Nonprofits pay employees the same way most businesses do: through regular paychecks funded by the organization’s revenue, with federal and state taxes withheld and standard wage laws in force. The money comes from donations, foundation and government grants, contracts, and fees the organization charges for its services. A 501(c)(3) can offer competitive, market-rate salaries as long as the total pay for each role is reasonable for the work performed.1Internal Revenue Service. Intermediate Sanctions – Compensation The one structural difference from a for-profit company is that no part of the organization’s earnings may benefit private insiders. There are no owners, no shareholders, and no profit distributions.2Office of the Law Revision Counsel. 26 USC 501 – Exemption From Tax on Corporations, Certain Trusts, Etc.
Where the Money for Payroll Comes From
Most nonprofits cover payroll from a blend of sources rather than a single stream:
- Individual donations, which, when given without restrictions, can go toward salaries, rent, or any other lawful expense.
- Foundation and corporate grants, which often include line items for the salaries of staff carrying out the funded work.
- Government contracts and awards. Federal cost principles treat employee compensation and fringe benefits as allowable direct costs that can be charged to a federal award.3eCFR. 2 CFR Part 200 Subpart E – Cost Principles
- Program service revenue, such as museum admissions, tuition, or counseling fees.
- Investment income from endowments and reserves.
Restricted vs. Unrestricted Funds
Not every dollar is available for every purpose. Unrestricted funds carry no donor conditions and can pay any lawful expense, including administrative salaries. Restricted funds come with instructions: a grant might pay only for program staff on a specific project, not for the executive director or general office overhead. Using restricted money on unauthorized costs can force the organization to return the funds and damage its relationship with the funder. Clean internal accounting matters, because payroll charges have to line up with each funder’s terms.
Payroll Taxes: What Applies and What Doesn’t
Tax-exempt status applies to the organization’s own income. It does not exempt employee wages from payroll taxes.
Social Security and Medicare
Most 501(c)(3) organizations withhold Social Security and Medicare taxes from wages and pay the employer’s matching share. For 2026, the Social Security tax rate is 6.2 percent on earnings up to $184,500, and Medicare is 1.45 percent on all earnings, with employer and employee each paying their share.4Social Security Administration. Contribution and Benefit Base Some nonprofits, particularly certain religious employers, do not participate in Social Security. Their employees are treated similarly to self-employed individuals and pay a combined 15.3 percent self-employment tax.5Social Security Administration. If You Work for a Nonprofit Organization
Federal Unemployment Tax
Section 501(c)(3) organizations are exempt from the Federal Unemployment Tax Act. Wages that would otherwise be subject to FUTA are not taxed when paid by a qualifying charitable, religious, or educational nonprofit.6Internal Revenue Service. Section 501(c)(3) Organizations – FUTA Exemption
State Unemployment Insurance
State systems are a different matter. Most 501(c)(3) organizations still participate in state unemployment insurance, and federal law generally requires states to give qualifying nonprofits a choice between paying regular quarterly contributions and electing a reimbursable method, under which the organization repays the state dollar-for-dollar only when a former employee actually collects benefits.7U.S. Department of Labor. Nonprofit Organizations Not Required By Federal Law To Be Covered The reimbursable option can save money for organizations with low turnover but creates unpredictable costs if several employees file claims at once.
Income Tax Withholding
Nonprofits withhold federal and state income taxes from paychecks and remit them on the same schedules as any other employer.
Wage and Hour Rules
The Fair Labor Standards Act reaches nonprofits the same way it reaches for-profit companies. Any nonprofit with annual gross revenue of at least $500,000, or whose employees engage in interstate commerce, must meet federal minimum wage and overtime rules.
The federal minimum wage remains $7.25 per hour in 2026, though many states and localities set higher floors.8U.S. Department of Labor. State Minimum Wage Laws Employees who work more than 40 hours in a workweek are generally entitled to overtime pay at one-and-a-half times their regular rate.
Salaried staff can be treated as exempt from overtime only if they earn at least $684 per week ($35,568 per year) and meet the duties tests for executive, administrative, or professional roles. A 2024 rule that would have raised the threshold to $58,656 was vacated in November 2024, so the 2019 figure remains the current legal standard.9U.S. Department of Labor. Earnings Thresholds for the Executive, Administrative, and Professional Exemptions Paying a salaried employee below $35,568 while classifying them as exempt is a violation.
Volunteers Are Not a Payroll Workaround
Nonprofits can use true volunteers, but the line matters. If a “volunteer” receives more than nominal compensation, or if payment is tied to hours worked, that person may legally be an employee entitled to minimum wage and overtime. The Department of Labor generally treats a fee as nominal only if it stays below 20 percent of what a full-time employee would earn for the same work. Hour-based stipends carry more reclassification risk than flat amounts.
