Nonprofits pay employees the same way any employer does: through a regular payroll funded by organizational revenue, with federal and state taxes withheld from each check. What sets nonprofit payroll apart is a short list of extra rules. Salaries must be “reasonable” by IRS standards, executive pay is publicly disclosed on Form 990, restricted grant dollars can only pay staff working on the funded program, and 501(c)(3) organizations are exempt from federal unemployment tax while still owing most other payroll taxes.
Where the Money to Pay Staff Comes From
Nonprofit payroll draws on two categories of revenue. Restricted funds come from grants or targeted donations earmarked for a specific program, and they can only pay staff directly involved in delivering that program. Spending restricted grant dollars on unrelated administrative salaries creates a contractual breach with the donor, and for federal grants it can produce a finding that the misspent portion was a taxable expenditure.1Internal Revenue Service. Violations of Expenditure Responsibility Requirements: Private Foundations
Unrestricted funds cover everything else: leadership salaries, rent, general overhead. That money flows from general donations, membership dues, event revenue, and fees for services. A nonprofit clinic might use patient fees to pay front-desk staff and cover utilities. A healthy unrestricted balance is what keeps payroll running when a grant cycle ends or a major donor doesn’t renew.
One restriction catches organizations off guard. Federal grant money cannot pay anyone to lobby government officials. Grantees are prohibited from using appropriated funds to influence members of Congress, congressional staff, or agency employees in connection with any federal award.2U.S. Department of Education. Reminder Regarding Prohibited Use of Federal Grants Funds for Lobbying and Allowable Membership Costs If a staff member spends part of their time on advocacy, the portion paid from a federal grant must be allocated only to allowable, non-lobbying work.
Employee or Independent Contractor
Before you run payroll for anyone, decide whether the person is an employee or an independent contractor. Employees trigger tax withholding, FICA, and wage-and-hour protections. Contractors get a Form 1099 and handle their own taxes. Misclassifying an employee as a contractor exposes the organization to back taxes, penalties, and interest.
The IRS looks at three categories of evidence:3Internal Revenue Service. Independent Contractor (Self-Employed) or Employee?
- Behavioral control: does the organization direct how and when the work gets done, or does the worker set their own methods and schedule?
- Financial control: does the organization reimburse expenses, provide tools, and pay a set wage, or does the worker invest their own equipment and risk profit or loss?
- Relationship type: is there a written contract, employee-style benefits, and an ongoing relationship, or is the engagement project-based?
No single factor is decisive. The IRS considers the full picture and asks whether the organization has the right to control what the worker does and how they do it. When in doubt, document every factor you weighed and lean toward treating the person as an employee.
Onboarding Paperwork Before the First Paycheck
Each new employee completes two federal forms. IRS Form W-4 tells you how much federal income tax to withhold based on filing status, dependents, and any additional adjustments the employee requests.4Internal Revenue Service. Form W-4, Employee’s Withholding Certificate Form I-9 verifies work authorization. You must examine the employee’s original identity and work-authorization documents and complete Section 2 of the I-9 within three business days of the start date. For a job lasting fewer than three business days, the I-9 must be completed on day one.5U.S. Citizenship and Immigration Services. 4.0 Completing Section 2: Employer Review and Verification
You’ll also collect Social Security numbers, bank details for direct deposit, and any state withholding forms. The organization itself needs a federal Employer Identification Number and, in most states, a separate state employer number for state income tax withholding and unemployment insurance reporting.
Federal law requires you to report every new hire to your state’s directory of new hires within 20 days, though some states set shorter deadlines.6The Administration for Children and Families. New Hire Reporting This reporting supports child support enforcement and is easy to miss during a busy onboarding cycle. Settle on a consistent pay schedule early. Biweekly or semimonthly are common, and that schedule drives every subsequent withholding calculation and tax deposit deadline.
Payroll Taxes Nonprofits Owe
Nonprofits owe most of the same payroll taxes as any other employer. The largest piece is FICA, which funds Social Security and Medicare. In 2026, the Social Security tax rate is 6.2 percent for the employer and 6.2 percent for the employee, applied to the first $184,500 of each employee’s wages.7Social Security Administration. Contribution and Benefit Base The Medicare tax rate is 1.45 percent on each side with no wage cap.8Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates Combined, FICA runs 7.65 percent from the paycheck and a matching 7.65 percent from the organization. Employees earning more than $200,000 in a calendar year also owe an additional 0.9 percent Medicare tax that the employer withholds but does not match.9Internal Revenue Service. Topic No. 560, Additional Medicare Tax
The one major payroll tax advantage for 501(c)(3) organizations is a complete exemption from the Federal Unemployment Tax Act. Service performed for a qualifying tax-exempt organization is excluded from “employment” under FUTA, so you owe no federal unemployment tax at all.10Internal Revenue Service. Exempt Organizations: What Are Employment Taxes The exemption is automatic and cannot be waived.
State unemployment insurance still applies. Federal law gives 501(c)(3) organizations a choice: pay quarterly state unemployment taxes like other employers, or elect “reimbursable” status and repay the state dollar-for-dollar only when a former employee files a successful unemployment claim. The reimbursable option can save money for organizations with low turnover, but it produces unpredictable costs if layoffs happen. Either way, you’re responsible for tracking state-specific wage bases and rates.
The Reasonable Compensation Rule
Every 501(c)(3) can only pay what the IRS calls “reasonable compensation,” meaning the amount that would ordinarily be paid for similar services by similar organizations under similar circumstances.11Internal Revenue Service. Exempt Organization Annual Reporting Requirements: Meaning of “Reasonable” Compensation This isn’t a salary cap. A nonprofit can pay a skilled executive $300,000 if comparable organizations routinely pay that much for the same role in the same region. The rule targets the gap between market rate and actual pay.
