Do U.S. Government Agencies Pay Taxes? – A Detailed Analysis

Abdurrahman BESNI
TAX CONSULTANT

Introduction

Alright, so here's a question people often wonder about: Do government agencies in the U.S. actually pay taxes? It might seem like a straightforward "No, obviously not!"—but in reality, it’s not always that simple.

Yes, government entities are generally tax-exempt, but there are quite a few exceptions, especially when it comes to payroll taxes, excise taxes, and cases where the government competes in business-like activities. So, let’s break it down and take a detailed look at when and where government agencies might still have tax obligations.

1. Federal Income Tax – Do They Pay It?

Short answer: Nope.

Long answer: U.S. government agencies do not pay federal income tax. Under the Intergovernmental Tax Immunity Doctrine, government entities—federal, state, and local—are not subject to federal income tax because, well… the government taxing itself would be pointless, right?

The Internal Revenue Code (IRC) §115 backs this up, stating that any revenue generated from government functions (think taxes, fees, or permits) is exempt from federal income tax【35†L293-L301】. This is rooted in both the U.S. Constitution and historic legal rulings (McCulloch v. Maryland, 1819).

However, if a government creates a separate entity (say, a business that isn't carrying out a core governmental function), then that entity could be subject to tax. So, while a local police department doesn’t pay income tax, a government-owned coffee shop? That might be another story.

2. Payroll Taxes – What About Employees?

Now, just because government agencies themselves don’t pay income tax doesn’t mean they get away without contributing anything. They still have payroll tax obligations as employers. Here’s how it works:

Federal Income Tax Withholding → When a government agency pays its employees, it must withhold income taxes just like any private employer. Employees working for the government are not exempt from personal income tax【35†L301-L308】.
Social Security & Medicare (FICA) → Government agencies must pay Social Security and Medicare taxes for their employees, unless the employee is covered under a separate public retirement system (which was the case for some older state and local government workers). Since 1986, though, most government hires are included in Social Security【23†L7-L15】.
Unemployment Taxes (FUTA & SUTA) → Here's where it gets interesting. Government agencies do not pay federal unemployment taxes (FUTA). However, state and local agencies still have to fund unemployment benefits in different ways—many do this through reimbursement plans rather than regular tax payments【21†L104-L111】.

So, while government entities themselves don’t pay income tax, they do have to follow payroll tax rules when it comes to paying their employees.

3. Sales & Use Taxes – Are Government Purchases Taxed?

Federal Level

Nope, federal agencies are exempt from state and local sales taxes. The Supremacy Clause of the Constitution prevents states from taxing the federal government. So, if the U.S. Department of Defense buys office supplies, it doesn’t pay state sales tax【33†L65-L73】.

State & Local Level

This is where things vary. Some states exempt their own agencies from sales tax, while others don't.

For example:

Minnesota doesn’t tax state agencies on purchases【7†L202-L210】.
Texas also exempts government purchases.
California and Arizona? They do impose sales tax on their own agencies in some cases【34†L1-L4】.

Also, reciprocity is a thing—some states exempt purchases from other states’ agencies only if that other state does the same for them【33†L97-L105】.

4. Property Taxes – Do They Pay?

Nope!

Federal, state, and local government properties are generally exempt from property taxes. So, that city hall building or the local fire station? No property tax due【27†L100-L107】.
However, if a government leases property to a private company, that lease may be subject to a possessory interest tax. Meaning, the government is still exempt, but the private business using the space gets taxed【26†L1-L9】.

5. Excise Taxes – Any Special Cases?

Here’s where it gets a little more complex. While government agencies don’t pay income tax, some federal excise taxes do apply:

Federal fuel taxes – Government fleets (police cars, fire trucks, etc.) are usually exempt from these taxes【11†L146-L153】.
Federal communications taxes – Federal agencies don’t pay tax on phone services【13†L87-L95】.
Customs Duties (Import Taxes) – The government often doesn’t pay these, especially for items bought under a federal contract【14†L125-L133】.

So, while most excise taxes don’t apply to government entities, some can come into play depending on the situation.

6. Exceptions & Special Cases

Alright, here are some cases where government agencies might actually have tax obligations:

Unrelated Business Income Tax (UBIT) → If a government-owned entity earns money outside of its normal governmental functions, it might have to pay tax on that income (e.g., a public university running a commercial business)【28†L1-L9】.
State-run businesses → If a government agency operates a revenue-generating business (like a utility company), it may be required to make “payments in lieu of taxes” (PILOT) to local governments【25†L21-L29】.
High Compensation Excise Tax → Since 2017, if a tax-exempt government entity pays an employee more than $1M, a 21% excise tax applies【36†L30-L38】.

So yeah, while agencies themselves don’t pay typical taxes, they aren’t always entirely exempt from taxation in every case.

7. Recent Legal Changes & Developments

Dawson v. Steager (2019) → The Supreme Court ruled that states cannot tax federal retirees differently than state retirees—it violated intergovernmental immunity【31†L46-L54】.
2017 Tax Cuts and Jobs Act → Introduced the 21% excise tax on highly paid employees in tax-exempt organizations (like state universities)【36†L30-L38】.
COVID-19 Relief Bills → Some state and local governments considered tax changes or PILOT programs to offset revenue shortfalls, though no major new taxes on government entities have been introduced【20†L41-L49】.

Conclusion

So, do government agencies pay taxes? Mostly no, but sometimes yes.

While income tax and property tax exemptions are pretty much universal, agencies do have obligations for payroll taxes, excise taxes, and special business-related taxes in some cases. If they engage in business-like activities, they might have to pony up for taxes, but their core functions remain tax-exempt.

At the end of the day, the U.S. tax code treats government agencies differently than private entities, but that doesn’t mean they’re completely off the hook. It’s a nuanced system, and as laws evolve, new exceptions and obligations can pop up!