IRS Section 115: Tax Exemption for Government Entities

Section 115 of the Internal Revenue Code excludes certain income from federal taxation. This provision ensures the federal government does not tax states, their political subdivisions, and related entities as they perform their public duties, protecting the financial resources governments need to serve the public. This income exclusion is rooted in the concept of intergovernmental immunity, which recognizes the separate and sovereign nature of state and federal governments.

Entities Qualifying for the Income Exclusion

The income exclusion under Section 115 applies to states, which include the fifty states, the District of Columbia, and U.S. possessions. Their income, when meeting specific criteria, is not included in gross income for federal tax calculations.

The exclusion also extends to any “political subdivision” of a state. The Internal Revenue Service defines a political subdivision as a division of a state that has been delegated a portion of the state’s sovereign powers, such as the power to tax, the power of eminent domain, or police powers. Common examples are counties, cities, towns, and special-purpose districts like school or water districts, which exercise governmental authority over a specific geographic area. To be recognized, an entity must be a division of the state created to carry out governmental functions on the state’s behalf.

Core Requirements for Excludable Income

For income to be excluded under Section 115, it must satisfy several requirements. These tests ensure the tax benefit is limited to income that is governmental in nature and purpose. The analysis focuses on where the money goes and the activity that generated it.

Accrual to a Government Entity

A primary requirement is that the income must “accrue to” a state or its political subdivision, meaning the income must ultimately belong to the governmental entity. This involves a prohibition of private inurement, where none of the entity’s net earnings can benefit any private shareholder or individual. This prohibition is strictly interpreted by the IRS. If an organization’s structure allows for its net income to be distributed to private individuals or for its assets to be liquidated for private benefit, the income is not excludable under Section 115.

Essential Governmental Function

The income must be derived from the exercise of an “essential governmental function.” This term refers to activities that are traditionally the responsibility of government. Functions like public safety, public health, education, infrastructure development, and the administration of public services are considered essential governmental functions. Conversely, activities that are primarily commercial and compete with private businesses are not considered essential governmental functions. For example, while operating a public water utility is a recognized governmental function, operating a hotel or a manufacturing plant is not.

Derived From a Public Utility or Governmental Function

Another requirement is that the income must be “derived from” a public utility or the exercise of an essential governmental function. This links the income directly to the qualifying activity. Income derived from a public utility includes revenue from providing services like water, electricity, or gas to the public. For other governmental functions, the income must be a direct result of that activity, such as fees for building permits or court filing fees, or revenue from government-operated facilities like public parks.

Application to Integral Parts and Constituent Agencies

The Section 115 exclusion can also apply to entities considered an “integral part” of the government. An integral part is an organization so closely connected to a state or political subdivision that it is treated as part of the government for tax purposes. This status depends on factors like the degree of governmental control, the source of the entity’s funds, and whether it performs functions that would otherwise be done by the government.

A common application is with trusts established by governments to manage employee benefit plans, such as pension funds or health and welfare trusts. The income earned by these “Section 115 organizations,” such as investment returns, can be excluded from federal income tax. For the exclusion to apply, providing these benefits must be considered an essential governmental function, and any assets remaining upon the trust’s termination must revert to the government. The control and supervision of the trust must also be vested in public officials.

Federal Tax Filing and Reporting Obligations

An organization whose income is entirely excludable under Section 115 is not required to file an annual federal information return, Form 990. This filing exemption is provided under Treasury Regulation §1.6033-2.

This exemption has an exception related to unrelated business income (UBI). If a Section 115 entity generates $1,000 or more in gross income from a trade or business that is not substantially related to its exempt purpose, that income is subject to the Unrelated Business Income Tax (UBIT).

When an entity has UBI exceeding this threshold, it must file Form 990-T, Exempt Organization Business Income Tax Return. The organization is required to report its unrelated business income on this form and pay the applicable corporate income tax on its net earnings from that activity. This requirement ensures that when a governmental entity engages in commercial activities, it competes on a level playing field with private businesses.