The Reasonable Compensation Rule
Every dollar of pay a nonprofit provides has to be reasonable, meaning it cannot exceed what a similar organization would ordinarily pay for comparable services in similar circumstances.1Internal Revenue Service. Intermediate Sanctions – Compensation The standard covers salary, bonuses, benefits, and expense reimbursements as a package. There is no fixed cap; the IRS looks at the total against what the market supports for the role.
How Boards Establish Reasonableness
An organization can create a rebuttable presumption of reasonableness by following three steps before pay is set:
- The compensation is approved in advance by an authorized body, such as the board or a compensation committee, made up of people with no conflict of interest.
- That body obtains and relies on appropriate comparability data showing what similar organizations pay for similar positions.
- The board documents the basis for its decision at the time it’s made, including the data reviewed and the reasoning.10Internal Revenue Service. Rebuttable Presumption – Intermediate Sanctions
Following these steps doesn’t guarantee IRS acceptance, but it does mean the government has to affirmatively prove the pay is unreasonable rather than the organization defending it from scratch.
Penalties for Excessive Pay
Compensation that exceeds what the IRS considers reasonable becomes an excess benefit transaction under Section 4958 of the Internal Revenue Code. The penalties fall on both the recipient and the managers who approved the pay:
- An excise tax of 25 percent of the excess benefit on the person who received the overpayment.11Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions
- An additional tax of 200 percent of the excess if it isn’t returned within the correction period.11Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions
- A 10 percent tax on any organization manager who knowingly approved the transaction, capped at $20,000 per transaction.11Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions
These intermediate sanctions let the IRS punish the individuals without immediately revoking exempt status. Revocation is still possible for organizations with a pattern of excessive pay or that operate primarily for private benefit.12Internal Revenue Service. How to Lose Your Tax Exempt Status Without Really Trying
Pay Structures That Are Off-Limits
The rule against private inurement, which forbids any insider from benefiting from the organization’s net earnings, rules out several familiar for-profit pay tools.13Internal Revenue Service. Inurement/Private Benefit – Charitable Organizations
- No dividends, stock options, or ownership stakes. Nonprofits have no shareholders.
- No pay structured as a percentage of net earnings or surplus. A bonus that rises and falls with the bottom line looks like a disguised profit distribution.
- High-commission or revenue-share structures are risky even if total pay lands in a reasonable range, because they can pull staff toward maximizing revenue over mission.
Modest performance bonuses tied to individual goals, program outcomes, or fundraising benchmarks are generally acceptable, provided total compensation stays within the reasonable range established by comparability data. Losing 501(c)(3) status over inurement has immediate consequences: the organization becomes subject to corporate income tax, and donations stop being tax-deductible.2Office of the Law Revision Counsel. 26 USC 501 – Exemption From Tax on Corporations, Certain Trusts, Etc.
Retirement Benefits: 403(b) Plans
Employees of 501(c)(3) organizations and public educational institutions have access to 403(b) retirement plans, which are unavailable to typical for-profit workers. They function much like 401(k) plans and accept pre-tax or Roth contributions through payroll deduction.
For 2026, the employee elective deferral limit is $24,500. Employees age 50 and older can make an additional $8,000 catch-up contribution, and a higher catch-up limit of $11,250 applies at ages 60 through 63.14Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026, IRA Limit Increases to $7,500
A universal availability rule applies: if the employer lets any employee make salary deferrals, it generally must extend the option to all eligible employees. Certain categories can be excluded, including those who work fewer than 20 hours per week and nonresident aliens with no U.S. income.
What Nonprofit Pay Gets Disclosed Publicly
One of the trade-offs of tax-exempt status is that compensation is not private. Every year, tax-exempt organizations file IRS Form 990, a public information return.15Internal Revenue Service. About Form 990, Return of Organization Exempt From Income Tax Part VII lists the names, titles, and total compensation of officers, directors, trustees, key employees, and the highest-paid staff. When total compensation for any listed person exceeds $150,000, the organization also completes Schedule J, which breaks the pay down into base salary, bonus and incentive pay, other reportable compensation, retirement and deferred compensation, and nontaxable benefits.16Internal Revenue Service. Filing Requirements for Schedule J, Form 990
Form 990 is a public record. Anyone can request it directly from the organization or find it in online databases, and federal law requires tax-exempt organizations to make their returns available for public inspection.17Office of the Law Revision Counsel. 26 USC 6104 – Publicity of Information Required From Certain Exempt Organizations and Certain Trusts Failing to comply with these disclosure requirements carries a base penalty of $20 per day, up to $10,000 per return.18Office of the Law Revision Counsel. 26 USC 6652 – Failure to File Certain Information Returns, Registration Statements, Etc. For boards, the practical takeaway is that pay decisions will be reviewed not only by the IRS but by donors, grant-makers, and the press, which is why documenting the comparability data behind every salary matters as much as setting the right number.