Payroll for Nonprofits: A 101 Guide

You're in business for a good cause, but that doesn't relieve you of paying your employees — or your tax burden.

Although volunteers play a vital role in powering most nonprofits’ operations, charities and other tax-exempt organizations are run similarly to enterprises with paid employees.

Nonprofits, like for-profit businesses, face the expected challenges of accurately running payroll and filing annual returns to the IRS on time. But they also have plenty of unique considerations, such as using grant funding to cover payroll expenses and determining reasonable executive pay — all while staying within a tight budget.

This can seem daunting, but you’ll be far better prepared once you have a grasp on the basics. Keep reading for a breakdown of nonprofit payroll and tax compliance, so you can return your focus to what matters most: your mission.

What Is a Nonprofit Organization?

When you think of nonprofits, you probably think of charitable organizations that donate time, money, and other resources to specific causes. But the category is much broader and generally includes organizations with revenue that doesn’t benefit shareholders or private interests.

Charities and nonprofits have been part of the economy for centuries, but the modern tax structure provides select nonprofit organizations with tax-exempt status. The most common designation is 501(c)(3), which relieves the organization of liability for federal income taxes. According to the IRS, any organization that is “operated exclusively for religious, charitable, scientific, testing for public safety, literary, educational or other specified purposes” is eligible for tax-exempt status.

Other nonprofits that may qualify for tax exemption include:

• Private foundations
• Political organizations
• Social welfare organizations
• Civic and business leagues
• Labor organizations

Tax information, tools, and resources for nonprofits are available from the IRS and can help these organizations navigate paying employees and maintaining tax compliance. But there’s more to nonprofit payroll than complying with federal tax codes.

What’s Different About Paying Employees as a Nonprofit?

Understanding how to do payroll is critical for any employer, but nonprofit organizations must consider several added layers of calculations. Grants, employee classifications, and unique compliance requirements make nonprofit payroll complex, so setting up payroll properly is crucial for avoiding costly errors later.

How to Set Up Payroll for a Nonprofit

Setting up payroll for nonprofit organizations starts with providing information to the government about your business and employees. You need a federal employer identification number (EIN), a state payroll tax identification number (TIN), and possibly a local tax identification number to file and pay payroll taxes.

Once you’ve registered with the relevant agencies, it’s time to collect your employees’ information and employment documents:

• Form I-9, which verifies employment eligibility
• Form W-4, which determines federal tax withholding percentages
• State tax withholding forms, if applicable

Finally, you’ll purchase workers’ compensation insurance, which is required, and employee benefits, which are generally optional but expected in today’s competitive labor market.

This is not an exhaustive list of your payroll responsibilities to the government, so be sure to consult with professionals who are familiar with nonprofit organizations. You can also partner with an HR and payroll solution for payroll processing to maintain timeliness and compliance.

Can I Use Grants to Pay Nonprofit Employees?

Nonprofit organizations are typically eligible for grants, awarded by providers that focus on specific causes related to their mission. For example, Dollar Tree’s corporate giving program partially funds organizations that provide necessities to low-income families.

Grant funding can be used to cover the projects and expenses detailed in the grant’s terms, including payroll. However, paid employees whose wages come from grants are required to track their work to ensure their hours and activities qualify for grant dollars. Modern time collection software integrated with your payroll system makes this relatively easy.

Can My Nonprofit Pay Volunteers?

As a nonprofit, you likely have a bevy of volunteers, whether regular or irregular, who put in unpaid time throughout the year to help your organization's mission. While these folks are unpaid and not subject to the Fair Labor Standards Act (FLSA), there are still potential tax issues you must consider.

Some nonprofits offer stipends, expense reimbursement, or discounts to their volunteers, but there are some potential issues to consider.

• Taxable benefits. In general, employers must withhold income tax and FICA contributions from wages, so stipends and allowances should be treated as wages. Inexpensive items like occasional snacks or holiday gifts may be excluded from taxable income as de minimis fringe benefits.
• Volunteer liability. Paid employees are protected by the FLSA, while volunteers are shielded from tort liability when acting for a nonprofit organization under the Volunteer Protection Act. However, this only applies to volunteers whose compensation totals less than $500 annually.

In short, you can pay volunteers in a sense, but be wary of the restrictions.

Paying Executives and Board Members

Executives and paid board members must be paid “reasonable compensation,” which the IRS defines as an amount that they would ordinarily be paid by an enterprise. This includes wages, benefits, bonuses, and other parts of the compensation package.

Here are some considerations for determining how much to pay executives and board members:

• What is “reasonable” compensation? This varies among organizations, but The Foundation Group recommends being prepared to defend six-figure salaries.
• How do you calculate executive compensation? Factors that figure into the equation include the job requirements, educational background and experience, local compensation averages, hours worked, and organizational budget.
• Who determines compensation? Nonprofits should document how they determine salaries and be sure to exclude the recipient of each salary in compensation discussions.

