Yes — municipalities are tax exempt in most of the ways that matter. Under federal law they owe no income tax on revenue from their public functions, most states exempt their property and purchases from state and local taxes, and certain federal excise taxes do not apply to them either. The exemption is broad but not total. Cities still pay payroll taxes as employers, file information returns for contractor payments, and can owe federal tax on commercial activities that fall outside their public mission.
Federal Income Tax: The Section 115 Exclusion
The core protection sits in Internal Revenue Code Section 115, which excludes from gross income any revenue “derived from any public utility or the exercise of any essential governmental function” that accrues to a state or political subdivision.1Office of the Law Revision Counsel. 26 U.S. Code 115 – Income of States, Municipalities, Etc. The IRS describes this as the “primary tax difference” between government entities and other taxpayers.2Internal Revenue Service. Government Entities and Their Federal Tax Obligations
Essential governmental functions include running public schools, maintaining police and fire departments, regulating transportation, and providing public utilities. Revenue from those activities, when it stays with the government entity, falls outside federal income tax. The logic is straightforward. Taxing a local government on money it collected from its own residents to fund public services would let the federal government siphon off local tax dollars, effectively taxing the same community twice.
State and Local Taxes
Municipalities generally sit outside the state and local tax base as well. Most states exempt government-owned property from property tax, so city halls, fire stations, public libraries, maintenance yards, and parks used for public purposes are not on the tax rolls. The principle is the same one behind the federal exemption: one level of government should not drain another’s resources through taxation.
Sales tax works the same way. When a city buys police vehicles, road maintenance equipment, or office supplies, it usually does not pay state sales tax on the purchase. States write these exemptions into statute for sales made to governmental bodies. Because combined state and local sales tax rates vary widely, the savings on a large procurement budget can be substantial.
Getting the exemption usually requires paperwork at the point of sale. In most states, that means handing the seller an exemption certificate or a government purchase order at the time of the transaction.
Federal Excise Taxes
Some federal excise taxes are also off the table. A common example is the federal communications excise tax. Under IRC Section 4253(i), political subdivisions of a state are exempt from the excise tax that normally applies to telephone and data services.3Internal Revenue Service. Communications Tax Exemption for Government Entities To claim it, the city must certify its governmental status to the communications provider. The IRS does not issue an official exemption certificate for this purpose, so providers generally supply their own forms.
Not every entity with a government connection qualifies. Quasi-governmental agencies must show either direct control by a state or local government or that they perform a traditional governmental function on a nonprofit basis. The IRS has drawn some specific lines: voluntary fire departments qualify, but local Head Start programs and community recreational programs do not.3Internal Revenue Service. Communications Tax Exemption for Government Entities
Municipal Bonds and Borrowing Costs
The tax code also shields investors who lend to municipalities, which in turn lowers what cities pay to borrow. Under IRC Section 103, interest earned on state and local government bonds is generally excluded from federal gross income for the investor.4Office of the Law Revision Counsel. 26 U.S. Code 103 – Interest on State and Local Bonds The tax-free yield makes the bonds more attractive than a comparable taxable investment, so cities can raise capital at lower interest rates. Without that treatment, borrowing costs would rise and fewer local projects would pencil out.
Private Business Use Limits
The break is conditional. Federal rules generally require that no more than 10 percent of bond proceeds be used in a private trade or business, with a tighter 5 percent cap for unrelated or disproportionate private use. Cross those thresholds and the IRS reclassifies the bonds as private activity bonds, subject to different and more restrictive rules.
Arbitrage Rebate
Cities also cannot profit by parking bond proceeds in higher-yielding investments before the project spends them. Under IRC Section 148, any earnings above the bond’s own yield count as arbitrage, and the issuer has to rebate the excess to the U.S. Treasury. Noncompliance can cost the bonds their tax-exempt status entirely, which retroactively raises borrowing costs and creates serious financial fallout for the issuer.5Internal Revenue Service. Complying With Arbitrage Requirements – A Guide for Issuers of Tax-Exempt Bonds
What Municipalities Still Owe
Tax-exempt status does not follow a city into its role as an employer. Local governments have to withhold federal income tax from employee wages and handle payroll tax compliance the same way any private employer does.6Internal Revenue Service. Federal, State and Local Governments The employer’s share of Social Security and Medicare applies, with matching amounts withheld from employees.7Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates
Social Security coverage for municipal employees is not automatic, though. It depends on whether the state has entered into a Section 218 Agreement with the Social Security Administration. These agreements are voluntary, cover positions rather than individuals, and can only extend to a public retirement system after a referendum among eligible members. In states that allow a divided-vote referendum, employees who vote against coverage remain excluded as long as they stay in the same retirement system coverage group.8Social Security Administration. Section 218 Agreements
In practice, some municipal employees pay into Social Security while others in the same city do not, depending on which positions are covered under the state’s agreement and whether certain employees participate instead in a qualifying public pension. Municipal treasury staff carry the burden of tracking which positions fall under which system and withholding correctly. Errors can bring IRS penalties and interest.
Information Reporting
Cities also function as information reporters for the IRS. When a municipality pays independent contractors, attorneys, or other service providers, it has to issue the right Form 1099.9Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC Payments to nonemployees for services go on Form 1099-NEC. Certain payments to attorneys, including gross legal proceeds, go on Form 1099-MISC.
One rule that catches some municipal finance offices off guard: payments to corporations for legal services must be reported, even though payments to corporations are generally exempt from 1099 reporting for most other services.9Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC Municipalities that miss required information returns face the same penalties as any private employer.
When Municipal Income Becomes Taxable
The income tax exemption has an outer edge. When a municipality moves into commercial territory that has nothing to do with its public mission, the income can become taxable as unrelated business income. The IRS applies this rule when a government entity “regularly carries on a trade or business not substantially related to its exempt purpose.”10Internal Revenue Service. Unrelated Business Income A city that leases government-owned property to private businesses purely for commercial use could see those lease payments taxed.
The line is not always obvious. Income from a government-run activity stays exempt if it is “substantially related” to the entity’s public purpose, even when the activity looks like a business.10Internal Revenue Service. Unrelated Business Income A municipal water utility selling excess capacity to a neighboring town is probably still performing an essential governmental function. A city running a commercial catering operation that competes with local restaurants probably is not.
Two exceptions narrow what counts as unrelated business income. If substantially all the work is performed by unpaid volunteers, the activity is excluded regardless of how commercial it looks. And a governmental college or university that operates a business primarily for the convenience of its students, staff, or patients gets a similar exclusion; a campus bookstore or cafeteria at a public university is the standard example.11Internal Revenue Service. Unrelated Business Income Tax Exceptions and Exclusions