How Do Nonprofits Pay Employees? A Founder's Guide
Yes, nonprofits pay employees. Where the money comes from, the FUTA exemption, reasonable compensation, W-2 vs 1099, and how to run your first payroll.
How Do Nonprofits Pay Employees?
Where the money comes from, what the IRS requires, and how to run your first payroll
The question behind "how do nonprofits pay employees" is usually a different question wearing a disguise. It is really: am I allowed to pay myself, and where would the money even come from?
The answer to the first part is yes. The word nonprofit describes what happens to a surplus, not whether the organization can compensate people. It cannot distribute earnings to owners, because it has none. It absolutely can, and must, pay the people who do the work.
The answer to the second part is more interesting, and it is where small nonprofits actually get into trouble. This guide covers where salary money legitimately comes from, the reasonable compensation rules that govern what you can pay yourself, the one real tax break nonprofits get, the state unemployment election most organizations never hear about, the FLSA nuance almost every article on this topic states incorrectly, and how to run your first payroll without creating a problem you will pay for later.
Yes, Nonprofits Pay Employees
Nonprofits pay employees through ordinary payroll. They withhold federal income tax, withhold and match FICA, issue Forms W-2 in January, and comply with wage and hour law. There is no separate nonprofit payroll system and no charitable exemption from paying people.
The persistent confusion comes from the word itself. "Nonprofit" is a tax status describing what the organization may do with a surplus: it cannot be distributed to owners or shareholders, because there are none. It says nothing about whether the organization may spend money on salaries. Salaries are a program expense, and an organization that cannot pay a competitive wage generally cannot deliver on its mission, because it cannot keep anyone.
What is genuinely different for a nonprofit is not whether it pays people. It is where the money comes from, and who decides how much.
Where the Money Comes From
The distinction that matters operationally is restricted versus unrestricted. An unrestricted dollar can pay any salary. A restricted dollar can only pay the portion of a salary that corresponds to the program it was given for, and only if you can demonstrate that the person actually spent that time on that program.
This is why an organization with a healthy-looking budget can still fail to make payroll. If 90 percent of your revenue is restricted program money and your executive director's time is mostly spent on fundraising and administration, there is very little money that can legally pay them.
The Reasonable Compensation Rule
Nonprofits may pay what is reasonable, meaning what a similar organization would pay for similar work in a similar community. Pay someone more than that and the IRS may treat the excess as an "excess benefit transaction" under section 4958, with excise taxes falling on the individual and on the board members who approved it.
The three conditions are not bureaucratic decoration. Each one is doing work.
Advance approval, conflict-free. The person being paid cannot be in the room voting. A founder who sets their own salary has satisfied nothing.
Comparability data. This is the requirement small organizations think they cannot meet, and they are wrong. Organizations with annual gross receipts under $1 million may rely on compensation data from five comparable organizations in the same or similar communities. Five. That is achievable with a few hours and publicly available Form 990 filings from peer organizations.
Contemporaneous documentation. The board minutes must record the terms, the date, who was present, who voted, what comparability data was used and where it came from, and any conflicts. "Contemporaneous" means the records are prepared before the later of the next board meeting or 60 days after the decision. Reconstructing minutes two years later when the IRS asks does not count.
Can a Founder Pay Themselves?
Yes, provided you actually do the work, the amount is reasonable, and you did not decide it yourself.
That last clause is the entire game. As a founder or executive director you are a "disqualified person" under section 4958: someone in a position to exercise substantial influence over the organization. The rules exist specifically because you are the person most able to overpay yourself.
So the process is: recuse yourself, let a conflict-free board approve your compensation in advance using comparability data, and make sure they document it properly. If your board is you and two friends who defer to you, you do not have a conflict-free authorized body, and you have a governance problem that will eventually become a tax problem.
Nonprofit Payroll Taxes
Being exempt from income tax does not make you exempt from payroll tax. Per the IRS, exempt organizations that compensate workers are generally subject to employment taxes like any other employer.
The FUTA exemption is the one genuine break, and it is worth stating precisely because a lot of writing on this topic is imprecise. Per the IRS, an organization exempt under section 501(c)(3) is also exempt from FUTA, and this exemption cannot be waived. An organization that is not a 501(c)(3) is not exempt.
