Tax-exempt — is there a more beautiful hyphenated adjective in the English language? Since the very first income tax was collected in 1913, the U.S. tax code has included special exemptions for individuals and organizations in order to lower their tax burden.
Let's start by defining what is and isn't a tax exemption.
Tax exemptions are not the same as tax deductions, even though they accomplish the same thing: lowering your taxable income. To further confuse things, exemptions and deductions sit right next to each other on the 1040 tax form (lines 40 and 42). So how exactly are they different?
- Tax exemptions represent a fixed amount that can be claimed by all taxpayers on behalf of themselves, their spouses and dependents.
- Deductions, on the other hand, are different from taxpayer to taxpayer. They vary depending on your filing status if you claim the standard deduction, or the nature of your personal and business expenses if you itemize your deductions.
Over the years, Congress has recognized certain types of taxpayers and certain types of organizations as tax-exempt. Organizations have to apply for tax-exempt status, but people may qualify depending on how much money they make, whether they are foreign students and other criteria.
Keep reading to find out if you could use tax exemptions to save even more money on your income taxes.
The personal exemption is like a free gift from the IRS. But if the whole point of income taxes is to collect revenue, then why does the government automatically exempt such a healthy chunk of change — $3,950 in 2014 — from your taxable income?
Congress writes the tax code and legislators recognize that the lowest-income Americans are hardest hit by income taxes. Not that they pay the most — no, that would be the megarich — but the loss of a few thousand dollars could be the difference between subsistence and homelessness.
The personal exemption, as well as the spousal and dependent exemptions, are designed to exempt a certain baseline level of income from taxation. When the very first income tax was collected in 1913, the personal exemption was set at $3,000 (more than $72,000 in 2014 dollars), meaning relatively few people made enough to owe income tax [source: Tax Policy Center]. Today's exemption is not nearly as generous, but serves the same purpose.
Since the exemption is designed to benefit lower income earners, the IRS has instituted a phase-out for higher income earners. If you are a single filer and your adjusted gross income (AGI) is higher than $254,200, the amount of your personal exemption is reduced by 2 percent for every $2,500 that your income exceeds that limit. Once the AGI reaches $376,700, the personal exemption is reduced to zero [source: IRS]. (The AGI is the amount left after subtracting certain expenses, like student loan interest or alimony from your gross income).
A married couple filing a joint tax return can claim an exemption for both spouses of $3,950 each. The amount of the exemption is lowered if the couple has a total AGI greater than $305,050, phasing out completely at $427,550 [source: IRS].
If a married couple decides to file separately, the rules get trickier. If both of the spouses earn income, then they cannot claim each other for a spousal exemption. If one spouse earns income, but the other one doesn't, then the working spouse can claim two exemptions, one for him or herself and one for the nonworking spouse.
If you're filing as head of household, you need to either be unmarried or "considered unmarried" to qualify. It would seem, then, impossible to claim a spousal exemption. Not so! According to IRS rules, you are "considered unmarried" if your spouse didn't live with you for the last six months of the tax year, you provided more than half of the cost of keeping up your home, and you filed a separate return. If you meet those criteria, plus your spouse didn't earn any income, you can still claim a spousal exemption as head of household, provided you're supporting at least one child or qualifying relative (see the next page for more on this).
Some notes on spouse exemptions for widows/widowers [source: IRS]:
- If your spouse died during the tax year, you can still claim an exemption for him or her.
- If you remarry in the same year that your first spouse dies, you cannot claim an exemption for both spouses.
The tax code lets you claim a personal exemption, a spousal exemption, and a separate exemption for each of your dependents. Again, sounds simple enough, right? Dependents must mean your children, right? But if that's your sole definition, you're not thinking like the IRS.
The agency allows you to claim someone as your dependent if they are either your qualifying child or your qualifying relative.
A qualifying child, according to the IRS must be your "son, daughter, stepchild, foster child, brother, sister, half-brother, half-sister, stepbrother, stepsister, or a descendant of any of them." A qualifying child must be younger than 19 (or 24 if a full-time student) and younger than you and your spouse. The child must have lived with you for more than half of the tax year and you must have provided more than half of the child's financial support.
A qualifying relative, on the other hand, is someone for whom you provide financial support, but who doesn't fit the description of a qualifying child — he or she is older than you, for example. A qualifying relative doesn't necessarily have to live in your house, as long as you provide more than half of the person's financial support and they don't earn more than $3,900 per year. In a strange twist, a roommate or even a boyfriend/girlfriend can be a qualifying relative if you financially support them and they live with you. (Unlike an actual relative, the roommate or partner has to live with you to be a dependent).
Now that we've discussed the personal and household exemptions available to taxpayers, let's talk about an entirely different chapter of the tax code: tax-exempt organizations. Congress recognizes certain types of organizations as contributing to the public good. These organizations — typically, but not exclusively nonprofits —can apply to the IRS for an exemption from taxes on any business revenue.
