Do Nonprofits Pay Taxes on Payroll? A Clear, Practical Breakdown

If you run a nonprofit, you’ve probably heard it a hundred times: “We’re tax-exempt.” But here’s the catch — being tax-exempt doesn’t mean your organization is off the hook for payroll taxes.

It’s one of the most common misunderstandings among nonprofit leaders. And it makes sense — the rules are confusing. You don’t pay income tax as a 501(c)(3), but what about Social Security? Medicare? Unemployment?

This article breaks it all down in plain English. We’ll cover exactly which payroll taxes 501(c)(3) nonprofits still pay, what they’re exempt from, and how to stay compliant while keeping your mission front and center.

Tax-Exempt Doesn’t Mean Payroll-Exempt

Let’s start with a simple truth: your nonprofit’s 501(c)(3) status protects you from federal income tax, not employment taxes.

If your organization pays employees, you must withhold and pay payroll taxes just like any other employer. That includes:

• Federal income tax withholding, based on employee W-4s

• Social Security and Medicare (FICA) contributions — both the employee and employer shares

  
  

✅ The IRS’s “Employment Taxes for Exempt Organizations” makes it clear: being tax-exempt does not exclude nonprofits from payroll tax responsibilities.

Think of payroll taxes as your contribution to the safety nets your employees rely on. Even if your work is charitable, your payroll obligations aren’t optional.

Which Payroll Taxes Do 501(c)(3) Nonprofits Still Pay?

If you have paid staff, your nonprofit must comply with these core payroll taxes:

1. Federal Income Tax Withholding (FITW)

You’re responsible for withholding federal income taxes from employee paychecks. The amount depends on each employee’s W-4 form and IRS tax tables. It’s your duty to calculate and remit those funds on their behalf.

2. FICA: Social Security and Medicare

This one trips up a lot of nonprofit leaders. Every employer — including nonprofits — must pay FICA taxes. That means:

• You withhold 7.65% from each employee’s paycheck (6.2% for Social Security + 1.45% for Medicare).

• You match that same 7.65% as the employer’s contribution.

Together, that’s 15.3% of taxable wages. It might sound steep, but it’s the law — and it ensures your team members get the benefits they’ve earned.

✅ The IRS “Employment Tax Requirements” confirms that all employers — including tax-exempt ones — must contribute to FICA.

3. FUTA (Federal Unemployment Tax)

Here’s where many nonprofits breathe a sigh of relief. Most 501(c)(3) organizations are exempt from FUTA/unemployment tax, which funds federal unemployment programs.

However, two important caveats apply:

• If you’re a non-501(c)(3) nonprofit (like a 501(c)(4) or trade association), FUTA still applies.

• Some state unemployment taxes (SUTA) may still be required, even if you’re federally exempt.

  
  

✅ According to the IRS’s “Exempt Organizations and Employment Taxes,” 501(c)(3)s are exempt from FUTA but must follow state unemployment rules.

In other words, your FUTA exemption doesn’t necessarily mean you’re off the hook for all unemployment contributions — it just depends on where you operate.

State Payroll Taxes for Nonprofits

Each state has its own payroll tax structure, and nonprofits are expected to follow it. Depending on where you’re registered, you may need to handle:

• State income tax withholding

• State unemployment insurance (SUI)

• Disability insurance or paid family leave programs

  
  

For example:

• In New York, even exempt nonprofits must pay into state unemployment funds unless they opt for a reimbursement method.

• In California, nonprofits with one or more employees must register with the EDD and file quarterly payroll reports.

Before you run your first payroll, check your state’s Department of Labor or Revenue for specific nonprofit requirements. Staying ahead of state rules prevents future penalties and back payments.

Worker Classification and Payroll Tax Liability

One of the biggest risks for nonprofits isn’t late tax payments — it’s misclassifying workers.

The difference between an employee and an independent contractor determines whether you must withhold payroll taxes. Misclassification can lead to thousands in back taxes, penalties, and even loss of exempt status.

Employees

• Work under your direction or schedule

• Use your organization’s tools or resources

• Are paid regularly (hourly or salary)

Independent Contractors

• Control when and how they work

• Provide their own tools or workspace

• Invoice for specific projects or deliverables

If a worker looks and acts like an employee, the IRS will likely classify them as one — no matter what your contract says.

