Nonprofits parallel corporations in that they have paid employees and regularly scheduled paydays. It’s important for them to file withholding payroll taxes accurately; if they don’t, they can face unique obstacles, such as needing to stay within a tightly limited budget, using grant money for certain payroll expenses, and determining reasonable executive compensation.
Typically, nonprofits are registered as 501(c)3 organizations, meaning they provide their services as a public good without rendering a portion of their earnings back to the government. Likewise, individuals and companies donating to these organizations can write off their contributions as tax-deductible.
As 501(c)(3) nonprofit organizations, they don’t pay Federal Unemployment Tax Act (FUTA) taxes, which is an employer-only payroll tax. However, not all tax-exempt nonprofits are 501(c)(3) organizations. They must apply for an Employer Identification Number (EIN) and file Form 1023. Those nonprofit organizations without 501(c)(3) status are required to pay FUTA taxes to the federal government.
According to the IRS, to be considered a 501(c)(3), your nonprofit must qualify as:
- Testing for public safety
- Fostering national or international amateur sports competition
- Children or animal cruelty prevention
When managing payroll taxes for non-profits, the employees on staff, despite the organization having tax-exempt status, are still subject to payroll taxes, just like for-profit organizations. Federal income tax and FICA (Social Security and Medicare) taxes must be withheld from employee paychecks, along with paying the employer portion of FICA taxes.
- While State Unemployment Tax Act (SUTA) tax rules vary by state; nonprofits can elect to forgo quarterly SUTA tax payments and pay the state directly for unemployment benefits paid to their former employees.
- If an employee is paid less than $108.28 in a calendar year, that organization doesn’t need to withhold FICA (Social Security and Medicare) taxes from that employee’s wages.
- While rewarding your volunteers is appreciated, make sure you don’t offer taxable rewards. If you do, taxes must be withheld from gifts and the volunteer must report their value to the IRS as taxable income. In lieu of this, you can offer parking passes, on-site meals, educational training, etc.
Closely monitor tax law changes to maintain your tax-exempt status and remain compliant.
In addition, nonprofits must be careful when paying workers. There’s a difference between employees, contractors, volunteers, and board members. And any board members who are compensated must be paid a reasonable amount per a special IRS test.
Other types of nonprofit organizations include:
- 501(c)(1): Nonprofits organized by Congress, such as a federal credit union.
- 501(c)(2): Holding corporations for exempt organizations. This means they can own properties for an exempt nonprofit. A church establishing an organization with the sole purpose of holding the title to its properties is an example.
- 501(c)(4): Social welfare organizations and civic leagues that focus on providing education, charity, and community welfare.
- 501 (c)(5): Labor, agricultural, and horticultural organizations that are educational and are created to improve work conditions and efficiency. Labor unions are an example.
Nonprofits other than 501(c)(3)s have different rules regarding eligibility, lobbying, and tax exemption. However, in general, every organization must withhold Social Security, Medicare, and federal income tax from employees’ wages.
How to Pay Nonprofit Workers
As a nonprofit, when handling payroll, you need to decide how much to pay your workers. Federal law dictates that all employees must be paid a minimum wage of $7.25 an hour, but this doesn’t apply to volunteers. There are 17 states and territories with rates that match the federal minimum wage, but most of the others are higher. Check your state’s minimum wage before making job offers. Commissions and bonuses should be avoided, because the IRS will likely view them as red flags, because they’re typically tied to performance and can open the door to fraudulent activity.
Some nonprofits hire employees with disabilities; this allows them to pay a lower rate than the minimum wage law allows. You’ll need to request a certificate from the DOL’s Wage and Hour Division before implementing. You can also pay employees under the age of 20 a minimum rate of $4.25 an hour for their first 90 days of employment.
Independent Contractors Working for Nonprofits
Independent contractors are workers who provide goods or services to an organization per a contract or other agreement. Similar to other employers, nonprofits don’t have to withhold or pay payroll taxes on payments made to independent contractors. They simply have them complete a W-9 form that will collect their tax identification number and other information to make it easy for you to report their annual earnings on a 1099 at year’s-end.
There’s a difference between an employee and an independent contractor. If you fail to withhold and pay taxes on amounts paid to an independent contractor and the IRS discovers that your contractor is actually an employee, you could face penalties and additional payroll taxes. Contractors generally have more control over their time, pay, and work method than employees.
Consider Grants to Pay Employees
Another option for nonprofits to pay employees is to use grants to fund specific projects that support their overall mission. Grants can cover payroll expenses for select staff members who work on projects related to the grant.
These employees need to track their time and the activities they perform back to a specific grant, because some of the work they perform in a given pay period might qualify for grant dollars, while some may not. This makes tracking critical.
This is where a time system that allows the employee to track time spent on grant-related work via a mobile app is important. The employee’s time spent is captured in real-time, and the data flows to the payroll application. This makes it easy to report on payroll expenses connected with a specific grant. The administration can then run reports to determine payroll expenses allocated to the grant, and those that flow to a designated general ledger account in their accounting system.