The State Unemployment Election Most Nonprofits Miss
Federal unemployment tax is off the table for a 501(c)(3). State unemployment is not, but here you have a choice that most nonprofits never learn about.
A 501(c)(3) may generally elect to become a reimbursing employer: instead of paying quarterly SUTA contributions like everyone else, you skip the tax and reimburse the state dollar-for-dollar for any unemployment benefits actually paid to your former employees.
| Approach | How It Works | Best For |
|---|---|---|
| Pay SUTA contributions | Quarterly tax on wages up to your state's wage base, at your assigned rate. Predictable, budgeted, and you pay it regardless of whether anyone claims. | Organizations with higher turnover, or those that need budget certainty and cannot absorb a surprise claim. |
| Elect reimbursing employer status | You pay nothing quarterly. You reimburse the state only when a former employee actually collects unemployment benefits. | Stable organizations with low turnover. If nobody claims, you pay nothing at all, which over years can be a substantial saving. |
The tradeoff is real and it is about risk, not just cost. Reimbursing means a single laid-off employee's benefit claim lands on you as a direct bill rather than being spread across the insurance pool. Several states also require a surety bond or collateral before they will let you elect it.
For a stable small nonprofit with low turnover, reimbursing frequently saves money. For an organization that expects layoffs, it is a bad bet. Run the arithmetic with your accountant before electing, because in most states the election is not something you flip back and forth annually.
Minimum Wage and Overtime
This is the section most articles on this topic get wrong, in both directions. Some say nonprofits are exempt from the FLSA. Others say the FLSA applies to all nonprofits. Neither is right.
Per DOL Fact Sheet 14A, nonprofit charitable organizations are not covered enterprises under the FLSA unless they engage in ordinary commercial activities that result in sales made or business done, such as operating a gift shop or providing veterinary services for a fee. Crucially, income from contributions, membership fees, dues, and donations is not counted toward the $500,000 enterprise coverage threshold. Only commercial revenue counts.
So a $2 million charity funded entirely by donations and grants, with no commercial activity, is not a covered enterprise. That is the part most sources miss.
The practical upshot: pay at least the highest applicable minimum wage among federal, state, and local, and pay overtime to non-exempt staff. The enterprise coverage nuance is worth understanding, but it is not a strategy. The exempt vs non-exempt guide covers the classification tests, and the FLSA guide covers the overtime rules.
W-2 Employee or 1099 Contractor?
Small nonprofits misclassify workers more often than almost any other category of small employer, and the reason is not malice. It is cash. The FICA match is 7.65 percent, and when you are scraping together payroll from restricted grants, a 1099 looks like a way to make the numbers work.
It is not. It is a way to owe back taxes plus penalties later.
The IRS applies the same tests to you as to any employer: behavioral control, financial control, and the type of relationship. There is no charitable-purpose exception and no small-organization exception. The employee vs contractor guide covers the full analysis.
Volunteers and the Line You Cannot Cross
Volunteers are the legitimate way a nonprofit gets work done without paying for it, and the rules around them are stricter than most founders realize.
A genuine volunteer donates time freely, for public service or humanitarian purposes, without expectation of compensation. That is permitted and it is a core part of how the sector functions.
Three lines you cannot cross. Volunteers may not displace paid employees or perform work that would otherwise be done by regular employees. Volunteers generally may not work in commercial activities the nonprofit runs, such as a gift shop. And a paid employee generally cannot volunteer to do the same type of work they are paid for, because that time is compensable and you owe them for it.
That last one catches struggling organizations. The development coordinator who stays late to stuff envelopes for the annual appeal, unpaid, because the organization cannot afford the overtime, is not volunteering. They are working, and you owe them.
Running Your First Payroll
Allocating Salary Across Grants
This is the operational problem that has no equivalent in a for-profit business, and it is where small nonprofits create audit findings without meaning to.
