Government Entities and Federal — Publication 963

The Bureau of the Census collected data showing that there were approximately 89,000 units of local government in the United States in 2012. These units of government employ more than 20% of the American workforce.

This chapter discusses the legal basis for different types of government entities and the specific tax questions that arise in connection with them. Many tax laws apply differently to government entities than to other organizations and individuals.

The income of certain government entities, including states, political subdivisions of states, or integral parts of states or political subdivisions, is generally exempt from tax. The income of other government entities, such as instrumentalities, might be excludable from gross income under IRC Section 115 if that income is derived from the exercise of an essential governmental function and accrues to a state or political subdivision of a state.

Certain government entities, such as colleges or universities, that are agencies or instrumentalities of a state or political subdivision of a state, are subject to the tax on unrelated business income under IRC Section 511. For more information, see Publication 598, Tax on Unrelated Business Income of Exempt Organizations.

State Government

States are recognized as entities by the U.S. Constitution. However, different definitions of a state apply for different legal purposes. Federal employment taxes generally apply to all 50 states, the District of Columbia and all U.S. Territories. For purposes of a Section 218 Agreement, a state may refer to any of the 50 states, Puerto Rico, the Virgin Islands and interstate instrumentalities. For this purpose, the definition of a state does not include the District of Columbia, Guam, American Samoa, the Commonwealth of the Northern Mariana Islands or Indian tribal governments.

Authority

The states have primary responsibility for many aspects of government. The 10th Amendment to the U.S. Constitution reserves to the states, or to the people, all powers not delegated to the federal government nor prohibited by the Constitution. Some services for which the state has primary responsibility include:

Protection of lives and property by maintenance of a police force
Regulation and improvement of transportation and roads within the state
Regulation of business within the state
Education and maintenance of schools within the state
Condemnation of property through eminent domain within the state

In many cases, the federal and state governments share responsibility, with the federal government providing most of the funding and the state distributing the services. Some common services involving shared responsibility include:

Health care
Public assistance for persons in need
Protection of natural resources
Improvement in living and working conditions

Local Government and Political Subdivisions

Local governments are generally political subdivisions of states. They differ from state and federal governments in that their authority is not based directly on a constitution. Each state constitution governs the procedure for the establishment of local governments. In most cases, the state legislature must approve the creation or incorporation of a local government. The local government then receives a charter defining its organization, authority and responsibilities, including the means for electing governing officials.

Local government units bear a variety of names, such as city, county, township, village, parish, borough or district. The legal significance of these terms may vary from state to state.

Authority

The authority of local governments varies greatly among the states and individual jurisdictions. Generally, a local government has the authority to:

Impose taxes
Try people accused of breaking local laws or ordinances
Administer local programs within its boundaries

In addition to funding provided by local taxes, fees and other sources, local governments receive financial aid from state and federal governments in providing these services according to need.

Some of the services that local governments take primary responsibility for providing include:

Conducting and coordinating elections
Maintaining public safety
Building and repairing local roads and streets
Providing police and fire protection
Collecting garbage and recycling
Ensuring the safety of drinking water
Maintaining courts, courthouses and jails
Collecting state and local government taxes
Keeping official records, such as for marriage, birth and death

Instrumentalities

An instrumentality is an organization separate from, but affiliated with, a state or local government. It may or may not be created by or pursuant to state statute, but it is operated for public purposes. Generally, an instrumentality performs governmental functions, but does not have the full powers of a government, such as police authority, taxation and eminent domain (sovereign powers). Direct questions on the legal status of an instrumentality, for federal tax or Social Security and Medicare purposes, to the IRS. Address questions on a specific Section 218 Agreement to the State Social Security Administrator or the SSA (see Chapter 7).

A wholly-owned instrumentality of one or more states or political subdivisions is treated as a state or local government employer for purposes of the mandatory Social Security and Medicare provisions of IRC Section 3121(b)(7)(F).

Interstate Instrumentalities

An interstate instrumentality is an independent legal entity organized by two or more states to carry on governmental functions. Examples include a regional planning authority, transportation system or water district. For purposes of Section 218 Agreements, an interstate instrumentality is treated as a state.

