Public school districts are tax exempt from most taxes, but not all of them. As political subdivisions of a state, districts owe no federal or state income tax on their governmental revenue, and nearly every state exempts their purchases from sales tax and their property from property tax. The exemption has real edges, though. Districts still withhold and pay payroll taxes, can owe federal tax on commercial side income, and have to follow strict rules to keep their bond financing tax-exempt.
Why the Exemption Exists
A school district’s tax-free status flows from what it is, not from any application it files. Districts are political subdivisions of their state, created by state law with delegated governmental powers like levying property taxes and issuing bonds. The federal government generally does not tax state and local governments when they carry out public functions.
The statutory hook is IRC Section 115, which excludes from gross income any revenue “derived from the exercise of any essential governmental function” that accrues to a state or its political subdivisions. Public education fits that definition, so property tax collections, state aid, federal education grants, and lunch program reimbursements all fall outside the federal tax base.1Office of the Law Revision Counsel. 26 USC 115 – Income of States, Municipalities, Etc.
Unlike a private nonprofit that applies to the IRS for recognition under Section 501(c)(3), a district’s exemption is inherent in its governmental status. The IRS does not issue tax-exempt numbers to government entities. A district can request a free governmental information letter from the IRS, which describes the entity’s exempt status and cites the applicable code sections. Most vendors and organizations accept this letter as proof of tax-exempt status.2Internal Revenue Service. Governmental Information Letter
Federal and State Income Tax
Districts pay no federal income tax on their governmental revenue, and they do not file the corporate income tax return a business would file or the Form 990 that private nonprofits submit annually.1Office of the Law Revision Counsel. 26 USC 115 – Income of States, Municipalities, Etc. State income tax treatment follows the same logic: states do not tax their own political subdivisions.
Sales Tax
Nearly every state exempts school district purchases from state and local sales tax when the goods or services are for official educational use. Textbooks, classroom technology, maintenance supplies, buses, and professional development all qualify. Districts typically present a governmental exemption certificate or the IRS information letter at the point of sale.
Construction projects are where districts most often get surprised. In many states, when a contractor buys building materials to construct or renovate a school, those materials are taxable at the time the contractor purchases them, even though the finished building will be owned by a tax-exempt government. The exemption often belongs to the district as the end user, not to the contractor as the purchaser. Whether a contractor can use the district’s exemption certificate for materials varies by state, and getting it wrong can add real cost to a multimillion-dollar build. Confirm the rule with the state tax authority before breaking ground.
Property Tax
Districts sit in an odd spot in the property tax system. They are funded primarily by property taxes levied on homes and businesses in their boundaries, but property the district itself owns is exempt from those same taxes. School buildings, athletic facilities, administrative offices, bus garages, and undeveloped land held for future school use all carry no property tax burden.
The exemption generally applies only to property used for the district’s governmental purpose. If a district owns property used for a commercial activity unrelated to education, some states may treat that property differently. Leasing a district-owned building to a private business on a long-term basis, for instance, could jeopardize the property tax exemption on that parcel depending on state law.
Federal Excise Taxes
Districts get several federal excise tax breaks. Federal law exempts fuel used in school buses from the diesel fuel excise tax, and separately exempts fuel purchased for the exclusive use of a state or local government.3Office of the Law Revision Counsel. 26 USC 4041 – Imposition of Tax IRC Section 4221 also exempts manufacturers’ excise taxes on articles sold to a state or local government for its exclusive use.4Office of the Law Revision Counsel. 26 USC 4221 – Certain Tax-Free Sales
When excise tax has already been paid upfront, a district recovers it by filing IRS Form 8849 (Schedule 1), typically for fuel burned in school buses. The claim must be filed within three years after the close of the taxable year in which the fuel was used.5Internal Revenue Service. Form 8849 – Claim for Refund of Excise Taxes For districts running large bus fleets, missed filings leave real money on the table.
