Churches are exempt from state unemployment taxes. Federal law removes church employment from the unemployment insurance system, and every state honors that exemption because its employers’ federal tax credits depend on the state’s law conforming to federal rules. The exemption also reaches organizations operated primarily for religious purposes under a church’s control, along with religious elementary and secondary schools. The practical consequence is significant: employees of an exempt church generally cannot collect unemployment benefits when they lose their jobs, unless the church has voluntarily elected coverage.
Why the Exemption Exists
The Federal Unemployment Tax Act takes church employment out of the system in two steps. Services performed for any 501(c)(3) organization are excluded from FUTA’s definition of “employment.”1Office of the Law Revision Counsel. 26 U.S. Code 3306 – Definitions Section 3309(a) then requires states to extend unemployment coverage to most nonprofit employers as a condition of the FUTA tax credit, but Section 3309(b) explicitly exempts churches and certain church-related entities from that requirement.2Office of the Law Revision Counsel. 26 USC 3309: State Law Coverage of Services Performed for Nonprofit Organizations or Governmental Entities
States follow this rule because their employers depend on it. Employers receive a credit against federal unemployment tax for contributions to a state fund, but only if the state’s law has been certified as meeting federal requirements under Section 3304.3Department of Labor (Doleta). Conformity Requirements for State UC Laws – FUTA Tax Credit System The credit can offset up to 5.4 percent of the federal tax. A state that tried to tax church employment would put that credit at risk, so the exemption is effectively uniform nationwide.
What Counts as a Church
The Internal Revenue Code uses the word “church” without defining it, and the IRS evaluates organizations against a combination of characteristics drawn from agency practice and court decisions. No single factor is decisive. The list includes a distinct legal existence and recognized creed, a definite form of governance and formal doctrine, a distinct religious history, a membership not associated with another church or denomination, ordained ministers who completed prescribed study, its own religious literature, established places of worship with regular congregations and services, and programs for religious instruction.4Internal Revenue Service. Definition of Church
Christian churches, synagogues, mosques, and temples all fit this framework. A convention or association of churches, like a denomination’s governing body, also qualifies. An organization that lacks most of these characteristics, or one that primarily engages in commercial activity rather than worship, will not qualify regardless of religious branding.
Which Church-Related Organizations Share the Exemption
Section 3309(b)(1) creates three categories of exempt entities. Where an organization sits determines whether it owes unemployment tax.
A church, convention, or association of churches is fully exempt. The Supreme Court clarified in St. Martin Evangelical Lutheran Church v. South Dakota that “church” means the congregation or hierarchy that hires and directs employees, not just the physical building. Schools and other operations without a separate legal existence from the church fall under this exemption too.5Library of Congress. St. Martin Lutheran Church v. South Dakota, 451 U.S. 772 (1981)
An organization operated primarily for religious purposes and operated, supervised, controlled, or principally supported by a church is also exempt. The key word is “primarily.” The organization’s main function must be religious, not educational, charitable, or medical with a religious flavor.2Office of the Law Revision Counsel. 26 USC 3309: State Law Coverage of Services Performed for Nonprofit Organizations or Governmental Entities
A K-12 school operated primarily for religious purposes, recognized as a 501(c)(3), and exempt from income tax qualifies even if it is separately incorporated from its sponsoring church.2Office of the Law Revision Counsel. 26 USC 3309: State Law Coverage of Services Performed for Nonprofit Organizations or Governmental Entities
Organizations That Do Not Qualify
The exemption does not reach religiously oriented organizations that lack affiliation with a particular church. The Department of Labor has taken the position that these nonaffiliated entities must be covered under state unemployment law, and states that fail to cover them risk their FUTA certification.6U.S. Department of Labor. Unemployment Insurance Program Letter No. 28-87 A faith-based hospital, nursing home, or social service agency that operates independently of any church falls into this category, however religious its mission.
