A Typology of Governments and Governmental Affiliates
1 Pages Posted: 31 May 2013
Date Written: May 31, 2013
There is much confusion as to how states and their political subdivisions are categorized and treated for purposes of the federal income tax. Many assume that a constitutional doctrine of intergovernmental tax immunity requires the federal government to refrain from taxing states and their political subdivisions. However, Supreme Court in cases such as New York v. United States, 326 U.S. 572 (1946), and Garcia v. San Antonio Transportation District, 469 U.S. 528 (1985), has rejected this position. Others believe that these governmental institutions are exempt under Internal Revenue Code (IRC section 115(1), which excludes “income derived from any public utility or the exercise of any essential governmental function and accruing to a State or political subdivision thereof, or the District of Columbia.”
In fact, however, the IRS does not treat IRC section 115 as the basis for exempting states and their political subdivisions. The IRS has concluded that the income of states and their political subdivisions are exempted from federal income tax under an implied statutory immunity. That is, these institutions are exempt from tax because, in general, no provision of the Internal Revenue Code taxes them at such. (There is one exception. IRC section 511(a)(2)(B) subjects state colleges and universities, however organized, to the unrelated business income tax.)
Moreover, any institution that is an integral part of a state or local government is also free of income tax under this implied statutory immunity. To be an integral part, the institution must be subject to control or substantial involvement by governmental officers and have a financial commitment from a state or political subdivision.
The IRS interprets IRC section 115 as applying to the income of an entity that is separate and distinct from a state or its political subdivision, that saves or makes money for the state or political subdivision, and whose assets revert to the state or political subdivision upon dissolution. In addition, the IRS balances public and private balancing in determining qualification for IRC section 115. In the view of the IRS, too much private benefit prevents IRC section 115 status, in the view of the IRS. As an example or entities that do qualify, many private ruling recognize IRC 115 status for pooled insurance funds of various political subdivisions.
For particular purposes – special rules for social security tax and federal unemployment tax and eligibility for governmental pension plans, the Internal Revenue Code refers to the category of “instrumentality” of a state government or political subdivision. Status as an instrumentality does not in and of itself qualify an institution for exemption. Nonetheless, institutions that qualify as instrumentalities also generally qualify as IRC section 115 entities, although the IRS applies a different set of tests to these two categories.
To complicate these matters further, a governmental institution can in many cases choose to quality for exemption under various categories of IRC section 501(c), including 501(c)(3). To qualify as an IRC section 501(c)(3) entity, the governmental institution must be deemed to be a separate entity and be a clear counterpart of a charitable, educational, or similar organization. Governmental institutions may choose to qualify under IRC section 501(c)(3) for a variety of reasons, including easier fundraising and eligibility for property tax exemptions.
These five categories – political subdivision, integral part of a state or political subdivision, section IRC 115 entity, instrumentality, and IRC section 501(c) organization – form a complicated patchwork. A fire department, public library, hospital, or college may fall into one or several of these categories.
Two articles of mine have discussed in detail the federal income tax treatment governments and their affiliates: The Integral, the Essential, and the Instrumental: Federal Income Tax Treatment of Governmental Affiliates, 23 J. Corp l L. 803 (1998), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=924607 and Excluding the Income of State and Local Governments: The Need for Congressional Action, 26 Ga. L. Rev. 421 (1992), reprinted at 6 Exempt Org. Tax Rev. 691 (1992).
Here, I offer, for easy reference, a one-page table summarizing filing requirements, charitable percentage limits, key authorities, and qualification requirements for each of these five categories.
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