Examples of tax-exempt organizations (and their associated chapter of the tax code) include:
- Charitable organizations — 501(c)(3)
- Churches and religious organizations — 501(c)(3)
- Private foundations — 501(c)(3)
- Civic leagues and social welfare organizations — 501(c)(4)
- Business leagues and trade associations — 501(c)(6)
- Social clubs — 501(c)(7)
- Veterans organizations — 501(c)(19) and 501(c)(23)
- Political organizations (that promote the election of political officials, not lobbying groups) — 527
Even small organizations can benefit. For example, tax-exempt status is available for certain childcare organizations under chapter 501(k). Let's say you run a small daycare out of your home. If the majority of your clients are people who could not otherwise work without placing their kids in childcare, and if you're open to all kids within a certain age range, you could qualify as tax-exempt [source: IRS].
To find out how your organization can gain tax-exempt status, read the IRS instructions in Publication 557.
The Alternative Minimum Tax (AMT) is a little-understood chapter of the U.S. tax code. In fact, the AMT represents an entirely separate and parallel set of calculations for determining taxable income. The AMT was designed to collect more taxes from wealthy individuals who take advantage of deductions and tax-sheltered income to lower their taxable income to close to zero.
The AMT excludes personal exemptions and some common itemized deductions — like state and local taxes, and child care credits — when calculating taxable income [source: The New York Times]. If you have a lot of dependents and live in a high-tax state like California or New York, the AMT can raise your taxable income considerably. By design, the amount of tax owed under the AMT will always be higher than under the regular tax code.
If you use tax preparation software, your tax program will run your income through the AMT rules and see if you qualify. If you do taxes by hand, you need to do the math on Form 6251.
Because the AMT excludes so many categories of deductions, the IRS offers an AMT exemption. In 2014, the AMT exemption is $52,800 for single filers and $82,100 for married couples filing jointly [source: IRS]. This exemption is subtracted from your taxable income similar to the way that the standard deduction is applied under the regular tax system.
The Self-employment Tax Exemption
If you are self-employed, you have to pay a self-employment tax in April, which amounts to your contribution to the Social Security and Medicare trust funds. (If you worked for someone else, those contributions are automatically deducted from each paycheck and your employer covers half of the cost.) But the tax code recognizes that not everyone wants to collect Social Security or Medicare assistance when they retire, and therefore shouldn't have to pay into the system.
Rather than opening up this exemption to all tax objectors, the IRS limits the self-employment tax exemption to licensed and ordained clergy members, and members of certain religious orders who have conscientious objections to receiving social services from the government [source: IRS]. This exemption is often claimed by members of Amish and Mennonite communities and Christian Science practitioners.
To claim the self-employment tax exemption, you must apply to the IRS using Form 4361. God speed.
Low-income Filing Exemption
Not everyone is required to file a tax return in April. If you earn less than the minimum filing requirement published by the IRS, you are off the hook. Here's the logic behind the minimum filing requirement:
- Every taxpayer is entitled to claim a personal exemption.
- Every taxpayer is entitled to claim the standard deduction.
- If the taxpayer's income is less than the sum of the personal exemption and standard deduction, he or she will have no taxable income.
For the 2014 tax year, you were considered exempt from filing federal income taxes if your gross income was less than the following amounts [source: IRS]:
- Single filers under 65: $10,150
- Single filers over 65: $11,700
- Married filing jointly, both under 65: $20,300
- Married filing jointly, one spouse over 65: $21,500
- Married filing jointly, both spouses over 65: $22,700
- Married filing separately, any age: $3,950
- Head of household, under 65: $13,050
- Head of household, over 65: $14,600
- Qualifying widow(er) with dependent child, under 65: $16,350
- Qualifying widow(er) with dependent child, over 65: $17,550
Veterans With Disabilities
Disabled veterans have made an enduring sacrifice for their country. These disabilities may exclude them from better-paying jobs or paid employment of any kind. Both federal and state legislators recognize the high price that disabled veterans have paid by offering a number of tax exemptions specifically for disabled vets.
On the federal level, disabled veterans can exclude all disability compensation and pension benefits from their gross income. That includes grants for homes or motor vehicles modified for greater accessibility [source: IRS]. Additionally, any money that a disabled vet earns as part of a Compensated Work Therapy (CWT) program is tax-exempt [source: IRS].
In addition, all 50 states offer some sort of property tax exemption for disabled vets [source: Duncan]. Some states require that the veteran be 100 percent disabled, while others are more generous. In general, the state property tax exemptions only cover a portion of the value of the home. Others limit the exemption based on income level.
International Organizations and Foreign Governments
Normally, the IRS collects income taxes from everyone living and working in the U.S., regardless of citizenship. A few lucky foreigners, however, are allowed to live and work in the U.S. without paying a dime in income tax.
Individuals working in the U.S. on behalf of a recognized international organization fall into this category. Check out this list of organizations designated as tax-exempt by the executive order of various American presidents. Among them are well-known entities like the World Health Organization and the United Nations. But there's also the Pacific Salmon Commission and the International Fertilizer Development Center.
