Confused.... the income is exempt from federal taxes because of the type of arrangement the company has with the government or just an arrangement your client has with the government?

Because if it is the company, then why would the company withhold federal taxes on federal exempt wages ??

What is in box 1 of the W2 ?

It's because of the type of arrangement the company has with the government. Box 2 is almost 5% of the amount in box 1.

Off the top of my head I don't know any types of income for which the federal government hands out dispensations, at least for income tax.  Maybe FICA taxes?  Maybe the company is exempt from mandatory withholding, but did it on a voluntary basis?  

"based on the US government arrangements"

"the" arrangement is some sort of secret? Which or what arrangement is this? No one knows what this is in reference to, if you don't give some details. "The company" sounds like the Mafia or some secret nongovernment entity.