Yes. Organizations recognized under Section 501(c)(3) of the Internal Revenue Code are exempt from the Federal Unemployment Tax Act (FUTA) on all wages they pay their own employees. The exemption is written directly into the tax code, applies automatically once the IRS grants 501(c)(3) status, and has no dollar threshold. But it stops at FUTA. A 501(c)(3) still owes FICA, still withholds federal income tax, and in most cases still participates in its state’s unemployment insurance system.
How the Exemption Works
Section 3306(c)(8) of the Internal Revenue Code says that services performed for a religious, charitable, educational, or other organization described in Section 501(c)(3) do not count as “employment” for FUTA purposes at all.1Office of the Law Revision Counsel. 26 USC 3306 – Definitions Because those wages fall outside the definition of employment, there is no FUTA tax to compute and no credit to claim.
The exemption is entity-wide. It covers every person on the nonprofit’s payroll regardless of job title or whether the work directly advances the charitable mission. The IRS has stated that the exemption cannot be waived, so a 501(c)(3) cannot voluntarily opt into FUTA. And because there is no liability, most 501(c)(3) organizations do not file Form 940, the annual federal unemployment tax return.2Internal Revenue Service. Exempt Organizations: What Are Employment Taxes?
One boundary worth stating: the exemption is specific to 501(c)(3). Other tax-exempt nonprofits, such as 501(c)(4) civic leagues or 501(c)(7) social clubs, remain fully subject to FUTA.
When a 501(c)(3) Still Owes FUTA
The exemption protects wages a 501(c)(3) pays to its own employees. It does not protect wages a 501(c)(3) pays on behalf of another organization that lacks 501(c)(3) status. The situation comes up most often in common paymaster arrangements, where a nonprofit handles payroll for a related entity such as a 501(c)(4) advocacy arm or a for-profit subsidiary.
In that scenario the 501(c)(3) must file Form 940 and pay FUTA on the wages of the non-exempt entity’s employees. The nonprofit’s own employees remain exempt. If the 501(c)(3) also pays the state unemployment tax on those wages, it can claim the state tax credit on Form 940. If the related entity files its own Form 940 instead, that entity cannot claim credit for state taxes the 501(c)(3) paid, because the credit does not transfer between separate employers.3Internal Revenue Service. Common Paymaster
The Form 940 instructions confirm this. A 501(c)(3) is subject to FUTA whenever it pays wages on behalf of a non-501(c)(3) organization, whether as a common paymaster, a Section 3504 agent, or under any other arrangement.4Internal Revenue Service. 2025 Instructions for Form 940 – Employers Annual Federal Unemployment (FUTA) Tax Return
Payroll Taxes That Still Apply
The FUTA exemption can create a false sense of broader relief. It shouldn’t. A 501(c)(3) must still withhold and pay FICA taxes, meaning Social Security at 6.2% and Medicare at 1.45%, on employee wages of $100 or more per year, just like any other employer.5Internal Revenue Service. Section 501(c)(3) Organizations – FUTA Exemption The employer pays a matching share on top of the amount withheld from the employee.
Federal income tax withholding applies to nonprofit employees the same way it does anywhere else. FUTA is the only payroll tax a 501(c)(3) skips. Organizations that assume the exemption reaches further can accumulate real liabilities with the IRS before anyone notices.
State Unemployment Tax
Exemption from FUTA does not mean exemption from state unemployment tax. Federal law actually requires states to bring most 501(c)(3) employers into their unemployment insurance systems once the organization meets a size threshold: four or more employees on at least one day in each of 20 different calendar weeks during the current or preceding year.6Office of the Law Revision Counsel. 26 USC 3309 – State Law Coverage of Services Performed for Nonprofit Organizations or Governmental Entities Some states set a lower bar. A monetary threshold as low as $1,000 in quarterly wages can also trigger coverage. Small nonprofits under the four-employee mark may be exempt from state obligations entirely, though they can voluntarily participate.
Contributions or Reimbursement
Federal law gives qualifying nonprofits a choice most for-profit employers do not have. Under 26 U.S.C. § 3309(a)(2), state law must allow a 501(c)(3) to elect to reimburse the state unemployment fund dollar-for-dollar for benefits actually paid to former employees, instead of paying regular quarterly contributions based on a tax rate.6Office of the Law Revision Counsel. 26 USC 3309 – State Law Coverage of Services Performed for Nonprofit Organizations or Governmental Entities
Reimbursement can save money for organizations with stable, low-turnover workforces, because the nonprofit only pays when a former employee actually collects. The downside is unpredictability. A layoff or a large reduction in force can trigger reimbursement bills that dwarf what the organization would have paid under the contribution method. Federal law permits states to require safeguards such as surety bonds or deposits. Some states require a bond based on projected payroll; others waive it for certain nonprofits such as hospitals and universities.