Tax-Exempt Bond Financing
When a district builds or renovates, it typically issues municipal bonds. Interest investors earn on these bonds is excluded from federal gross income under IRC Section 103, which lets the district borrow at lower rates than a private company could.6Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds
The exemption does not apply to “private activity bonds” or “arbitrage bonds.” A bond becomes a private activity bond if more than 10 percent of the proceeds benefit a private business, which can happen with significant commercial leases in a new building or an overreaching naming-rights deal. An arbitrage bond is one where the district invests the proceeds in higher-yielding investments rather than spending them on the project, profiting from the spread between the tax-exempt borrowing rate and the taxable investment return.7Office of the Law Revision Counsel. 26 USC 148 – Arbitrage Either situation can make bond interest taxable to investors, which is a disaster for the district’s borrowing costs.
Payroll Taxes
Tax-exempt status does not mean a district avoids payroll taxes. Districts are large employers, and their obligations here are more complicated than those of a typical private business.
Social Security and Medicare
Federal law generally excludes state and local government employees from mandatory Social Security coverage. Whether a district’s employees participate depends on whether the state has entered a voluntary Section 218 Agreement with the Social Security Administration. These agreements cover specific positions, not individuals, and may require a referendum among employees in a public retirement system before coverage takes effect.8Social Security Administration. Section 218 Agreements
Medicare is different. Since 1986, all state and local government employees hired after March 31 of that year are subject to mandatory Medicare tax at 1.45% each from employer and employee, regardless of Social Security coverage.9Social Security Administration. Mandatory Medicare Coverage In practice, virtually every current district employee has Medicare withheld, and the district pays the matching share.
Student Workers
One narrow exception: FICA taxes do not apply to services performed by students employed by a school where they are actively pursuing a course of study, as long as education rather than employment is the primary purpose of the relationship.10Internal Revenue Service. Student Exception to FICA Tax This matters most at colleges and universities, but it can reach a high school that employs its own students in limited roles.
Unrelated Business Income
The biggest exception to a district’s tax-free status involves commercial income unrelated to education. The IRS calls this Unrelated Business Income, and it is taxable at regular corporate rates under IRC Section 511, which specifically reaches state and local government colleges and universities and other governmental educational entities.11Office of the Law Revision Counsel. 26 USC 511 – Imposition of Tax on Unrelated Business Income of Charitable, Etc., Organizations
An activity generates unrelated business income when it meets three conditions: it is a trade or business, it is regularly carried on, and it is not substantially related to the educational mission.12Office of the Law Revision Counsel. 26 USC 513 – Unrelated Trade or Business Regularly renting an auditorium or sports complex to concert promoters or private leagues on a commercial basis can trigger it. Selling advertising in school publications or running a parking lot for outside events are other common examples.
Not every side activity counts. The tax code excludes activities staffed almost entirely by unpaid volunteers, businesses run primarily for the convenience of students or employees (such as a school cafeteria or bookstore), and sales of donated merchandise.12Office of the Law Revision Counsel. 26 USC 513 – Unrelated Trade or Business Occasional use, like renting the gym for a single weekend fundraiser, is unlikely to be “regularly carried on.”
When unrelated business income does arise, the district must file Form 990-T if gross income from the activity reaches $1,000 or more in a year.13Internal Revenue Service. 2025 Instructions for Form 990-T The taxable amount is gross income minus directly connected expenses, with an additional $1,000 specific deduction.14Office of the Law Revision Counsel. 26 USC 512 – Unrelated Business Taxable Income Most districts never hit these thresholds, but those with active rental programs or significant commercial partnerships need to track the income carefully.
Donations to School Districts
Individuals and businesses that donate to a public school district can claim a charitable deduction. IRC Section 170 treats a gift to a state or political subdivision as a charitable contribution, as long as it is made for exclusively public purposes.15Office of the Law Revision Counsel. 26 USC 170 – Charitable, Etc., Contributions and Gifts Because a district is a political subdivision, donations qualify without the district needing a 501(c)(3) determination letter.
The deduction is available only to donors who itemize. If the donor receives something in return, like preferred seating or a naming opportunity, the deductible amount drops by the fair market value of what was received. A $500 donation that comes with $50 worth of event tickets yields a $450 deduction. Donors should keep a written acknowledgment from the district for any gift of $250 or more, which the IRS requires to substantiate the deduction.