A referendum (vote) for Social Security and/or Medicare coverage must be held prior to the execution of a Section 218 Agreement for interstate instrumentality employees in positions under a retirement system. All interstate instrumentalities are authorized to hold a referendum using either a majority vote or a divided system retirement process. (see Chapter 5 for referendum procedures). Employees of an interstate instrumentality who are not covered for Social Security under a Section 218 Agreement, but who are qualified participants in a public retirement system, are not covered for Social Security even if the employer incorrectly continues to withhold and report Social Security taxes.

Characteristics of Instrumentalities

In Revenue Ruling 57-128, 1957-1 C.B. 311, the IRS addressed the question of whether an organization is a wholly-owned instrumentality of one or more states or political subdivisions. This revenue ruling established the following factors as relevant to a determination of whether the entity is an instrumentality of a government:

Whether it is used for a governmental purpose and performs a governmental function
Whether performance of its function is on behalf of one or more states or political subdivisions
Whether there are any private interests involved, or whether the states or political subdivisions involved have the powers and interests of an owner
Whether control and supervision of the organization is vested in public authority or authorities
The degree of financial autonomy and the source of operating expenses
Whether express or implied statutory or other authority is necessary for its creation and/or use of the instrumentality, and whether that authority exists

Schools, hospitals and libraries, as well as associations formed for public purposes, such as soil and water conservation districts, may be instrumentalities of government, depending on the facts and circumstances. State sponsorship of an organization, state regulation of its activities, the participation of its employees in a public retirement system, and operation with public funds are among the factors to be considered in determining whether an organization is an instrumentality. If an organization is essentially under private ownership and control, it is not an instrumentality of government.

Associations formed for conservation, protection and promotion, although carrying out a public purpose, may not rise to the level of state instrumentalities. The following associations may or may not be state instrumentalities:

Soil and water conservation districts
Fire associations that protect forestland
Associations that promote a state or municipality

To determine the status of an entity, it is essential to review the documents that establish statutory authority. The following cases elaborate on the principles established in Revenue Ruling 57-128.

Soil and Water Conservation Districts - Entities whose revenues are principally generated from fees collected from land owners within the district may or may not be instrumentalities of government, depending upon application of the factors listed above, including whether the district is under public or private control.

Example: A soil conservation district in Minnesota was established to carry out a state conservation program. The Soil Conservation Service of the U.S. Department of Agriculture furnished the district with technical and clerical personnel. The disbursements made by the district were made from fees collected from members (occupiers of the land within the district) for services rendered, from funds allocated by the U.S. Department of Agriculture and from state appropriations. The soil conservation district was created by statute as a political subdivision of the state and was under the control of a board of supervisors elected or appointed in accordance with state law. The soil conservation district is a political subdivision of the state. [Revenue Ruling 57-120, 1957-1 C.B. 310]

Example: A Connecticut soil and water conservation district was formed as a private nonstock corporation by private individuals. The state had authority to assist private individuals in forming conservation districts but did not have the power to operate them. The private individuals had complete control over the corporate operations, revenue and expenditures. Therefore, the soil and water conservation district is not a wholly-owned instrumentality of the state. [Revenue Ruling 69-453, 1969-2 C.B. 182]

Fire Associations - Fire associations may or may not be instrumentalities of government, depending on whether they are under public or private control.

Example: A fire association was organized under an Oregon state law that required all forest land in the state to be adequately protected from the dangers of fire. While the fire association was organized as a result of an Oregon law, it was organized and operated for the mutual benefit of its members and was not an instrumentality of the state. Furthermore, except for the work it performed on a cost basis for the state and federal government, the association derived most of its support from assessments imposed on its members. [Revenue Ruling 70-483, 1970-2 C.B. 201]

Example: Under the laws of the state of Pennsylvania, townships have the authority to purchase fire engines and fire apparatus out of general township funds for use of the township and to appropriate money to fire companies located in the township to secure fire protection. These volunteer fire companies are instrumentalities under Pennsylvania state law, and the members of volunteer fire departments are employees of the political subdivision.

[Revenue Ruling 70-484, 1970-2 C.B. 202]

Associations that Promote a State or Municipality - State sponsorship of promotional activities is not sufficient to raise an association to instrumentality status.

