Federal bonds.
  • Tax Exemption, Tax Deduction, and Tax Credit are three different terms and must not be confused with each other.
  • The IRS exempts the tax of public welfare firms. It comprises charitable institutions, churches and religious groups, private foundations, political entities, and nonprofits.
  • Its merits are decreased tax burden, socio-economic advantages, and increased transparency. On the other hand, the demerits include increased cost of compliance and reduced tax collection. 

Tax Exempt Explained

Tax exempt or immunity signifies that a portion of or the total revenue of an entity is not liable to tax. Moreover, the tax exempt certificate allows the association or individual to make a tax-free purchase. For example, interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more on municipal bondsMunicipal BondsA municipal bond is a debt security issued by a national, state, or local authority to finance capital expenditures on public projects related to the development and maintenance of infrastructures such as roads, railways, schools, hospitals, and airports.read more and US Federal bonds are tax-free.

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If the married exempted taxpayer reports a joint federal tax return to the Internal Revenue Service (IRS), both partners collect the tax exempt income. Also, it permits the taxpayers to acquire additional exemptions for each claimed dependent. 

Please note that income tax exemption, tax deduction, and tax credit are three distinct concepts. 

  • Tax exemption represents wages that are partially or wholly non-liable to tax. 
  • Tax deduction depicts particular incurred payments and holdings qualified to decrease the taxable compensation. 
  • The tax credit is the capital amount subtracted from the overdue income taxes. 

Examples

Let us go through the following tax-exempt examples to understand the concept better:

You can download this Tax Exempt Excel Template here – Tax Exempt Excel Template

Example #1

Let us compute the taxable salary and payable tax amount of businessman Henry. Please note that the applicable tax rate is 24%. 

Furthermore, the details of his gains, expenditures, and assets are as follows:

Example 1

Here are the losses, donated amount, interest, and taxes paid:

Example 1-1

So, the taxable salary and payable tax amount will be:

Example 1-2

Example #2

Let’s determine the taxable income and tax liability for another businessman named Jacob. Please note that the applicable tax rate in this situation is 22%. Moreover, here lie the complete details and the required calculation. 

Example 2-2

Example #3

On 8 March 2021, Thailand announced the relaxation of investment tax rules in digital assets. The move will assist develop and facilitate the industry. In addition, it will allow traders to counterbalance the yearly losses against profits for taxes overdue on cryptocurrencyCryptocurrencyCryptocurrency refers to a technology that acts as a medium for facilitating the conduct of different financial transactions which are safe and secure. It is one of the tradable digital forms of money, allowing the person to send or receive the money from the other party without any help of the third party service.read more investments. 

Also, it has exempted a 7% Value Added TaxValue Added TaxValue-added tax (VAT) refers to the charges imposed whenever there is an accretion to a product's usefulness or value throughout its supply chain, i.e., from its manufacturing to its final selling point. It is an indirect tax levied on the product consumption.read more (VAT) for cryptocurrency trading performed on the authorized exchanges. The exemption will be effective during April 2022-December 2023. Furthermore, it incorporates the central bank-issued commercial central bank digital currencyDigital CurrencyDigital currency is a currency found only in an electronic form as it is used for trading over the internet. They are famous for allowing transparent and secured digital payments. Although their popularity is constantly growing, their adoption as a reliable alternative to physical money is nowhere close. Some of the popular digital currencies are Ethereum, Bitcoin, and Litecoin.read more trading. 

Tax Exempt Organizations

Tax-free organizations are mostly IRS-accredited associations committed to the public good. Moreover, it assists them in encouraging public prosperity efficiently. This relies upon the pursuits, revenue sources, and motives of the non-profits. Although exempt, they must typically lodge annual profits and bill returns with the IRS. 

types of tax exempt organizations

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1. Churches and Religious Bodies

Eligible churches (entailing unified auxiliaries and treaties or alliances) are automatically untaxed. Therefore, they don’t have to fill out the IRS tax-exempt forms

2. Charitable Institutions

It incorporates solely structured establishments and is utilized for charitable, scientific, religious testing for literary, educational, public safety, or further stated objectives. 

3. Political Entities

A committee, party, fund, association, or other agency (incorporated or not) is essentially regulated and employed for directly or indirectly spending and/or receiving donations for an exempted activity. 

4. Private Foundations

Generally, they have one crucial financing source (grants from a single company or family). They don’t directly conduct charitable trusts. Instead, most of them make grants to other humanitarian organizations and entities and receive a considerable tax benefitTax BenefitTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place.read more.

5. Other Non-profits

The civic leagues, social welfare institutions, labor organizations, business leagues, and social clubs must fill out the tax-exempt form.  

Advantages & Disadvantages Of Tax Exempt

Availing tax immunity or exemption may have pros and cons for any individual or entity. So let us look at them:

Benefit and Drawbacks of Tax Exempt

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1. Benefits

Reduced Tax Burden

It helps diminish the tax pressure on an individual or firm. 

Socio-economic Benefits  

Providing tax benefitsTax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place.read more to the public welfare programs refines their business structureBusiness StructureBusiness structure is the legal framework adopted by a company to execute business activities in compliance with the corporate rules and regulations. An organization can be a sole proprietorship, partnership, limited liability company or corporation.read more and offers numerous socio-economic advantages. 

No Downplaying Of Income 

Filing tax exempt forms on specified investments (for example, US federal bonds) reduces the odds of reporting incorrect financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more. Needlessly, this brings more accountability and enhances transparency.

2. Drawbacks

Increased Cost Of Compliance 

Filling the tax-exempt forms mandates the amenability to many formalities. Subsequently, this keeps adding to the cost of the organization.

Time-Consuming

The entire legal procedure may be quite time-consuming, with tons and tons of paperwork. So, the entity must be well-prepared for the same and be patient throughout the process. 

Misappropriation of Income/Expense 

Sometimes, individuals or firms use fraudulent activities to hamper their actual income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more. As a result, they tend to weigh the expenditures way higher than the profits.

Decreased Tax Collection

The government typically ends up with a much-reduced tax collection. Also, this reduces the net tax liability amount.

Frequently Asked Questions (FAQs)

What is Tax Exemption?

Tax exemption is the decrement or elimination of tax liability from eligible earnings or transactions by the federal or state government. This applies to both individual and non-profit organizations. Furthermore, it takes off the tax burden on an entity, enhancing the scope for transparency. 

What is Tax Exempt Interest?

Tax-exempt interest is the non-taxable interest amount on a bond utilized to fund government activities. For example, the interest income obtained from US Federal bonds or municipal bonds. Even if not a bond, interest income on the local or state government obligation may be tax-exempt. 

What is Tax Exemption Certificate?

A tax exemption certificate is an official document permitting the exempt entity to make a tax-free purchase from the seller. Its expiration date varies as per the entity type and state. Also, qualified taxpayers and charitable foundations can apply for the tax exempt certificate through the IRS portal. 

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