Do Private Schools Pay Taxes? A Breakdown of the Rules

Whether a private school pays taxes depends on its legal structure. Many private schools are established as non-profit organizations, which allows them to be largely exempt from paying most taxes. This is the most common structure for independent and faith-based schools.

Conversely, a smaller number of private schools are set up as for-profit businesses. These institutions are treated like any other commercial enterprise from a tax perspective. They are subject to the same tax obligations as a local retailer or a technology company.

The Basis for Tax Exemption

The foundation for tax exemption for most private schools is Section 501(c)(3) of the Internal Revenue Code. This provision grants tax-exempt status to organizations that are organized and operated exclusively for specific purposes, including charitable, religious, or educational missions. To qualify, a private school must demonstrate to the IRS that its primary purpose is educational and that it operates to serve the public interest.

A key requirement for obtaining and maintaining this status is that the school must adopt and publicize a racially nondiscriminatory policy. This policy must clearly state that the school does not discriminate on the basis of race in its admissions, programs, or any other school activities.

Another requirement is the prohibition against private inurement. This legal doctrine means that none of the school’s net earnings can benefit any private shareholder or individual. While schools can and do pay reasonable salaries to their administrators and staff, they cannot distribute profits to owners or investors. This ensures that all surplus funds are reinvested back into the school’s educational activities.

To secure and keep their 501(c)(3) status, schools must refrain from certain political activities. They are barred from participating in or intervening in any political campaign on behalf of any candidate for public office. While some lobbying on legislative issues may be permissible within strict limits, direct campaign involvement would jeopardize the tax-exempt status.

Scope of Tax Exemptions

Achieving 501(c)(3) status provides a private school with a range of tax exemptions. The most prominent of these is the exemption from federal income tax. Because the school is not organized to generate profit for owners, the government does not tax its net revenues.

However, exemption from other taxes, such as state and local property and sales taxes, is not automatic. These exemptions are governed by state and local laws, and a school must apply separately to the relevant authorities. For many schools, the exemption from property taxes on land and buildings used for educational purposes is one of the most significant financial benefits. Similarly, an exemption from sales tax on purchases of goods and services is a considerable saving.

Taxes Private Schools Still Pay

Despite their broad exemptions, non-profit private schools still have tax obligations. They are required to pay federal and state payroll taxes for their employees. These taxes include contributions to Social Security and Medicare, collectively known as FICA taxes, which are withheld from employee paychecks and matched by the employer. As 501(c)(3) organizations, however, they are exempt from paying federal unemployment taxes.

A more complex area of taxation for non-profit schools involves the Unrelated Business Income Tax (UBIT). The IRS requires schools to pay income tax on revenue generated from activities that are not substantially related to their educational mission. To be considered unrelated business income, an activity must be a trade or business, be regularly carried on, and not be significantly connected to the school’s exempt purpose.

For instance, if a private school rents its auditorium to a commercial concert promoter for a series of public performances, the income generated would likely be subject to UBIT. This is because the activity is a commercial enterprise not directly related to student education. However, if the same auditorium is used for a student drama production where tickets are sold to the public, the income is related to the school’s mission and would not be taxed.

Other common examples of UBIT-generating activities could include operating a fitness center that serves the general public or selling merchandise online that is not related to the school’s programs. The first $1,000 of net income from such activities is exempt from the tax, but any amount above that threshold is taxed at the 21% federal corporate tax rate.

For-Profit Private Schools

In contrast to their non-profit counterparts, for-profit private schools operate as fully taxable business entities. These schools are owned by individuals or corporations and are structured to generate a profit for their owners or shareholders.

These schools pay taxes in the same manner as any other commercial enterprise. They are subject to federal and state corporate income taxes on their net profits—the amount of revenue left after all operating expenses, such as salaries, rent, and supplies, have been paid.

Furthermore, for-profit schools must pay property taxes on all real estate they own. Their buildings and land are assessed at fair market value, and they contribute to the local tax base. They also pay sales tax on their purchases and must handle all payroll tax obligations.