Do Nonprofit Employees Pay Tax?

One of the most common misconceptions of the nonprofit industry is that nonprofit employees are exempt from paying tax. In this article we're going to clear up this misconception, and many others, while coming to a clear understanding of the tax implications of organizations and their employees in the nonprofit sector.

We'll get started by squashing some of the other common misconceptions related to the taxation of nonprofit employees:

1. Nonprofits don't pay their employees and therefore don't pay payroll taxes.

Those who hold this misconception may be confusing employee with volunteer. Volunteers are individuals that choose to offer their labor to a nonprofit without expecting compensation. In this case, since volunteers are unpaid, there will be no payroll taxes for the nonprofit to pay. However, just like for-profit businesses, nonprofit organizations have an obligation to pay payroll taxes.

2. Nonprofits and their employees don't pay into the Social Security system.

Nonprofits and their employees are held to strict tax-paying standards. This includes Social Security contributions. Currently nonprofits and their employees are each obligated to pay a 6.2% Social Security tax on up to $168,600 of an employee's earnings. If an individual is self-employed in the nonprofit sector they'll have to pay the combined employer and employee amount. This combined amount totals a 12.4% Social Security tax.

3. Nonprofits and their employees don't pay Medicare tax.

Similarly to the Social Security tax-paying obligations of nonprofits and their employees, Medicare tax is paid by each party as a percentage of an employee's earnings. Unlike Social Security tax, which is paid on earnings up to $168,600, Medicare tax is assessed based on the total earnings of an employee. The employer and the employee each pay a 1.45% Medicare tax on all the employee's earnings. Self-employed individuals in the nonprofit sector are expected to cover both the employer and employee Medicare amount. This combined amount totals a 2.9% Medicare tax on a self-employed individual's entire net earnings.

Plenty more misconceptions exist surrounding the taxation of nonprofits and their employees, such as whether or not tax is paid on fundraising revenue. In the remainder of this article we'll cover as much tax-based information as possible to help dispel these nonprofit myths. We'll cover the different tax statuses of nonprofits and how this affects their employees, the tax requirements for nonprofit employees, tax deductions and credits for nonprofit employees, and more.

Nonprofit Tax Status and Employee Implications

The difference between nonprofit tax-exempt status and the personal tax liabilities of nonprofit employees can be difficult to understand. These concepts are not mutually exclusive and more often than not exist together in the nonprofit sector. Let's break it down.

What is Nonprofit Tax-Exempt Status?

Tax-exempt status is afforded to nonprofit organizations that are "organized and operated exclusively for exempt purposes set forth in section 501(c)(3)" of the Internal Revenue Code (IRC). These organizations may not distribute any of their earnings to private shareholders or individuals, and they're prohibited from being an action organization. An action organization is one that attempts to influence legislation as a major portion of its activity. The campaigning of nonprofits for or against political candidates is strictly forbidden.

Organizations that qualify for 501(c)(3) status are usually referred to as charitable organizations. However organizations described in this section of the IRC aren't always a typical charity. 501(c)(3) organizations can be religious in nature, operate on the basis of testing for public safety, or have a variety of other purposes.

Once an organization qualifies for tax-exempt status under section 501(c)(3) of the IRC it's exempt from federal income tax and eligible to receive tax-deductible contributions. What does this mean?

• Federal Income Tax Exemption: Organizations that receive tax-exempt status based on section 501(c)(3) of the IRC are exempt from paying federal income tax on their income. The stipulation is that they are only exempt from federal income tax on income related to their exempt purpose.
• Tax-Deductible Contributions: Individuals that donate to 501(c)(3) organizations can deduct qualifying donations from their taxable income. This tax exemption solely benefits donors and acts as an incentive to support charitable organizations. Those who wish to take advantage of this tax benefit will likely have to itemize their deductions on Schedule A (Form 1040), Itemized Deductions.

Personal Tax Liabilities of Nonprofit Employees

Although tax-exempt organizations under section 501(c)(3) of the IRC are exempt from federal income tax this doesn't extend to individuals employed within these organizations. Nonprofit employees are subject to a federal income tax rate based on their income bracket. This is in line with employees of for-profit businesses. Federal income tax for nonprofit employees covers wages, salaries, bonuses, and, in some cases, benefits. Tax-exempt benefits typically include health insurance, education assistance, and transportation benefits.

As mentioned earlier nonprofit employees, and their employers, must pay a Social Security and Medicare tax. We'll explore this in more detail later in the article.

Employee Tax Liabilities of Nonprofit Organizations

Section 501(c)(3) of the IRC doesn't exempt charitable organizations from payroll taxes. These taxes include, but are not limited to, Social Security tax, Medicare tax, and federal and state unemployment tax. These taxes must be paid for each individual that is employed by a nonprofit organization.

