IRS Code 115: Tax Exemption for Governmental Entities

Internal Revenue Code (IRC) Section 115 provides a federal income tax exemption for specific types of income earned by government entities. This provision is based on the constitutional principle of intergovernmental immunity, which prevents the federal government from taxing the operations of states and their political subdivisions. Section 115 codifies this principle by directly excluding certain income from the definition of “gross income” for federal tax purposes. This supports the financial autonomy of state and local governments, allowing public funds to be fully utilized for public purposes.

Entities Eligible for the Exemption

To qualify for tax benefits under Section 115, an entity must be a “State or political subdivision thereof.” The Internal Revenue Service defines a political subdivision as an entity possessing one or more sovereign powers of the state, such as taxation, eminent domain, or police powers. This includes counties, cities, towns, and other municipalities, along with their various agencies that carry out public functions.

An entity can also qualify if it is an “integral part” of a state or political subdivision. An integral part is not a legally separate entity but operates as a component within the governmental structure. The IRS determines this status by examining factors such as whether it is used for a governmental purpose, its function is performed on behalf of the government, and if the government has the powers of an owner. A city’s public works department is an example of an integral part.

The IRS may also recognize other entities as governmental by examining facts that indicate they have characteristics of a government, like powers of taxation and law enforcement. To confirm its status, an entity can request a free governmental information letter from the IRS or seek a formal private letter ruling for a fee. This is often done to provide proof of tax-exempt status to grantors or vendors.

Income Qualifying for the Exemption

The exemption under Section 115 is not a blanket exemption and is restricted to two specific categories. The first is income derived from a public utility, which is revenue from government-owned utilities providing services like electricity, water, or gas. The second, more broadly applied category, is income from the exercise of any “essential governmental function.”

An essential governmental function is an activity fundamental to governing and traditionally undertaken by governments. Examples include services related to public safety, infrastructure maintenance like roads and bridges, public education, and the administration of public parks. Revenue from a city-operated parking garage or a county hospital could qualify under this provision.

A requirement for the income to be exempt is that it must “accrue” to the state or its political subdivision. This accrual principle means the net income must be dedicated solely to the benefit of the governmental entity and cannot result in private inurement, where earnings benefit a private shareholder or individual. Upon dissolution of any related entity, all of its assets must revert to the governmental unit.

The Section 115 Trust

A common application of this tax code is the establishment of a Section 115 trust. These are trusts created by governmental employers to hold and invest funds for public purposes, often to pre-fund employee benefits. A primary use for these trusts is to manage and pay for Other Post-Employment Benefits (OPEB), such as retiree healthcare and life insurance, which represent significant long-term liabilities for public entities.

For a trust to qualify for tax exemption, it must meet several requirements, including a governmental control test. This test requires that the state or political subdivision has control over the trust, which is achieved through the appointment of trustees who are public officials or are otherwise accountable to the government. This ensures the trust operates as an extension of the government’s functions.

The trust must also adhere to the accrual and non-private inurement principles. The trust’s organizing documents must explicitly state that its assets will be used for these designated functions and that, upon termination, any remaining funds will revert to the government.

Reporting and Compliance

While income qualifying under Section 115 is exempt from federal income tax, associated entities may still have reporting obligations to the IRS. An entity whose income is excluded solely under Section 115, such as a state institution or political subdivision, is not required to file the annual information return, Form 990, “Return of Organization Exempt From Income Tax.”

This filing exception has a limitation related to unrelated business income (UBI). If a governmental entity or a Section 115 trust generates income from a trade or business that is regularly carried on and not substantially related to its exempt purpose, that income may be subject to tax. In such cases, the entity must file Form 990-T, “Exempt Organization Business Income Tax Return,” to report and pay tax on its unrelated business taxable income.

For example, if a public university exempt under Section 115 operates a bookstore that sells items to the general public beyond what is needed for its educational mission, the income could be considered UBI. Maintaining compliance requires careful tracking of all revenue streams to distinguish between exempt-function income and potentially taxable UBI.