Nonprofit organizations do a lot of good in the world, from advocating for a cleaner planet to feeding and clothing people in need. Governments relieve nonprofits of paying income, sales, and property taxes so charitable donations can go directly toward their missions.
But nonprofits aren’t absolved of all taxes. For one, nonprofit employees pay all the same payroll taxes — Medicare, Social Security, and income tax withholding — as for-profit employees. You wouldn’t be able to tell whether someone works at a nonprofit or a for-profit entity by looking at their pay stub.
Some payroll taxes are employer-paid, like federal and state unemployment, and that’s where nonprofit and for-profit payroll tax rules split.
Let’s explore the differences between nonprofit and for-profit payroll.
Federal unemployment taxes
Nonprofits with 501(c)(3) status from the Internal Revenue Service are exempt from Federal Unemployment Tax Act (FUTA) taxes.
U.S. employees who lose their job through no fault of their own are eligible for unemployment compensation. The federal government and states raise money through payroll taxes to fund state-deployed unemployment compensation programs. The 6% FUTA tax applies to the first $7,000 each employee earns during the year.
In most small business types, owners are self-employed and therefore ineligible to receive unemployment benefits. Except in some religious organizations, nonprofit leaders classify as employees, making them eligible for unemployment benefits if they lose their jobs.
FUTA is an employer-paid payroll tax, meaning the tax doesn’t come out of employee paychecks. Working for a nonprofit doesn’t afford you any payroll tax benefits.
If you’ve just started a nonprofit, communicate to your payroll software provider that your nonprofit is FUTA-exempt. You’ll need to send a copy of your nonprofit’s IRS determination letter to prove its tax-exempt status.
State unemployment taxes
Nonprofits can avoid paying State Unemployment Tax Act (SUTA) taxes, but it could come back to bite them later.
SUTA funds your state’s unemployment benefits program. It’s an employer-paid payroll tax in all states except Alaska, New Jersey, and Pennsylvania, where employers and employees contribute. The state doles out custom tax rates for each business based on its industry and history of former employees filing unemployment claims.
How does SUTA work for nonprofits?
Unlike for-profit entities, nonprofits can waive SUTA taxes if they promise to reimburse the state when former employees claim unemployment benefits. It’s called self-insuring when you waive unemployment insurance taxes.
Say you run a Michigan-based nonprofit that waives SUTA taxes. You won’t pay SUTA taxes on employee wages, thereby keeping more cash in your business. If and when you terminate an employee, the state will come knocking, asking you to foot the former employee’s unemployment compensation bill.
Self-insuring over paying SUTA is risky, however. You’re betting that your business won’t have to terminate or lay off employees in the future, and, if it happens, that you’ll have enough cash to fund their unemployment benefits.
But when global emergencies — such as, ahem, COVID-19 — wreak havoc on the economy, it’s often your only option to shrink your workforce. It’ll feel like you’re getting kicked when you’re already down to see a new bill crop up amid a financial emergency.
For COVID-19, legislation aided nonprofits that waived SUTA taxes. The Coronavirus Aid, Relief, and Economic Security (CARES) Act pays 50% of self-insured nonprofits’ unemployment benefit claims from March to December 2020. However, I can’t promise that will happen again in the next financial crisis.
In less turbulent times, you could achieve significant cash savings by not paying into SUTA over the years of no unemployment claims. Large nonprofits can find substantial savings by self-insuring, but smaller nonprofits will more likely lose out.
If you’ve run the calculations and want to self-insure, contact your state’s labor department and payroll software provider.
Are any nonprofits exempt from unemployment taxes and claims?
Most nonprofits must pay unemployment through SUTA or state reimbursement, but there are some exceptions.
Many states exempt religious nonprofits from paying for unemployment benefits. Nonprofits with fewer than four employees who work at least 20 weeks of the year are also exempt from SUTA.
The major catch: Former employees of SUTA-exempt organizations cannot collect unemployment benefits. It’s best practice for SUTA-exempt nonprofits to send off terminated employees with enough severance pay to tide them over until their next job.
As the name suggests, nonprofits don’t set out to earn massive profits and pay their executives 200% bonuses. Nonprofit salaries are commensurate with experience and skill set. It’s best practice to have a nonprofit’s board determine its executives’ pay.
If you’re looking for a “Go directly to jail; do not pass go” number, it’s $1 million. The Tax Cuts and Jobs Act (TCJA) of 2017 added a 21% excise tax on executive compensation exceeding $1 million. The excise tax also applies to excessive parachute payments — an evocative term for an executive’s severance package.
Say a nonprofit’s executive director earns $1.2 million in salary. The nonprofit would have to pay a 21% excise tax on $200,000, or $42,000.
The nonprofit executive compensation excise tax applies to a nonprofit’s five most highly compensated employees.
Nonprofit doesn’t mean non-payroll tax
Running payroll at a nonprofit looks nearly identical to cutting checks at any other type of business. Nonprofits and for-profits diverge at bookkeeping: Move on to exploring nonprofit accounting if you’re ready for the next challenge.