Tax Exemption

A tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the Internal Revenue Service (IRS), preventing them from having to pay income tax.

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Why Do Tax Exemptions and Tax-Exempt Entities Exist?

The tax code distinguishes between entities that receive revenue through voluntary donations used for charitable expenses and those that earn revenue through market activity. As a category, tax-exempt entities exist because they do not make a profit and therefore have no taxable income. By contrast, corporations and pass-through businesses earn net profit that is taxed.

For example, imagine two business: Nonprofit A and Corporation C. Nonprofit A receives voluntary contributions as its only source of income, which is then used to pay expenses such as salaries and program-related activities. Corporation C receives revenue from market activity, which is then used to pay workers, reinvest, and earn more income.

Nonprofit A (Do-Good Industries)	Corporation C (Investors Incorporated)
Monthly Revenue: $10,000	Monthly Revenue: $1 million
Expenses:	Expenses:
Salaries: $5,000	Salaries: $500,000
	Other Expenses: $200,000
Programmatic Expenses: $5,000
Taxable Income: $0	Taxable Income: $300,000

What Are the Limitations on Tax-Exempt Entities?

The IRS grants tax-exempt status to organizations that meet the requirements under Section 501(c) of the tax code. None of its revenue may be used to benefit any private shareholder or individual.

History of Tax-Exempt Entities

Tax-exempt entities trace their origin to the Revenue Act of 1913, where Congress began to define and exclude certain organizations from tax due to their activities related to social welfare, charitable contributions, or religious education.

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