If a program officer spends 60 percent of their time on a program funded by Grant A, 25 percent on a program funded by Grant B, and 15 percent on general administration, their salary must be charged proportionally, and you must be able to prove the split with contemporaneous time records.
| Practice | Why It Matters |
|---|---|
| Track time by program, not just by hours worked | A timesheet showing 40 hours tells a funder nothing. A timesheet showing 24 hours on Program A and 10 on Program B is what supports the charge. |
| Record it contemporaneously, not retroactively | An allocation reconstructed at year end from memory is exactly what an auditor is looking for. Record it as the work happens. |
| Use a consistent, written allocation method | Whatever method you use, document it and apply it consistently. Changing the method to fit whichever grant has money left is the finding. |
| Never charge more time to a grant than was actually worked on it | This is not a gray area. Charging unallowable costs to a federal grant is a serious matter, and 'we needed the money' is not a defense. |
The tooling question here is honest: this is a time tracking and records problem before it is a payroll problem. The time and attendance guide covers getting usable hours data, which is the input everything else depends on.
What Gets Reported on Form 990
Executive compensation is public. Form 990 requires disclosure of compensation for officers, directors, trustees, key employees, and the highest compensated employees, and the filing is a public document.
Anyone can look it up. Donors do. Journalists do. Your own staff do, and this is worth thinking about before you set a salary, because an executive salary that is defensible to the IRS may still be difficult to explain to a program coordinator earning a third of it.
Which filing you make depends on size: smaller organizations file the 990-N or 990-EZ, larger ones file the full Form 990. The IRS annual filing requirements set out the current thresholds, and they change, so check rather than assume.
Common Nonprofit Payroll Mistakes
| Mistake | What Happens | The Fix |
|---|---|---|
| Paying an employee as a 1099 contractor to save on FICA | You owe the back FICA you avoided, plus penalties and interest. The most common and most expensive small-nonprofit payroll error. | Apply the IRS control tests honestly. If your only argument for contractor status is your budget, they are an employee. |
| The founder setting their own salary | No rebuttable presumption. If challenged, you are defending on facts and circumstances, and excise taxes can fall on the individual and the approving board members. | Conflict-free board approval in advance, comparability data, contemporaneous minutes. The founder recuses. |
| Skipping comparability data because it seems unaffordable | You lose the safe harbor for no reason. Small organizations assume this requires a consultant. It does not. | Under $1 million in gross receipts, use five comparable organizations in similar communities. Their 990s are public. |
| Paying FUTA when you are a 501(c)(3) | You are spending money you are exempt from spending. The exemption is automatic and cannot be waived. | Confirm your payroll system has the FUTA exemption applied. Check your determination letter to confirm you are a (c)(3). |
| Assuming every nonprofit gets the FUTA exemption | 501(c)(4), (c)(6), and (c)(7) organizations pay FUTA like any employer. Assuming otherwise means underpaying. | Read your determination letter. The exemption is specific to 501(c)(3). |
| Concluding the FLSA does not apply because you are not a covered enterprise | Individual coverage catches most nonprofit employees anyway, and state wage law applies regardless. | Plan on paying minimum wage and overtime. The enterprise nuance is worth knowing but is not a strategy. |
| Letting a paid employee 'volunteer' for their own job duties | That time is compensable. You owe them, and if it was overtime you owe time and a half. | Employees may volunteer for genuinely different activities. They cannot volunteer to do their own job for free. |
| Charging salary to restricted grants without time records | Audit finding, potential disallowed cost, and a funder relationship you will not get back. | Track time by program contemporaneously. Set the allocation method before the first payroll run. |
The pattern is that almost none of these are payroll-calculation errors. They are documentation and governance errors: the board minutes that were never written, the classification analysis that was never done, the time records that were reconstructed rather than recorded.
That is the gap FirstHR is built to close. Employee records that hold the classification decision and the compensation approval together, document management with e-signature so board-approved compensation letters and offer letters live where the employee record lives, and onboarding workflows so the W-4, the I-9, and the handbook acknowledgment actually get collected before day one.
It does not run your payroll or your fund accounting. It holds the paper that proves you did this correctly, which is the part that goes missing at a ten-person nonprofit where everyone is doing three jobs. The HR document management guide covers what else belongs in that system, and the nonprofit employee handbook guide covers the policies to put around it.
Frequently Asked Questions
Do nonprofits pay employees?