✅ The IRS guide “Independent Contractors vs. Employees” outlines clear criteria to help nonprofits avoid misclassification penalties.

A good rule of thumb? When in doubt, classify conservatively. It’s easier to reissue a 1099 than to fix years of unpaid payroll taxes.

Volunteer Payroll Taxes Nonprofit: What You Need to Know

Volunteers are the heart of every nonprofit — but when does volunteer appreciation cross into taxable territory?

The answer depends on whether you’re providing compensation or reimbursement.

Volunteers Are Not Employees

True volunteers don’t receive wages and therefore don’t trigger payroll taxes. You can provide small tokens of appreciation, like:

• T-shirts, hats, or event meals

• Reimbursement for travel or supplies

• Public recognition

  
  

When It Becomes Taxable

If you start giving stipends, cash “thank-yous,” or frequent gift cards, the IRS may consider that compensation. And if that happens, those volunteers legally become employees — which means you owe payroll taxes on those payments.

✅ BDO’s “Nonprofit Volunteers: Unpaid Employees or Independent Contractors?” warns that recurring cash gifts can reclassify volunteers as employees for payroll purposes.

The takeaway? Keep volunteer rewards minimal, occasional, and clearly tied to appreciation — not compensation.

Payroll Tax Compliance: Reporting, Filing, and Deadlines

Knowing what to pay is one thing; knowing when and how to file is another. Here’s a quick look at the basics:

Tax Type	Form	Due
Federal income, Social Security & Medicare	Form 941	Quarterly
Federal unemployment (if applicable)	Form 940	Annually
State withholding	Varies	Usually quarterly
Employee W-2s	W-2/W-3	By January 31
Contractor payments	1099-NEC	By January 31

✅ The IRS’s “Employment Tax Requirements” provides detailed schedules and deposit rules for nonprofits.

Missing a deadline can lead to penalties — often up to 15% of the unpaid amount — so setting automated reminders or using payroll software is essential.

Common Payroll Tax Mistakes Nonprofits Make

Even experienced organizations make payroll mistakes. Here are a few of the most common pitfalls:

1. Assuming tax-exempt means tax-free. Your nonprofit is exempt from income tax — not payroll taxes.

2. Ignoring state unemployment laws. FUTA exemptions don’t apply to state unemployment insurance in many states.

3. Misclassifying staff as contractors. It’s tempting to save costs, but the penalties aren’t worth it.

4. Paying volunteers stipends or gift cards. That “thank you” payment could trigger payroll tax liability.

5. Neglecting grant-funded payroll tracking. If staff are paid from restricted funds, you must track wages to the correct grant or program.

Payroll Tax Checklist for Nonprofits

A clean, compliant payroll system isn’t just good accounting — it’s mission protection. Use this checklist to stay organized:

• Verify 501(c)(3) status and confirm FUTA exemption

• Register for EIN and state payroll accounts

• Classify employees vs. contractors correctly

• Set up automated payroll deposits (EFTPS)

• File Form 941 quarterly

• Review volunteer policies annually

• Conduct a payroll audit every year

  
  

✅ Altruic Advisors’ “Nonprofit Payroll Taxes” recommends annual reviews to catch errors before they turn into penalties.

Final Thoughts: Compliance Protects Your Mission

No one starts a nonprofit to think about payroll taxes — but getting them right keeps your doors open and your impact strong.

Understanding and managing nonprofit payroll taxes shows donors, funders, and your board that your organization is responsible and trustworthy. It’s not just compliance; it’s stewardship.

If payroll still feels like a puzzle, you don’t have to solve it alone.

👉 MightyNonprofits helps mission-driven organizations simplify payroll, manage compliance, and stay audit-ready year-round. 

We’ll help you set up a system that’s accurate, transparent, and designed for nonprofit realities.

Schedule a free discovery call today and let’s make your payroll as purpose-driven as your mission.

Sources

✅ “Employment Taxes for Exempt Organizations” – IRS ✅ “Employment Tax Requirements for Nonprofits” – IRS ✅ “Tax Policies Affecting Nonprofit Employment” – Council of Nonprofits ✅ “Nonprofit Volunteers: Unpaid Employees or Independent Contractors?” – BDO ✅ “Nonprofit Payroll Taxes” – Altruic Advisors ✅ “Independent Contractors vs. Employees” – IRS