The Integral, the Essential and the Instrumental: Federal Income Tax Treatment of Governmental Affiliates
Journal of Corporation Law, Vol. 23, 1998
37 Pages Posted: 17 Aug 2006 Last revised: 1 Jun 2013
No provision of the Internal Revenue Code explicitly exempts states and their political subdivisions from federal income taxation. The IRS has concluded that states and their political subdivisions - which the IRS defines as entities with the sovereign powers of taxation, eminent domain, and police power - are free from federal income tax under an implied statutory immunity. That is, states and their political subsidiaries are exempt because no provision of the Internal Revenue Code taxes them as such.
States and their political subdivisions, however, are not the only governmental organizations that qualify for exemption. According to the IRS, if an organization or enterprise can qualify as an integral part of a state or political subdivision, it is also exempt on the basis of the implied statutory immunity. In addition, section 115, a relatively obscure provision of the Internal Revenue Code, excludes from federal tax "income derived from any public utility or the exercise of any essential governmental function and accruing to a State or any political subdivision thereof, or the District of Columbia." As interpreted by the IRS, however, section 115 does not afford the basis for exempting states and their political subdivisions from federal income tax. The IRS instead has concluded that section 115 applies to the income of an entity separate from a state or its political subdivision.
For particular purposes, the IRS and the Internal Revenue Code also recognize "instrumentality" as a category of entities separate from, but affiliated with, state and local governments. Unlike section 115 entities, instrumentalities are not exempt from tax by virtue of their status, although they may qualify for exclusion of their income under section 115. Indeed, the tests for status as a section 115 entity and those for status as an instrumentality exhibit striking similarities. Thus, rarely would an instrumentality fail to qualify as a section 115 entity.
This Article examines the tests for integral parts and for instrumentalities as well as those for section 115. It argues that the IRS could, and should, rationalize federal income tax treatment of governmental affiliates by promulgating regulations applicable to integral parts, section 115 entities, and instrumentalities. The long-standing tests for status as an instrumentality along with the statutory criteria for exemption of Workers' Compensation Act companies provide the model for the suggested regulations.
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