Whether you run a business or work for someone else, you’ll pay taxes on that income. You’ll also pay sales tax on the products you buy each week. But there are instances where you may not have to pay tax to the federal, state or local government, or a combination of all three. A tax-exempt service or organization has approval from authorities to conduct transactions without tax liability, usually because of established status as a nonprofit.
Tax Exempt Definition
When something is tax exempt, no tax has to be paid on transactions related to it. Government agencies can grant tax-exempt status to organizations, individuals and certain transactions. A church may have tax-exempt status, for instance, as may the interest on certain municipal bonds. If an organization has tax-exempt status, it can actually affect taxpayers who donate money to it.
Tax exempt is often confused with a tax deduction or tax credit, both of which apply when you’re filing your taxes. But a tax-exempt item may not have to be reported at all. If it is reported, it’s for informational purposes, with no taxes coming out of it. A taxpayer may find that tax-exempt status reduces part of his tax liability or all of it, depending on how far the exemption extends.
Obtaining Tax-Exempt Status
If you’re running a nonprofit, you’ll want to obtain 501(c)(3) status from the IRS as early as possible. This will allow you to make purchases without paying sales tax, and get a break on your property taxes.
You’ll use Form 1023 to apply for this designation, but before you can submit it, you’ll need to have an Employer Identification Number, which you can obtain in a few minutes on the IRS website. You’ll also need information such as your articles of incorporation and details on the people involved with your organization.
Once you’ve been approved, it’s important to make sure you operate your organization on the up and up. Information on your operations becomes of interest to those who support and do business with your nonprofit, and if you have suspicious activity, you could put your tax-exempt status at risk. The IRS maintains a searchable database that was once called Select Check but has been renamed Tax Exempt Organization Search. Through this, anyone can see your tax returns and read a copy of the letter confirming your tax-exempt status.
Read More: How to File for a Tax Exempt Certificate
Maintaining Tax-Exempt Status
In order to maintain your 501(c)(3) status, you’ll need to make sure you remain in compliance with IRS guidelines in the years to follow. This includes filing the appropriate form within the 990 series by the tax deadline, regardless of whether you owe taxes on the money that has come through your organization during the tax year. There also may be certain forms and disclosures required of your nonprofit on an ongoing basis and failing to file one of those could put your status in jeopardy.
You can lose your tax-exempt status if you’re found to be operating outside of the parameters as set by the IRS. To keep your status, you’ll need to operate exclusively as a tax-exempt organization, which means engaging mostly in activities that support your mission, avoiding acting in ways that benefit private interests and never financially profiting from the activities of the organization.
As a tax-exempt organization, you’ll also be expected to refrain from political activities, including lobbying for politicians or activities not related to your organization and donating funds to campaigns.
Read More: 501c3 Bylaw Guidelines
Tax Exempt and Sales Tax
One huge perk of being a nonprofit is that you can make purchases without paying sales tax. Although it can vary from state to state, generally speaking, you’ll merely need to document proof of your 501(c)(3) status. The purchase will need to relate to your organization’s “charitable mission.”
You provide a certificate of sales tax exemption to each seller, which that seller will then keep on record in case the taxability of the sale is ever questioned. If you regularly buy from a particular seller, you may be able to set up a blanket exemption certificate that will cover every purchase.
If you’re selling products or services with the proceeds going toward your mission, you also may be exempt from collecting and remitting sales tax on those items. However, if you’re selling online or outside your typical business area, you’ll want to research local sales tax laws to make sure you’re compliant. In Washington State, for instance, nonprofits must collect and remit sales tax on any goods or services they sell.
Tax-Exempt Status and Donations
If you donate goods or money to a tax-exempt organization, you can tax deduct the amount, but the IRS will only accept donations to charities that it has qualified as having 501(c)(3) status. These are cataloged on the Tax Exempt Organization Search database. However, some organizations are acceptable recipients of tax-deductible donations without appearing in the database. Certain churches and other local-based nonprofits with annual gross receipts of $5,000 or less can receive tax-exempt treatment without going through the application process.
Those donating to nonprofit organizations must have written acknowledgment of any donation of $250 or more before they can claim it on their taxes. You, as a nonprofit, are required to provide written confirmation of any single payment of more than $75 in exchange for goods or services.
This means you’ll need to be set up to either send confirmation letters or provide receipts to everyone who donates to your organization. The document should contain the donor’s name, the amount of the donation, a description of any goods donated, a good-faith estimate of the goods or services provided and a statement detailing any goods or services received in exchange for the donation.
In addition to organizations, employees can also hold tax-exempt status. Although this is rare, businesses need to know how to deal with it when it happens. An employee is generally tax exempt because she filed her taxes last year and was due a refund of all the income withheld from her taxes and she will be due a refund this year. This usually happens when an employee doesn’t make enough of an annual income to require filing an income tax form, which means no taxes need to be withheld throughout the year.
To qualify for tax-exempt status, employees must complete a Form W-4 certifying that they’re exempt from withholding for the year. The exemption is only good for that tax year. The employee will have to submit a new W-4 form by Feb. 15 of each year and meet the requirements for tax exemption to avoid withholdings.
Certain forms of income are exempt from taxes each year. But unless the IRS specifically states an exception for it, all forms of income are taxable, but there are a few exceptions. Disability insurance payments are among those that fall into this category, although they are taxable if your employer paid the premiums. However, in some cases, disability insurance payouts aren’t taxable, including when the premiums are paid with after-tax dollars or when the payments are part of a workers’ compensation claim.
Other types of tax-exempt income include employer-provided insurance, tuition or medical expenses paid on someone else’s behalf, political and charitable contributions and life insurance payouts. You can also give up to $15,000 per year per individual.
Over the course of your life, as of 2020, you can give up to $11.58 million, which means even if you exceed $15,000 in a given year, you can count it toward your lifetime exclusion. The funds given will just count toward your estate when you die, which could result in a tax liability for your survivors if you have a substantial net worth.
Property Tax Exemptions
When asking, “What counts as a tax exemption?” it’s important to consider property in the answer. Since property tax can take a significant amount of a person’s income, having even a small exemption can make a big difference. One popular exemption is the Homestead Exemption, which allows you to avoid paying taxes on a certain amount of your home’s value. In Alaska, for instance, residents who are age 65 or older are exempt from paying property tax on the first $150,000 of their primary home’s assessed value.
In addition to the Homestead Exemption, seniors may find property tax relief in other ways. Several states have programs that provide generous property tax breaks to the elderly and the disabled. Military veterans are also offered exemptions on property tax in some areas. For those living in an older home, simply renovating it to get it up to current codes could qualify you for a property tax exemption in some states.
Tax Exemptions Versus Deductions
Tax exemptions can often be confused with tax deductions. Both help to reduce your taxable income, but they serve very different purposes. If money coming in is tax exempt, it means that no taxes are due on that amount, making it pure earnings. It reduces the need for employers to withhold taxes from paychecks or submit reports to tax authorities showing how much was earned.
A tax deduction, on the other hand, must be filed at tax time. The taxpayer needs to keep records of the expenses and input the information on the appropriate forms at tax time. There is a limit as to what can be deducted and unless the taxpayer is offsetting business income, the deductions must be enough to exceed the standard deduction, which can be difficult to do if it’s merely charitable contributions and property taxes.
For those who are self employed or run their own businesses, however, deductions can dramatically reduce the amount of annual earnings subject to self-employment tax, which is designed to help take care of these taxpayers’ retirement.
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Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.