Some employee tax liabilities vary by state. For example state unemployment tax and state disability insurance may or may not be assessed based on the state that the nonprofit organization operates in. California, Hawaii, New Jersey, New York, and Rhode Island are examples of states that impose a state disability insurance tax. The responsibility of this tax is typically split between the employer and the employee.

Income Tax Requirements for Nonprofit Employees

Individuals employed in the nonprofit sector are subject to many of the same income taxes as those employed in the for-profit sector. As we've already made clear tax-exempt status under section 501(c)(3) of the IRC doesn't extend to nonprofit employees. Below we will unpack the common income tax requirements of employees in the nonprofit sector.

1. Federal Income Tax

Federal income tax is a percentage of your income that is paid to the federal government and is assessed in layers called tax brackets. As your income increases the tax rate on your next level of income is greater. A single tax rate isn't applied to the entirety of your income unless you earn $11,000 or less per year. Let's take a look at a simple table to help visualize the tax brackets.

2023 Tax Rates for a Single Taxpayer

Tax RateOn Taxable Income From...Up To...10%$0$11,00012%$11,001$44,72522%$44,726$95,37524%$95,376$182,10032%$182,101$231,25035%$231,251$578,12537%$578,126And Up

The 2023 tax rates have been used as an example. It's important to remember that tax brackets can change from year to year.

2. State and Local Income Tax

State and local income tax is assessed in a similar way to federal income tax, using tax brackets. The major difference is that state and local income tax rates vary from state to state. States like California, Hawaii, and New York are known for their high state and local income tax rates, whereas some states, such as Alaska and Florida, don't have a state and local income tax.

3. Social Security Tax

Social Security tax is an obligation that is shared by the employer and the employee fifty-fifty. Currently you and your employer will each have to pay a 6.2% Social Security tax on up to $168,600 (wage base limit) of your income. Any earnings that exceed this amount won't be subject to Social Security tax. The Social Security tax rate and wage base limit can vary from year to year.

4. Medicare Tax

Currently you and your employer will each have to pay a 1.45% Medicare tax on the entirety of your earnings. If you earn over $200,000, or $250,000 for married couples filing together, you'll be subject to 0.9% more in Medicare taxes. The Medicare tax rate and wage base limit for extra Medicare tax can vary from year to year.

5. State Disability Insurance

State disability insurance tax is only assessed in certain states: California, Hawaii, New Jersey, New York, and Rhode Island. The tax rate and wage base limit varies from state to state, and can change from year to year. This tax contribution can be the sole responsibility of the employee or split between the employer and the employee. In New Jersey it's currently the sole responsibility of the employer. This means that the income of nonprofit employees in New Jersey is unaffected by state disability insurance tax.

6. Retirement Plan and Health Savings Account Contributions

Retirement plan and health savings account contributions aren't themselves taxes, but are tied to taxes and will affect your income. These contributions can typically be made before tax, meaning they aren't subject to tax and your overall taxable income is reduced.

Taxes and Withholding for Nonprofit Organizations

Nonprofits are subject to a very similar set of taxes as for-profit businesses, aside from one major difference. Let's analyze the effect of tax-exempt status under section 501(c)(3) of the IRC on the taxes and withholding of nonprofit organizations.

Like for-profit businesses, nonprofits must withhold all relevant taxes from their employees' paychecks. Any taxes withheld from an employee's paycheck are the responsibility of the employee. There are also many taxes for which the nonprofit itself is liable for.

1. Federal Income Tax

Charitable organizations under section 501(c)(3) of the IRC are exempt from federal income tax. This only applies to income that is related to the exempt purpose of the organization.

2. State and Local Income Tax

This exemption varies state by state, but most charitable organizations with tax-exempt status under section 501(c)(3) of the IRC are exempt from state and local income tax.

3. Social Security Tax

Currently nonprofit employers have to pay a 6.2% Social Security tax on each of their employee's earnings up to $168,600. The Social Security tax rate and wage base limit can vary from year to year.

4. Medicare Tax

Currently nonprofit employers have to pay a 1.45% Medicare tax on each of their employee's total earnings. The Medicare tax rate and wage base limit can vary from year to year.

5. State Disability Insurance

Nonprofit organizations that operate in California, Hawaii, New Jersey, New York, or Rhode Island have to account for state disability insurance tax. In California and Rhode Island state disability insurance tax is the sole responsibility of the employee, meaning that nonprofits in these states don't contribute to this tax. In Hawaii and New York the responsibility of this tax is split between the employer and the employee, meaning that each party pays half. And nonprofit organizations in New Jersey pay 100% of the state disability insurance tax.