The contribution method works like insurance. The organization pays a regular quarterly amount whether or not any former employees file claims. The rate starts at whatever the state assigns new employers and adjusts over time based on the organization’s experience rating.
Most states require the election when the organization first becomes subject to coverage or during an annual enrollment window. Switching methods is usually allowed but may be restricted to certain times of year and may require advance notice. Contacting the state workforce agency before hiring the first employee prevents expensive surprises.
Churches and Religious Schools
All 501(c)(3) organizations are exempt from FUTA. Churches, conventions of churches, and certain religious schools get an additional layer of protection at the state level. Under 26 U.S.C. § 3309(b), federal law does not require states to cover unemployment insurance for employees of churches, organizations operated primarily for religious purposes that are controlled or supported by a church, or elementary and secondary schools operated primarily for religious purposes. The same exclusion applies to ordained ministers exercising their ministry and members of religious orders performing duties required by their order.6Office of the Law Revision Counsel. 26 USC 3309 – State Law Coverage of Services Performed for Nonprofit Organizations or Governmental Entities
A church employee who loses their job may therefore have no state unemployment benefits available, depending on whether the state has voluntarily extended coverage beyond what federal law requires. Some states cover church employees; many do not. A secular 501(c)(3) charity, by contrast, is almost always required to participate in its state’s system.
How the Exemption Can Be Lost
The FUTA exemption lasts only as long as the 501(c)(3) status does. Lose the status, and the organization becomes a regular employer subject to FUTA from the date of revocation. Two paths lead there most often.
Operational Violations
A 501(c)(3) must be organized and operated exclusively for exempt purposes, and none of its earnings may benefit any private shareholder or individual. It cannot participate in any campaign activity for or against political candidates, and lobbying cannot make up a substantial part of its activities.7Internal Revenue Service. Exemption Requirements – 501(c)(3) Organizations Violating any of these rules puts the exempt status at risk, which would retroactively create FUTA liability back to the point of the violation.
Three Missed Form 990 Filings
Every 501(c)(3) must file an annual information return. Form 990, 990-EZ, or the electronic Form 990-N (e-Postcard), depending on gross receipts and total assets.8Internal Revenue Service. Form 990 Series: Which Forms Do Exempt Organizations File Organizations with gross receipts of $50,000 or less can file the e-Postcard, which takes minutes. Fail to file any version for three consecutive years and the IRS automatically revokes the tax-exempt status. Revocation takes effect on the filing due date of the third missed return.9Internal Revenue Service. Automatic Revocation of Exemption
Once revoked, the organization loses both its federal income tax exemption and its FUTA exemption. Reinstatement requires a new application, the applicable user fee, and potentially back income tax returns for the period the organization was not exempt. The IRS publishes a searchable list of automatically revoked organizations.
Setting Up Payroll Correctly
The paperwork side is short, but skipping steps compounds quickly.
The IRS determination letter is the primary proof of 501(c)(3) status and should be kept permanently. A lost letter can be replaced by requesting an affirmation letter from IRS Customer Account Services.10Internal Revenue Service. Exempt Organizations – Affirmation Letters
Any third-party payroll provider needs a copy of the determination letter to configure the account correctly. Without it, most payroll software defaults to withholding FUTA and filing Form 940 automatically, which drains charitable funds toward a tax the organization does not owe. Organizations handling payroll in-house should simply not file Form 940 unless they pay wages on behalf of a non-exempt entity.
Payroll records should also cleanly distinguish employees from independent contractors, because the exemption applies only to employees of the 501(c)(3). Misclassification can create both FUTA and FICA exposure if the IRS reclassifies contractors as employees during an audit.
State registration is separate from anything filed federally. The organization must register with its state’s labor or workforce agency, and, if choosing the reimbursement method, submit an election form. Late registration can trigger penalties and back-assessments with interest.
Recovering FUTA Paid by Mistake
Organizations that paid FUTA before receiving their determination letter, or that had a payroll provider withhold it in error, can recover the overpayment. There is no separate correction form for Form 940. The organization files a corrected Form 940 for the affected tax year by checking the “amended return” box in the top right corner.11Internal Revenue Service. Correcting Employment Taxes The amended return reflects zero FUTA liability and requests a refund.
The general statute of limitations for a refund claim is three years from the date the return was filed or two years from the date the tax was paid, whichever is later. Reviewing payroll tax filings promptly after receiving a determination letter is worth the effort, because older overpayments may fall outside the window.