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What Is a Tax-Exemption?

Not all income or transactions are taxable! There are various reasons why something may be tax-exempt. Understanding why something is tax-exempt can save you, or your business, quite a bit of money. But what is tax-exempt, and what do you need to know about it?

Simply put, income/transactions are tax-exempt when they do not have to pay federal, state, or local tax. Various entities will receive tax-exemption breaks, and individuals can also qualify for some tax-exemptions breaks contingent on circumstances. 

How Does a Tax Exemption Work?

Tax-exemption works by reducing one’s tax liability. Say, one has an income of $100,000, it’s not unreasonable to think they’d have to pay tax on that income. Assuming the all-in tax rate is 25%, the individual or business would need to pay $25,000 in taxes to the federal, state, and local government. 

However, some of that income could be tax-exempt. This means the individual or business would not be obligated to pay tax on the portion of income that is in fact tax-exempt. Following the same example, if $20,000 of the initial $100,000 was tax-exempt income, the individual or business would only be responsible for paying tax on $80,000. 

What Are Tax Exemptions Used for?

Tax-exemptions are attractive for numerous reasons. As a household the less money you pay in taxes, the more money you keep in your wallet each year. You’ll be free to spend that saved money, or save it, as you please! Businesses also benefit from tax-exemptions.

The more money a business is able to retain, the more they can put that money to use. The business can invest or use the saved money as they please. Additionally, saving money on taxes increases the overall profitability of the business, which can benefit the various shareholders. 

Is a Tax Exemption a Good Thing?

Being exempt from paying taxes seems like a great thing! Who wouldn’t want to keep more money in their wallet each year. It’s true, when you’re the one saving money on your taxes, it’s hard to think of any negative consequences! 

But there is more than meets the eye. Imagine if you lived in a town that had the headquarters of a large corporation.

This corporation was for profit, and they paid taxes on the federal, state, and local level. If that corporation moves out of town, and – for example – a university expands their footprint and occupies that old space, that is a lot of tax dollars that is no longer going to the town.

As a result, the town will likely increase the tax rate for all the residents so the budget can still be achieved. 

What Is an Example of Tax Exemption?

Similar to the above example, some cities/towns actually offer various tax-exemption benefits to corporations so they can move their headquarters to a specific town. The town may negotiate with the corporation and say ‘if you move your business to our town, we will not charge you property tax.

This can save the company a great deal of money, and the town may see an economic boost as the employees would move to the town and spend their money within the town at the various businesses. 

Who Qualifies For Tax Exemptions

Let’s review who qualifies for tax exemptions. 

Which Individuals Are Tax Exempt?

On an individual level, and according to the 2020 tax law, you can be exempt from paying income taxes if you’re single, under the age of 65 and your yearly income does not exceed $12,400. The same is true for married couples, but the income cannot exceed $24,800. 

Various dependents and individuals with disabilities may also be tax exempt, and there are certain tax-deductions one can claim. 

Which Entities Are Tax Exempt?

There are various entities that are also exempt from taxes. These entities most commonly include; churches, not for profit organizations, charities, government entities, various education platforms such as a private school or university, museums, and nonprofit hospitals.

Chances are, if the entity is not designed to make a profit, it likely has some degree of a tax-exemption benefit. 

How To Apply for Tax Exemption Status

As long as someone else is not claiming you as a dependent, you can file a personal tax exemption when you do your taxes. There are various criteria that must be met, and specific deductions will be given for specific variables, such as the number of dependents you’re claiming.

An entity can fill out a tax exempt form and send it to the IRS. The entity will need to claim why they believe they are tax exempt, and additional information/reports will likely be required.

What If Someone Falsely Claims They’re Exempt?

If someone falsified their income status or disabilities to gain exempt tax status, that’s highly illegal and the IRS can crack down on that. Any entity that falsified information to gain tax exempt status is also commuting a crime and the owners will be held accountable. 

This is a form of tax fraud and the IRS shows no mercy. Penalties include serving time in federal prison and financial fines! 

Why Are Tax Exemptions Important?

Tax exemptions are important for a few reasons. Most notable: 

  • They can incentivize an organization to move their headquarters to a specific location 
  • They can save an entity a lot of money
  • Tax exemptions help individuals who need the help 
  • Tax exemptions will also help put more money in your wallet if you use them properly, and legally

Taxes Can be Confusing 

Without question, tax law and tax exemptions can be confusing. If done incorrectly, it can cost you legal and financial ramifications. Working with a professional financial advisor is a great way to ensure you’re maximizing your tax benefit without doing anything incorrectly!

Financial advisors can also help you invest your money into securities best aligned with your risk tolerance and financial goals.