Church-affiliated entities whose primary purpose is something other than religion also lose the exemption. A separately incorporated hospital run by a religious denomination serves a medical purpose first. A church-linked daycare focused on childcare rather than religious instruction faces the same problem. The dividing line is whether day-to-day operations are primarily religious or primarily something else that happens to be run by religious people.
What This Means for Church Employees
The exemption belongs to the employer, and this is where it stings. When a church is exempt and has not elected coverage, its workers cannot file for state unemployment benefits if they lose their jobs. There is no federal backstop and no alternate program. A church secretary laid off after 15 years of service has no unemployment claim to file unless the church previously opted into the system.
This catches people off guard. Workers taking a job at an exempt church should understand that unemployment insurance is not part of their compensation package by default. For a church considering whether to elect coverage, this gap is the main reason to do so. It’s the only way employees gain access to the safety net available to nearly every other worker in the state.
How a Church Can Provide Coverage Anyway
Exempt churches and church-controlled organizations can voluntarily opt into their state’s unemployment insurance system. Most states allow employers to elect coverage for employment categories that would otherwise be excluded.7Department of Labor (Doleta). Unemployment Insurance: Chapter 1 Coverage – Section: Voluntary Coverage of Excluded Employment Once a church elects coverage, its employees become eligible for benefits under the same rules that apply to any other worker in the state.
Federal law requires states to give nonprofit organizations a choice between two financing methods: paying regular unemployment taxes like any employer, or reimbursing the state dollar-for-dollar for benefits actually paid to former employees.7Department of Labor (Doleta). Unemployment Insurance: Chapter 1 Coverage – Section: Voluntary Coverage of Excluded Employment For churches that elect coverage voluntarily rather than being required to participate, states have flexibility in how they handle the choice. Some let the church pick, some require one method or the other.8U.S. Department of Labor. Nonprofit Organizations Not Required by Federal Law to Be Covered
Contributory vs. Reimbursable
Under the contributory method, the organization pays quarterly unemployment taxes based on its payroll, just like a for-profit employer. Rates vary by state and are influenced by the organization’s claims history. New employer rates across states run roughly from 1 percent to over 10 percent of taxable wages. The advantage is predictable costs. The downside is paying taxes even in years when no former employee files a claim.
Under the reimbursable method, the organization pays nothing upfront but reimburses the state for the actual dollar amount of benefits paid to former employees. This can save money in years with few or no claims, but a single high-cost layoff can create a large, immediate bill. Some states require reimbursable employers to post a surety bond or security deposit.
The reimbursable method appeals to churches with stable staffing and low turnover. The contributory method makes more sense for organizations with fluctuating employment or limited cash reserves. Some states lock employers into the reimbursable method for a set period once they choose it, and liability for benefits can extend for years after switching away from it. Review the specific state rules before committing.
Common Mistakes
The most frequent error is assuming the exemption covers everything a church touches. A church that operates a separately incorporated thrift store, a coffee shop open to the public, or a community health clinic may owe unemployment taxes on workers in those operations even though the church’s own staff is exempt. The test comes back to the same questions. Is the entity operated primarily for religious purposes? Is it controlled or principally supported by a church? If either answer is no, the exemption doesn’t apply.
Another common mistake is failing to report or pay unemployment taxes for non-exempt affiliates. When a state determines that a church-related entity should have been participating, the organization can face back taxes, interest, and penalties. Those penalties vary by state but add up quickly when assessed per-worker over multiple years. The Department of Labor has specifically directed states to review their coverage of nonaffiliated religiously oriented entities and ensure those organizations are paying in.6U.S. Department of Labor. Unemployment Insurance Program Letter No. 28-87
Churches that have elected coverage also sometimes forget they can’t simply walk away. Dropping out doesn’t eliminate liability for claims already incurred, and states generally hold former reimbursable employers responsible for benefits paid to workers whose employment fell within the coverage period. Before electing in or out, consult both the state unemployment agency and a tax professional familiar with nonprofit employment law.