6. Federal and State Unemployment Tax

Depending on the state that a nonprofit organization operates in it will be subject to federal and state unemployment tax. The federal unemployment tax, often referred to as Federal Unemployment Tax Act (FUTA), rate is currently 6.0%. Only the first $7,000 paid to each employee as wages is subject to FUTA. The rates and stipulations of state unemployment tax vary from state to state. It's important to read up on local tax laws to understand the tax rates that your organization will be subject to.

Common Tax Deductions and Credits for Nonprofit Employees

As far as tax deductions and credits go W-2 employees in the nonprofit sector are no different from W-2 employees in the for-profit sector. The list of tax deductions and credits available to W-2 employees regardless of the sector they work in is the same.

Tax Deductions for Nonprofit Employees

Here's a list of some common tax deductions available to nonprofit employees:

• Standard Deduction: A specific dollar amount that reduces the total of your taxable income. This dollar amount varies based on your filing status: head of household, single or married filing separately, married filing jointly, or qualified widow(er).
• Tax-Deductible Contributions: Donations made to charitable organizations under section 501(c)(3) of the IRC can be claimed as deductions when filing your tax return.
• Medical and Dental Expenses: The portion of medical and dental expenses that exceeds 7.5% of your gross adjusted income can be claimed as a tax deduction.
• Home Mortgage Interest: On the first $750,000 of home mortgage indebtedness, you can claim the interest as a tax deduction. This total is reduced to $375,000 if married and filing separately. A higher limitation, of $1,000,000 or $500,000 if married filing separately, is offered to individuals deducting interest from indebtedness incurred before December 16, 2017.
• Retirement Contributions: Contributions made to a 401(k) plan reduce your total amount of taxable income. Contributions to a traditional IRA can be claimed as a deduction under certain circumstances.
• Health Savings Account Contributions: Contributions to a health savings account reduce your total amount of taxable income.

While this list isn't extensive, a combination of these deductions can be used to reduce your total taxable income and lessen your tax obligations while working as a W-2 employee in the nonprofit sector.

Credits for Nonprofit Employees

Now we'll take a brief look at some of the tax credits available to nonprofit employees:

• Earned Income Credit: This tax credit is available to individuals with low to moderate income. The amount of this credit varies based on the number of children you have, the number of dependents you have, whether or not you're disabled, and other criteria.
• Child Credit: This credit can be claimed for each qualifying child that has a social security number eligible for employment in the United States of America.
• American Opportunity Credit: For the first four years of education this credit can be claimed for qualified education expenses. A maximum credit of up to $2,500 per eligible student can be claimed annually.
• Saver's Credit: Eligible contributions to an IRA or employer-sponsored retirement plan qualify for this credit. The individual must be aged 18 or over, must not be claimed as a dependent, and must not be a student to receive this credit.

Similarly to tax deductions, credits are a great way to reduce your tax liability or increase the amount of your tax return. Be sure to thoroughly read through the credits available to you in order to understand your eligibility.

FAQs

Q: Do nonprofit employees need to file federal income tax returns even if their employer is tax-exempt?

A: Yes! Don't make the mistake of believing that tax returns don't apply to nonprofit employees. Everyone must file a tax return regardless of the sector in which they are employed.

Q: Are there any specific IRS forms that nonprofit employees must be aware of when filing their taxes?

A: One of the most important IRS forms to familiarize yourself with as a nonprofit employee is Schedule A (Form 1040), Itemized Deductions. This form is used to itemize individual deductions when filing your tax return. If you're making eligible contributions to a tax-exempt organization under section 501(c)(3) of the IRC, you'll need this form to claim deductions on your donations.

Q: Are nonprofit employees eligible for any unique tax credits?

A: There aren't any special credits available for nonprofit employees but they can benefit from credits available to all W-2 employees. This has been briefly discussed above and there are many more credits available that you can check your eligibility for.

Conclusion: Navigating Taxes as a Nonprofit Employee

Regardless of the sector of your employment, tax compliance is extremely important. Non compliance regarding taxes results in severe punishment. Nonprofit employees should be aware of their duty to file a yearly tax return while being mindful that tax-exemptions don't extend from charitable organizations to their employees. Always plan your taxes accordingly and use your employer's withholding to stand yourself in good stead for the tax season.

From the perspective of both nonprofits and their employees, we've covered the basics of taxation and the benefits of the tax-exempt status under section 501(c)(3) of the IRC. Both nonprofit employers and employees are going to be subject to various payroll taxes. Social Security, Medicare, and state disability insurance taxes are the responsibility of both the employer and the employee. Tax-exempt organizations can expect an exemption from federal income tax and likely state and local income tax as an extension.

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