Unfortunately, there are no hard-and-fast rules for paying these individuals, but research can reveal the salaries of executives at similar nonprofit organizations and guide your due diligence.

Minister Pay

Religious organizations, which fall into their own category of 501(c)(3) organizations, handle minister pay differently than wages for other employees. Ministers are typically classified as employees of the nonprofit, but they may be considered self-employed in certain circumstances. This is also a unique case in terms of tax requirements.

Minister pay is subject to income tax, just like other employees’ pay. However, religious nonprofit organizations do not withhold Social Security and Medicare taxes from their wages — they are responsible for paying both the employer’s and their own portion of the taxes.

Ministers may request a self-employment tax exemption from the IRS. Total compensation may also include housing or a housing stipend, which the religious organization must report on Form 990-T and exclude from gross income when reporting income taxes.

501(c)(3) religious organizations may be granted tax exemption from the employer portion of Social Security and Medicare taxes on employee wages. This requires all employees of the exempt organization to pay self-employment taxes, or both employer and employee portions of the tax.

Other Nonprofit Payroll Compliance Obligations

There are a few other compliance obligations to consider regarding payroll for nonprofit organizations.

1. Minimum Wage: As of 2009, the federal minimum wage is $7.25 per hour and applies to paid employees. Several states have minimum wages above the federal minimum, so it’s wise to check with local agencies before setting a pay rate.
2. Overtime: Nonexempt employees must be paid a rate of 1.5x their regular hourly pay per hour once they’ve exceeded 40 hours of work in a workweek.

The Fair Labor Standards Act provides further details and notes on recent legislation around independent contractors.

For more compliance information, check out our Introduction to Payroll Compliance

FAQs on Nonprofit Tax Liabilities

Nonprofits are tax-exempt organizations, meaning they do not have to pay federal income taxes, but they’re still liable for a few other taxes: payroll, unrelated business income, and state and local taxes.

Are Nonprofits Exempt from Payroll Taxes?

No, nonprofits are not exempt from payroll taxes. Tax exemptions for nonprofits include those for federal income tax and federal unemployment taxes (FUTA).

Nonprofit organizations are required to withhold and deposit the funds to pay Federal Insurance Contributions Act (FICA) taxes on each employee’s behalf, as well as file the relevant tax returns. FICA taxes cover Social Security and Medicare, and the cost is split evenly between employees and employers. Nonprofits may also be required to pay state unemployment taxes.

Be sure to stay on top of payroll tax due dates, so your nonprofit organization does not miss key deadlines and be subject to an audit. 

How Could My Nonprofit Lose its Tax-Exempt Status?

Not every nonprofit has tax-exempt status — only those designated under code 501(c)(3) are exempt from paying federal income taxes. This status is simple to maintain but just as easy to lose, according to the IRS. These are the infractions that will result in a loss of tax exemption status:

• Private Benefit: The activities of the organization benefit a private interest or an insider of the organization.
• Lobbying: The organization tries to influence legislation or spends too much time urging the public to influence legislation.
• Political Activity: The organization participates in a political candidate’s campaign.
• Unrelated Business Income: Too much business income is generated by activities irrelevant to the nonprofit’s mission.
• Failing to Report: The nonprofit does not complete and file Form 990.
• Pursuing New Activities: The organization deviates from pursuing its tax-exempt activities as promised to the IRS.

Do I Need to File a Tax Return as a Nonprofit?

Despite being tax- exempt organizations, most nonprofits must file an annual information return with IRS Form 990 that shows income, expenses, and activities. Form 990 must be filed within five months and 15 days of the nonprofit’s fiscal year end.

There are three versions of the form: Form 990, Form 990-EZ, and Form 990-N. Which form you file — and whether it’s required to file electronically — generally depends on your nonprofit’s financial activity.

The IRS provides the most recent guidance on tax forms, filing deadlines, and exceptions, but it’s also helpful to have all-in-one HR & payroll software that includes tax preparation services to help you file your state and federal payroll taxes accurately and on time.

How to Choose a Payroll Provider for Your Nonprofit

When shopping for an HR and payroll solution, it’s important to keep in mind both the day-to-day HR functions and the organization’s needs. You need a platform that can automate processes but also engage your employees and keep them connected to each other and to your organization’s mission. And finally, look for a solution that shows the most promise of growing and scaling with your organization.

Choosing the right payroll provider will support your nonprofit organization’s long-term evolution and improvement, so choose wisely! Your payroll software should have features to track time and labor, run payroll reports, manage expenses, and avoid payroll errors.

The community relies on your organization, and your employees rely on you. Stop worrying about your next payroll or open enrollment with a flexible, integrated HR and payroll software for nonprofit organizations that powers impactful, cost-effective decision making with data insights and analytics.

Request a payroll software demo today to learn more about how our Payroll Tax Services can alleviate headaches and keep your organization compliant.