Public school districts are tax exempt for federal income tax purposes and for most state and local taxes, but the exemption is not total. A district pays no income tax on property tax collections, state aid, or federal grants, and its own real estate and purchases are generally free of property and sales tax. It still owes payroll taxes on its employees, can owe federal tax on commercial income unrelated to education, and has to follow strict rules to keep its bond financing tax-free.
Where the Exemption Comes From
A school district’s tax-exempt status is built into what it is, not something it applies for. Districts are political subdivisions of a state, created by state law with delegated governmental powers such as the authority to levy property taxes and issue bonds. Federal law 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 description, so property tax levies, state funding, and federal education grants fall outside the federal tax base.1Office of the Law Revision Counsel. 26 USC 115 – Income of States, Municipalities, Etc.
Unlike a private nonprofit, a school district does not apply to the IRS for 501(c)(3) recognition, and the IRS does not issue tax-exempt numbers to government entities. A district that needs proof of its status can request a free governmental information letter from the IRS. The letter describes the entity’s exempt status and cites the applicable code sections, and most vendors and organizations accept it.2Internal Revenue Service. Governmental Information Letter
Federal and State Income Tax
School districts pay no federal income tax on their governmental revenue. Property tax collections, state aid payments, federal education grants, lunch program reimbursements, and similar funding streams are all excluded under Section 115. A district does not file Form 1120 the way a business does, and it does not file the Form 990 annual information return that private nonprofits must submit.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 impose income tax on 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, school buses, and professional development services all qualify. To claim the exemption at the point of sale, a district typically provides the vendor with a governmental exemption certificate or the IRS governmental information letter.
Construction projects are the trap. 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 district. The exemption often belongs to the district as the end user, not to the contractor as the purchaser, and rules on whether a contractor can use the district’s certificate for material purchases vary by state. Confirm with the state tax authority before breaking ground on a multimillion-dollar building project.
Property Tax
School districts sit on both sides of the property tax system. They are funded largely by property taxes levied on homes and businesses within their boundaries, and the 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 leases a building it owns to a private business on a long-term commercial basis, some states may treat that parcel differently and jeopardize its exemption.
Federal Excise Tax on Fuel
School districts get several federal excise tax breaks. Federal law exempts fuel used in school buses from the diesel fuel excise tax entirely, 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 a district pays excise tax on fuel at the pump and wants it back, the refund runs through IRS Form 8849, Schedule 1. 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 a district with a large bus fleet, missing the filing window leaves real money on the table.
Payroll Taxes Still Apply
Tax-exempt status does not extend to a district’s role as an employer. School districts are large employers, and their payroll obligations are in some ways more complex than a private business’s.
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 into a voluntary Section 218 Agreement with the Social Security Administration. Those agreements cover specific positions rather than individuals, and coverage may require a referendum among employees in a public retirement system before it takes effect.6Social 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 whether their positions are covered for Social Security.7Social Security Administration. Mandatory Medicare Coverage Virtually every current school district employee has Medicare withheld, and the district pays the matching share.
Unrelated Business Income
The biggest carve-out from a district’s tax-free status is commercial income that has nothing to do with education. The IRS calls this Unrelated Business Income, and it is taxable at regular corporate rates under IRC Section 511, which specifically reaches any college or university that is an agency or instrumentality of a government, or that is owned or operated by a government or political subdivision.8Office 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 is a trade or business, is regularly carried on, and is not substantially related to the district’s educational mission.9Office of the Law Revision Counsel. 26 USC 513 – Unrelated Trade or Business Regularly renting the auditorium or sports complex to concert promoters or private sports leagues on a commercial basis can trigger it. Selling advertising in school publications or running a parking lot for non-school events are other common examples.
Not every side activity counts. An activity staffed almost entirely by unpaid volunteers is excluded, as is a business run primarily for the convenience of students or employees, such as a school cafeteria or bookstore. Selling donated merchandise gets a pass.9Office 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.”
Where 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.10Internal Revenue Service. 2025 Instructions for Form 990-T Most districts never hit that threshold, but those with active facility rental programs or commercial partnerships need to track the income carefully.
Tax-Exempt Bond Financing Has Strings
When a district borrows to build or renovate schools, it issues municipal bonds whose interest is excluded from federal gross income under IRC Section 103. That makes the bonds attractive to investors and lets the district borrow at lower rates than a private company could.11Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds
The exclusion 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 through significant commercial leases in a new building or overly generous naming-rights arrangements. An arbitrage bond is one where the district invests the proceeds in higher-yielding investments instead of spending them on the project, profiting from the spread between its tax-exempt borrowing rate and a taxable investment return.12Office of the Law Revision Counsel. 26 USC 148 – Arbitrage Either situation can make bond interest taxable to investors, with predictable damage to the district’s future borrowing costs.
Donations to a District Are Deductible
Individuals and businesses that donate to a public school district can claim a charitable deduction on their federal return. IRC Section 170 defines a charitable contribution to include any gift to a state or political subdivision made for exclusively public purposes, so donations flow to a district without any need for a 501(c)(3) determination letter.13Office of the Law Revision Counsel. 26 USC 170 – Charitable, Etc., Contributions and Gifts
The deduction is available only to donors who itemize. If the donor receives something in return, such as preferred seating or a naming opportunity, the deductible amount is reduced by the fair market value of whatever was received. A $500 donation with $50 worth of event tickets yields a $450 deduction.