Reasonable compensation for executive salaries means the amount of compensation that would be provided by a similar organization in similar circumstances. Total reasonable compensation includes the employee’s salary, compensatory and fringe benefits, and other cash and non-cash compensation.
Because nonprofit organizations are generally led and directed by a board of directors who guide the future of the organization without having direct financial ownership, they must meet IRS requirements of reasonable compensation. According to the IRS, reasonable compensation is “the value that would ordinarily be paid for like services by like enterprises under like circumstances.” Reasonable compensation considers total compensation, including wages, fringe benefits, PTO, professional development costs, bonuses, health insurance, and more. While many nonprofits operate with very small payroll budgets, those with highly compensated employees should regularly review salaries to ensure they’re keeping compliant with IRS rules.
They should research an appropriate salary range for a particular position. Members of the group shouldn’t have any conflict of interest at work, meaning they shouldn’t have any benefits or losses from the determined salary. The group should record how they reached a decision on “reasonable compensation” so it can be reported on taxes and in case they are questioned.
A specific type of nonprofit charity, minister pay, is handled differently from that of other employees. Typically, ministers are set up as employees of tax-exempt organizations, though in some cases they may be considered self-employed if certain requirements are satisfied. Like other employees, ministers are paid a salary subject to income tax, however, some differences include:
- When calculating Social Security and Medicare tax, ministerial employees are considered self-employed, meaning the nonprofit does not withhold those taxes from the minister’s pay, and the employee is responsible for paying both the employee and employer’s portion of the tax. Ministers’ can request an exemption from self-employment tax from the IRS.
- Ministers’ pay may include housing or a housing allowance. This amount is reported by the religious organization on Form 990-T and is excluded from gross income for income tax purposes. However, as with wages, housing allowances are subject to self-employment, Social Security, and Medicare tax unless the minister has been granted an exemption.
There is a way that 501(c)(3) religious organizations can request exemption from the employer portion of Social Security and Medicare taxes on all employee wages. If the exemption is granted, all employees of the organization will be responsible for their self-employment taxes, paying both the employee and employer portions of the tax.
Handling Payroll Tasks
Employees at nonprofits often perform more than one job function. Unlike larger corporations that can hire dedicated HR and payroll staff, nonprofits might have payroll managed by someone who has another role within the organization. That’s okay unless the individual managing payroll doesn’t have the proper experience and training. Payroll can be complicated and can put your organization at risk if you fail to comply with federal, state, and local tax laws.
And for security reasons, you should always have a second individual verify all payroll data prior to processing and issuing checks or direct deposits. Make sure that no single individual can safely enter, approve, and process payroll for your organization.
Here are the payroll taxes nonprofits are generally subject to pay or withhold from employee paychecks:
- FICA: Social Security and Medicare taxes, 6.2% and 1.45%, respectively; you pay approximately 7.65% from your bank account and withhold the same from your employees’ wages.
- FUTA tax: You pay FUTA taxes on the first $7,000 of each employee’s wages at a rate of 7%. This is to cover unemployment benefits for employees in the event of their termination. Employees are not responsible for paying this tax; 501(c)(3)s are exempt.
- SUTA tax: SUTA tax rates can vary from 2.7% to 3.4%, and can sometimes be even higher for new employers who don’t have claim history. Nonprofits can pay into the tax fund regularly or reimburse the state when former employees make claims.
- Federal income tax: You should collect a W-4 form once your new employee is hired; it will show all of the allowances claimed so you can withhold the proper amount of federal taxes for each period.
- State income tax: You may have to withhold state income taxes if your state requires it, and the employee is not exempt. If your nonprofit is in certain states like Florida or Texas, you don’t have to withhold state income taxes.
- Local income tax: Some localities, like New York City, charge their own tax outside of the state income tax. You’ll need to check your state and local laws to verify how much needs to be withheld.
- Workers’ Compensation: Nonprofits are required to comply with state workers’ comp laws. This ensures your organization is covered if an employee suffers injury or death as a result of work performed on the job. Rates depend on position, claim history, etc.
Nonprofit Payroll Service Costs
The cost of processing payroll for your nonprofit can be cheaper than processing payroll for regular businesses. Some payroll services offer special discounts to nonprofit organizations, and those that don’t are generally inexpensive. Depending on your needs and how much research and work you’re willing to do, you can process payroll for a nonprofit with 12 employees at a cost ranging from $0 to $100 a month or more.
Here are the three cost levels you’ll generally find when researching payroll software:
- Inexpensive: An inexpensive payroll software for nonprofits can span $10 to $90 a month. You usually have access to some add-ons, like time and attendance, but not to high-end software. The interface is typically user-friendly.