Employees of these international organizations, plus their immediate families, are exempt from U.S. income taxes. The same exemption goes for foreign citizens who hold diplomatic visas to work in consulates and embassies. Both the diplomats and their families (spouses and children under 21) are exempt from U.S. income taxes.
Foreign Teachers, Trainees and Professional Athletes
There is a distinct advantage to filing taxes as a non-resident alien as opposed to a resident alien. Non-resident aliens only have to pay income tax on money earned from U.S. sources, while resident aliens (legal residents of the U.S. who are not citizens) owe tax on income from all sources, including foreign businesses and entities [source: Cussen].
One of the criteria that the IRS uses to decide if a taxpayer is a resident or non-resident alien is how many days they lived in the U.S. during the tax year and three prior years. So if you're a non-U.S. citizen and you want to pay less in taxes, there's a strong motivation to lower the official number of days you were in the country.
Here's where this particular exemption comes in. If you are a non-U.S. citizen temporarily in the country as a teacher or trainee (holding a J or Q visa), you can exempt all of the days you lived here. In other words, if you lived the entire year in the U.S. on a J visa while teaching at a university, you can still qualify as a non-resident alien for tax purposes. You would need to file Form 8843.
The same exemption covers an even smaller group of potential taxpayers: foreign professional athletes. If you are an Australian rugby player in the U.S. for an international tournament, none of those days count toward your total days of residency.
Many Americans don't think about their tax bills until the new year. But there are things you need to do before Dec. 31 if you want to pay less later.
Author's Note: 10 Tax Exemptions You Should Know
Seriously, though. I would love to be a fly on the conference room wall when the poor IRS writers sit down to compose their annual filing instructions. I am 100 percent sure that it's not their intention to create the most convoluted and confusing documents in the English language, but it's hard to tell from the results.
The true culprit, I know, isn't the IRS itself, but the 4-million-word tax code that it's trying to explain. There are so many terms to define, and so many caveats and special cases to decipher, that there's no way to be brief and straightforward. Also, your audience is so incredibly diverse — from wealthy households with vacation properties and foreign stock earnings, to struggling families surviving on government assistance.
This is how we get a definition of "dependent" that stretches over two pages and still doesn't address every possible way that a person can depend on your financially. So my heart goes out to the derided IRS, even as I mercilessly make fun of their forms. Why do I feel an audit in my future?
- Cussen, Mark P. "Tax Rules for Resident and Nonresident Aliens." Investopedia (Oct. 31, 2014) http://www.investopedia.com/articles/tax/11/tax-tips-for-non-residents.asp
- Duncan, Kimberly. "Full List of Property Tax Exemptions by State." Veterans United Network. Aug. 23, 2014 (Oct. 31, 2014) http://www.veteransunited.com/futurehomeowners/veteran-property-tax-exemptions-by-state/
- IRS. "Certain Payments to Disabled Veterans Ruled Tax-Free; Some May Be Due Refunds." Dec. 12, 2007 (Oct. 31, 2014) http://www.irs.gov/uac/Certain-Payments-to-Disabled-Veterans-Ruled-Tax-Free;-Some-May-Be-Due-Refunds
- IRS. "Form 4361, Application for Exemption from Self-Employment Tax for Use by Ministers, Members of Religious Orders and Christian Science Practitioners" (Oct. 31, 2014) http://www.irs.gov/pub/irs-pdf/f4361.pdf
- IRS. "H. IRC 501(k) – Child Care Organization" (Oct. 31, 2014) http://www.irs.gov/pub/irs-tege/eotopich89.pdf
- IRS. "In 2014, Various Tax Benefits Increase Due to Inflation Adjustments." Oct. 13, 2013 (Oct. 31, 2014) http://www.irs.gov/uac/Newsroom/In-2014,-Various-Tax-Benefits-Increase-Due-to-Inflation-Adjustments
- IRS. "Information for Veterans with Disabilities" (Oct. 31, 2014) http://www.irs.gov/Individuals/Information-for-Veterans-with-Disabilities
- IRS. "Personal Exemptions and Dependents" (Oct. 31, 2014) http://www.irs.gov/publications/p17/ch03.html
- IRS. "Publication 501" (Oct. 31, 2014) http://www.irs.gov/publications/p501/ar02.html
- The New York Times. "An Incomplete Fix." Jan. 13, 2013 (Oct. 31, 2014) http://www.nytimes.com/2013/01/14/opinion/an-incomplete-fix.html?_r=0
- Tax Policy Center. "Alternative Minimum Tax (AMT)" (Oct. 31, 2014) http://www.taxpolicycenter.org/taxtopics/amt.cfm
- Tax Policy Center. "Taxation and the Family: What is the personal exemption?" (Oct. 31, 2014) http://www.taxpolicycenter.org/briefing-book/key-elements/family/exemptions.cfm