Example: A municipal league comprised of qualified officials of member cities or villages, but with no control and supervision vested in a public authority, is not a state instrumentality. The league’s activities consisted of publishing a monthly magazine featuring articles on governmental matters, conducting conferences, and sponsoring and participating in municipal law institutes and seminars. The state had no statute for the incorporation of a league of this nature as an instrumentality. [Revenue Ruling 65-26, 1965-1 C.B. 444]

Note: Some state statutes specifically create certain associations as instrumentalities. A review of the establishing legislation is required to make a status determination.

Indian Tribal Governments

The legal relationship between the United States and Indian tribal governments is set forth in the Constitution, treaties, statutes and court decisions. Congress may limit the authority of Indian tribal governments, but within those limits, the tribal governments retain attributes of sovereignty over both their members and their territory. Generally, Indian tribal governments provide government services, such as transportation, education and medical care to its members.

Authority

Tribal governmental power includes the authority to:

Choose the form of tribal government
Determine tribal membership
Regulate tribal and individual property
Levy taxes
Establish courts
Maintain law and order

Employment Taxes

Generally, Indian tribal governments should follow general rules that apply to nongovernmental entities for employment tax. Publication 15 (Circular E), Employer’s Tax Guide, and Publication 15-A, Employer’s Supplemental Tax Guide, provide the basic rules for employers. There are, however, some special employment tax rules that apply to Indian tribal governments:

An exception applies to the definition of “employment” for FUTA purposes for services performed in the employ of an Indian tribe (IRC Section 3306(c)(7)). An Indian tribe may elect to make contributions to the state unemployment fund as if services by its employees were employment under FUTA, or it may make payments in lieu of the contributions to reimburse the state for benefits paid former employees of the tribe. An Indian tribe may make separate elections for any subdivision, subsidiary or business enterprise wholly owned by it. If an

Indian tribe fails to make either form of payment within 90 days of receiving a notice of delinquency, or if it fails to post a required payment bond, then service for the tribe is not excepted from “employment” until the failure has been corrected (IRC Section 3309(d)). For this purpose, the term “Indian tribe” has the meaning given in 25 USC Section 450b(e) (Section 4(e) of the Indian Self-Determination and Education Assistance Act), and includes any subdivision, subsidiary or business enterprise wholly-owned by an Indian tribe (IRC Section 3306(u)).

Amounts paid to members of Indian tribal councils for services performed as council members are generally not wages for purposes of FICA and income tax withholding, although these amounts are includible in gross income. (Revenue Ruling 59-354). The Tribal Social Security Fairness Act of 2018 authorizes SSA to enter into voluntary agreements with Indian tribes to provide individual tribal council members with Social Security coverage. Visit SSA.gov for more information.

Certain income derived by Indians from the exercise of their recognized tribal fishing rights is exempt from federal income and employment taxes (IRC Section 7873). Wages paid to a member of a tribe employed by another member of the same tribe, or by a qualified Indian entity, for services performed in a fishing rights-related activity of the employee’s tribe, are exempt not only from federal income tax, but also from both the employer’s and the employee’s share of the Social Security and Medicare tax (Notice 89-34, 1989-1 C.B. 674).

Information addressing Indian tribal governments and employment tax issues can be found in Publication 4268, Employment Tax for Indian Tribal Governments.

Frequently Asked Questions

1. How is the tax treatment of governments different from that of other entities? The income of certain government entities, including states, political subdivisions of states, or integral parts of states or political subdivisions, is generally not taxable. The income of other government entities, such as instrumentalities, might be excludable from gross income under IRC Section 115 if that income is derived from the exercise of an essential governmental function and accrues to a state or political subdivision of a state. Colleges and universities that are agencies or instrumentalities of any government, or any political subdivision of government, or that are owned or operated by a government or political subdivision of a government, are subject to tax on unrelated business income. [IRS]

2. Can the IRS issue a letter indicating that our entity is a tax-exempt government? For a government entity to receive an official determination of its status as a political subdivision, instrumentality of government, or whether its income is excludable from gross income under IRC Section 115, it must obtain a private letter ruling (PLR) by following the procedures in Rev. Proc. 2020-1 (updated annually). There is a fee to receive a PLR. [IRS]

As a service to government entities, IRS can issue a “governmental information letter” free of charge. This letter describes government entity exemption from federal income tax and cites the IRC sections on deductible contributions and income exclusion. Most organizations and individuals will accept the governmental information letter as the substantiation required for these purposes. Contact IRS Customer Account Services at 877-829-5500. [IRS]

n Chapter 3