- High-end: A high-end payroll for nonprofit service could cost $90 a month for 12 employees, depending on whether you add on á la carte features. You’ll usually have more HR support, which lets you can ask about specific compliance issues when they arise. However, once you reach 50 or more employees and need to provide insurance and FMLA leave, you’ll have to spend hundreds of dollars per month to reap the benefits of a high-end service.
- Free: Free payroll software for nonprofits limits the number of employees it can support and can sometimes be less up-to-date and intuitive. You should be able to run payroll and print checks, but the system might be cumbersome.
Health Insurance Benefits & Other Deductions
When processing payroll for your nonprofit, taxes aren’t the only consideration; health insurance benefits and other deductions must also be withheld and paid. You’re not required to offer health insurance unless you have at least 50 full-time equivalent (FTE) employees, but it could be a morale booster. You might also consider 401(k), commuter, dental insurance, and other benefit options.
Health Insurance Requirements Under the Affordable Care Act (ACA)
Again with 50 or more employees, the ACA requires you to offer health insurance. A full-time employee represents 30 hours worked per week. This means that two 15-hour employees (15 + 15 = 30) are the same as one full-time employee. When calculating net pay for employees, be sure to deduct any health insurance premiums you require them to pay.
Other Benefits & Deductions
You might also want to offer a 401(k), dental insurance, vision insurance, flexible spending accounts, and health savings accounts. These are all employee benefits that you can contribute to partially or fully. Remember, any contributions you make are considered expenses your organization pays, but any premiums you collect are just deducted from employee paychecks.
If you’re dealing with a wage garnishment, this is a court-issued order requiring you to withhold a certain amount from an employee’s check to pay one or more of their debts. Know that you have a certain number of days to respond and you must begin withholding the specified amount immediately, or you could be liable.
Here are some of the labor laws you should be aware of:
- Paid time off: This includes holiday, sick leave, vacation, and so forth. Federal law doesn’t require you provide paid vacation nor does it dictate when employees can use it. Some states require you to roll over unused vacation time from one year to the next.
- Overtime: Is generally paid at 1.5 times the employee’s regular rate for any hours worked over 40 in seven consecutive days. California requires you to pay overtime for any hours worked over eight in a day and double-time when it’s over 12 hours.
- Meals and breaks: The DOL doesn’t require you provide lunch breaks, but any breaks taken in 20-minute increments (or less) must be compensated.
- FMLA leave: If you have 50 or more employees, you must provide up to 12 weeks of unpaid, job-protected FMLA leave annually. Employees will sometimes use this for maternity leave or to care for a sick family member.
- Recordkeeping: You must keep organized records on each employee that include their name, occupation, hours worked each day, weekly overtime earnings, etc.
- Labor law posters: The DOL requires that you place certain posters in your workplace so they’re easily accessible to employees. You will need the Federal Minimum Wage poster and possibly the Equal Employment Opportunity poster, if you receive federal funds.
Labor Laws for Nonprofits
Nonprofits are expected to follow labor laws, including overtime rules, mealtime laws, and paid time off policy requirements. Nonprofits are generally exempt from these when it pertains to volunteers, but it’s important to be aware of labor laws when setting human resource policies for employees. You should also consider state-specific laws, because they can differ from federal.
Filing Annual Returns
Generally, nonprofits recognized as tax-exempt are obligated to file an annual information return with the IRS. Exceptions include those for certain religious organizations, schools, and political organizations. This reporting allows the IRS and the general public to audit nonprofit operations and maintain tax-exempt status. Form 990, Return of Organization Exempt From Income Tax, requires a significant amount of data, including payroll taxes, number of employees, and executive compensation. Forms for smaller organizations require less information.
- Form 990 (for organizations with gross receipts greater than or equal to $200,000 or total assets greater than or equal to $500,000 at the end of the tax year)
- Form 990-EZ (for organizations with annual receipts of less than $200,000 and total assets at the end of the year less than $500,000. This group has the option to file Form 990 instead.)
- Form 990-N (for small organizations with annual receipts less than or equal to $50,000) This form must be filed electronically. Certain types of organizations are ineligible to submit this form.
- Form 990-PF (for private foundations, including nonexempt charitable trusts treated as private foundations, regardless of financial status)
- Form 990-T (business income tax return to report unrelated business income)
- Form 990-W (to report estimated tax on unrelated business taxable income)
Accurately completing these forms each year is important. The IRS will reject incomplete paper and e-file returns or filing the wrong form. And, it’s critical to file every year, because organizations’ may be assessed penalties for late forms and may put their tax-exempt status at risk if they fail to file for three years.
…the most challenging part about doing payroll for a nonprofit is balancing the budget and other resources with compliance. Knowing you’re not subject to FUTA taxes or that you don’t need to pay volunteers a significant amount for their services is important to minimize penalties and save money.
ASAP Payroll Services can help you navigate the ins and outs of managing your particular payroll needs. Plus we offer a 10% discount to nonprofit organizations. Reach out to us at 317 887-2727 or by fax at 317 887-2741.