What does tax exempt mean under US Code 26 ?

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Tax exempt under Internal Revenue Code means that certain kinds of income are not taxed at the hand of the recipient of such income. It also means personal exemption from federal tax up to some dollars ($4000 till the year 2017). The personal exemption granted to individuals since 1913 was abolished after the Tax Cuts & Jobs Act (TCJA) became law in 2017.

The word tax-exempt may also mean the status of a business or organization which include religious and charitable institutions are approved by IRS as a tax-exempt organization. So, the answer to the often asked question “are churches tax-exempt ?” is yes and like churches, there are other social organizations or charitable trusts or NGOs that also can be granted tax-exempt status under US Code 26 by the IRS upon fulfilling certain conditions.

Tax-Exempt Organizations

A certain nonprofit corporation is recognized by IRS under IRC 501(c)(3) as tax-exempt. This type of tax exempt organization has two key benefits -it does not pay tax and by donation, it receives from a donor also reduce a taxpayer’s taxable income by the donation amount. A 501(c)(3) is a charitable organization involved in religious, charitable, educational, literary, preventing cruelty to animals and children, fostering amateur local and international sports competition, testing for public safety, and scientific activities or operations.

Tax-exempt under IRC 501(c)(12).

The following types of organizations are tax exempt

  1. Benevolent life insurance associations of a purely local character
  2. Mutual ditch or irrigation companies
  3. Mutual or cooperative telephone companies
  4. Mutual or cooperative electric companies

Tax exempt employees

When a tax exempt employee fills out Form W-4, employers need not withhold any federal income tax from their wages. However, unless an employees meet the following  qualifications to be tax exempt, withholding can not be prevented :

  1. In the previous year, the employee had the right to a refund of all federal income tax withheld from their wages because they had no tax liability.
  2. In the current year, the employee expects a refund of all federal income tax withheld because they plan to have no tax liability.

No Automatic Tax Exemption under State Law

But, the employee who has tax-exempt status under federal law ( IRC) can not automatically claim exemption from state or local income taxes. In some states, Form W-4 might or might not exempt the employee from state or local income taxes. The employee might need to fill out a different form for state or local withholding. Because the laws are different everywhere, you should check with your state and local laws. If an employee needs help determining if they are exempt from taxes, direct them to IRS Publication 505.

What are some common tax exempt earnings

Following are the most common types of tax-exempt income

  1. Interest earned on municipal bonds, – Municipal corporation in a State or city ,, often issue tax exempt bonds as part of funding its projects . On such bonds , the government tax exempt any earning of interest
  2. Capital Gains Tax Exemption

Under the 26 US code, there are several ways in which a taxpayer can tax-exempt his capital gains. For example, you can offset capital gains with other capital losses for the tax year. So, if you have $7,000 in gains on the sale of a capital asset A and $5,000 in losses on the sale of capital asset B, you will pay taxes on only $2,000 in capital gains.

Please note that the number of capital losses a taxpayer may offset with current year gains in a given year is limited to $3,000. If you have capital losses exceed this cap, the excess may be carried forward to offset gains in future years. The tax code also allows taxpayers to exclude from federal taxes a specific portion of capital gains from the sale of a home.5

Tax Exemption & Alternative Minimum Tax

The alternative minimum tax (AMT) is an alternative method for determining tax liability. AMT adds back specific tax-exempt items into the personal tax calculation. Interest from private activity bonds exempt from regular tax, for example, is added to the AMT tax calculation. Individual taxpayers must include the AMT calculation with their original tax return and pay tax on the higher tax liability.

How to Report Tax Exempt to IRS?

Taxpayers receive IRS Form 1099-INT for any investment interest they earn during the tax year. The reporting of tax-exempt interest is in box 8 of the 1099 form. This informational only data are not included in the calculation of personal income taxes.

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By Prashant Thakur

Prashant Thakur is a tax advisor . He has written two books on tax laws of India. He regularly writes on his paid-only website http://taxworry.com. He is learning about the Internal Revenue Code of USA as many of clients and readers are of India origin and also are tax resident of USA . So . solving their tax issues require reference to IRC of USA.

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