When the IRS decides someone received more than reasonable compensation, the overpayment becomes an “excess benefit transaction” under Internal Revenue Code Section 4958. The recipient owes an excise tax equal to 25 percent of the overpayment, and if the excess isn’t returned within the correction period, a second tax of 200 percent applies.12Office of the Law Revision Counsel. 26 U.S. Code 4958 – Taxes on Excess Benefit Transactions Board members or executives who knowingly approved the transaction face a 10 percent excise tax on the excess. Repeated violations can lead the IRS to revoke exempt status entirely.
The board of directors approves compensation, and the IRS offers a safe harbor called the “rebuttable presumption of reasonableness.” Follow three steps and the IRS presumes the pay is reasonable unless it can prove otherwise:
- Independent approval. A committee or the full board, made up entirely of members with no financial interest in the outcome, votes to approve the arrangement.
- Comparability data. Before voting, the committee reviews salary surveys, job postings, or compensation studies for similar roles at similar organizations.
- Concurrent documentation. The board records the decision and the data it relied on in meeting minutes at the time of the vote, not months later.
Following all three steps shifts the burden to the IRS to prove the pay was unreasonable.13eCFR. 26 CFR 53.4958-6 – Rebuttable Presumption That a Transaction Is Not an Excess Benefit Transaction Most failures in practice come from skipping the comparability step or writing up the reasoning after the fact. Neither holds up in an audit. Executive pay also becomes public: officers, directors, trustees, key employees earning over $150,000, and the five highest-compensated employees earning at least $100,000 are reported on Form 990.14Internal Revenue Service. Form 990 Part VII and Schedule J Reporting Executive Compensation Individuals Included
Minimum Wage, Overtime, and Volunteers
The Fair Labor Standards Act applies to nonprofits, but coverage works differently than at for-profit businesses. A nonprofit is subject to FLSA enterprise coverage only if its commercial activities generate at least $500,000 in annual revenue. Donations, membership dues, and grant income don’t count toward that threshold; only revenue from commercial operations like gift shops, clinic fees, or ticket sales does.15U.S. Department of Labor. Fact Sheet #14A: Non-Profit Organizations and the Fair Labor Standards Act (FLSA) Even without enterprise coverage, individual employees who personally engage in interstate commerce are still covered.
Covered employees must earn at least the federal minimum wage of $7.25 per hour, though many states set higher floors. Non-exempt employees who work more than 40 hours in a workweek must receive overtime at one-and-a-half times their regular rate. To be exempt from overtime, an employee generally must be paid on a salary basis at or above the current federal threshold of $684 per week ($35,568 annually) and perform executive, administrative, or professional duties.16U.S. Department of Labor. Earnings Thresholds for the Executive, Administrative, and Professional Exemption from Minimum Wage and Overtime Protections Under the FLSA
Volunteers are common in nonprofit work, and the line between a volunteer and an employee matters legally. A person can volunteer for a nonprofit and receive a nominal stipend without becoming an employee, as long as the payment isn’t a substitute for wages and isn’t tied to productivity.17eCFR. 29 CFR Part 553 Subpart B – Volunteers Whether a stipend counts as “nominal” depends on the time commitment, distance traveled, and overall economic reality. Paying someone $25 per shift to help at a weekend fundraiser looks very different from paying $500 a week to staff a front desk full time and calling it a stipend.
Retirement Plans and Other Benefits
One advantage available to 501(c)(3) employers is the 403(b) retirement plan, sometimes called a tax-sheltered annuity. Only public educational institutions and 501(c)(3) organizations can offer 403(b) plans, and they’re simpler to administer than the 401(k) plans for-profit employers typically use.18Internal Revenue Service. IRC 403(b) Tax-Sheltered Annuity Plans
In 2026, employees can defer up to $24,500 of salary into a 403(b). Workers age 50 or older can add $8,000 in catch-up contributions, for $32,500 total. Under SECURE 2.0, employees aged 60 through 63 can make a higher catch-up of $11,250 instead.19Internal Revenue Service. Retirement Topics – 403(b) Contribution Limits Employees with at least 15 years of service at the same eligible employer may qualify for an extra $3,000 per year, up to a $15,000 lifetime cap.
If you offer a 403(b) to any employee, the “universal availability rule” requires you to extend it to all employees, with limited exceptions for part-time workers averaging fewer than 20 hours per week, student employees, and nonresident aliens. Organizations sometimes stumble here by restricting the plan to full-time or management staff. Nonprofits can also offer 401(k) plans, health insurance, and other standard benefits, and those costs count as part of total compensation when the board evaluates reasonableness.
Issuing Paychecks and Keeping Records
Once payroll is calculated, the organization distributes net pay by direct deposit or physical check. Direct deposit is more common and avoids the risk of lost checks, which matters when staff work in the field or across multiple sites.
Federal law under the FLSA requires every employer to keep detailed payroll records for at least three years, including each employee’s hours worked, pay rate, total earnings, and all deductions.20U.S. Department of Labor. Fact Sheet #21: Recordkeeping Requirements Under the Fair Labor Standards Act The FLSA does not require employers to provide a written pay stub with each paycheck; that requirement comes from state law, and the vast majority of states mandate it in some form. Providing an itemized statement showing gross pay, deductions, and net pay is basic good practice regardless.
Between Form 990 disclosures, donor audits of restricted grant spending, and the IRS reasonable compensation standard, sloppy payroll records create risk on multiple fronts. Most organizations use payroll software or a third-party payroll provider to handle withholding calculations, tax deposits, and year-end reporting. The cost is modest compared to the penalty exposure from a missed deposit or an incorrectly filed return.