What is an Exemption?
In finance and accounting, an exemption is generally regarded as the exclusion of a payment or any type of liability that is put in place by a legal authority.
It is colloquially used to describe tax exemptions that people and businesses can utilize to reduce the amount owed to federal and local governments. They are generally legal exemptions to rules where tax would otherwise be required to be paid.
Sometimes, tax exemptions can be broad across a certain industry, or they can be more specific and apply to limited scenarios.
How an Exemption Works
Prior to the Tax Cuts and Jobs Act, there used to be a personal exemption. It could be claimed in addition to the standard deduction by people who did not itemize their tax deductions. Instead, there is now one higher standard deduction, passed with the TCJA. While exemptions used to make a bigger difference in calculating your annual taxes prior to the TCJA, they still can drastically change your tax situation by reducing taxable income.
The personal exemption was repealed with the 2017 reforms but, as mentioned, was essentially replaced with higher standard deductions for both couples and individuals. For tax year 2021, the standard deduction is $12,550 if you file as single, $18,800 for heads of household, and $25,100 for those married filing jointly.
For tax year 2022, the standard deduction increases to $12,950 if you file as single, $19,400 for heads of household, and $25,900 for married filing jointly taxpayers.
These changes were among many in the Tax Cuts and Jobs Act.
Through the 2017 filing year, individual tax filers were able to claim $4,050 for each taxpayer, spouse, and dependent child. Previously, for example, a taxpayer who had three allowable exemptions could have deducted $12,150 from their total taxable income. However, if that person earned over a certain threshold, the amount of the exemption would have been phased out and eventually eliminated.
Tax filers were only able to claim a personal exemption if that person was not claimed as a dependent on someone else’s income tax return.
This rule intentionally set exemptions apart from deductions. For example, take a college student with a job whose parents claimed them as a dependent on their income tax return. Because someone else claimed the student as a dependent, the student could not claim the personal exemption but could still claim the standard deduction.
In most cases, tax filers could also claim a personal deduction for a spouse, as long as the spouse was not claimed as a dependent on another person’s tax return.
In many cases, dependents most commonly include the minor children of the taxpayer. However, taxpayers may claim exemptions for other dependents as well. The IRS has a litmus test for determining who is considered a dependent, but in most cases, it is defined as a relative of the taxpayer (parent, child, brother, sister, aunt, or uncle) who is dependent on the taxpayer for support.
The Child Tax Credit doubled to a maximum of $2,000 per child under the Tax Cuts and Jobs Act, from $1,000 per dependent previously. Certain income thresholds exist, affecting how much credit a family can actually receive.
How Do Governments Provide Exemptions?
In the U.S., organizations can be exempt from federal income tax but not from different types of state and local tax, as well as employment tax. In the U.K., exemptions for specific organizations come in the form of property tax and income tax exemptions.
Other Types of Exemptions
In addition to the above, exemptions can come in many forms, including the following:
Exemption from withholding
Employers withhold income tax from their employees and remit it to the IRS. However, a person who has no tax liability can request an exemption from withholding. This simply means that the employer will withhold Medicare and Social Security taxes from the person’s paycheck, but will not withhold income tax.
Certain kinds of income are exempt from taxes. Exempt income includes municipal bond income, and gifts under $15,000 in 2021 and $16,000 in 2022.
Any distributions from health savings accounts (HSAs) used for qualified medical expenses will also be not taxed.