Yes. Nonprofits pay employees through regular payroll, exactly like any other employer. They withhold federal income tax, withhold and match FICA, issue W-2s, and comply with wage and hour law. The word nonprofit describes what happens to any surplus, which cannot be distributed to owners or shareholders, not whether the organization can compensate the people who do the work. Salaries are a legitimate program expense, and an organization that cannot pay competitive wages generally cannot deliver on its mission.
Can nonprofits pay employees?
Yes, and they are legally required to pay anyone who is an employee. There is no exception in wage and hour law for charitable purpose. If someone performs work under your direction and control, they are an employee and must be paid at least the applicable minimum wage. The only people who may work without compensation are genuine volunteers, and a volunteer cannot be doing work that would otherwise be done by a paid employee, and cannot expect compensation.
How do nonprofits afford to pay employees?
From the same revenue that funds everything else: unrestricted donations, earned income such as program fees or a thrift store, general operating grants, the indirect cost recovery portion of program grants, membership dues, and sponsorships. The organizations that struggle are typically those funded almost entirely by restricted program grants, because restricted money can only pay the portion of a salary that maps to that specific program, and only where time records prove it.
Can a nonprofit founder pay themselves a salary?
Yes, if the founder actually works for the organization and the compensation is reasonable and approved properly. What you cannot do is set your own salary. Compensation for a founder, executive director, or anyone with substantial influence over the organization must be approved in advance by a conflict-free authorized body, typically the board, using appropriate comparability data, with contemporaneous documentation. The founder must recuse themselves from that decision.
What is reasonable compensation for a nonprofit?
Reasonable compensation is what a similar organization would pay for similar work in a similar community. The IRS provides a rebuttable presumption of reasonableness if three conditions are met: advance approval by an authorized body with no conflict of interest, reliance on appropriate comparability data, and contemporaneous documentation of the decision. Organizations with annual gross receipts under $1 million may rely on compensation data from five comparable organizations in the same or similar communities.
Do nonprofits pay payroll taxes?
Mostly yes. Nonprofits must withhold federal income tax from wages, and must withhold and match FICA at 7.65 percent each, for a combined 15.3 percent. The significant exception is FUTA: organizations exempt under section 501(c)(3) are also exempt from federal unemployment tax, and that exemption cannot be waived. It does not extend to other nonprofits such as 501(c)(4) or 501(c)(6) organizations, which pay FUTA like any employer. Most nonprofits still have state unemployment obligations.
Are nonprofits exempt from minimum wage and overtime?
Generally no, though the analysis is more nuanced than most sources suggest. Under DOL guidance, nonprofit charitable organizations are not covered enterprises under the FLSA unless they engage in ordinary commercial activities producing at least $500,000 in sales or business done, and donations, dues, and contributions do not count toward that threshold. However, individual employees are still covered if they engage in interstate commerce, which includes making interstate calls, sending email across state lines, or shipping materials. In practice most nonprofit employees are individually covered, and state wage law usually applies regardless.
Should nonprofit workers be W-2 employees or 1099 contractors?
Apply the same IRS tests any employer applies: behavioral control, financial control, and the type of relationship. If you direct how, when, and where the work is done, provide the tools, and the work is ongoing and central to your mission, that person is an employee and belongs on a W-2. Being a nonprofit gives you no additional latitude, and being short on cash is not a defense. Misclassifying employees as contractors to avoid the FICA match is the most common and most expensive nonprofit payroll mistake.
Can a nonprofit employee also be a volunteer?
Only with real care. A paid employee generally cannot volunteer to do the same type of work they are paid to do, because that time is compensable and must be paid. An employee may volunteer for a genuinely different activity, freely and without expectation of compensation. The FLSA permits volunteering for charitable purposes, but volunteers generally may not work in commercial activities the nonprofit runs, such as a gift shop, and may not displace paid employees.
How does executive pay get reported on Form 990?
Form 990 requires disclosure of compensation for officers, directors, trustees, key employees, and the highest compensated employees. This is a public document. Anyone, including donors, journalists, and your own staff, can look up what your executive director earns. That transparency is why the board approval and comparability documentation matter beyond IRS compliance. The filing threshold matters too: organizations generally file the full Form 990 at higher gross receipts, the 990-EZ or 990-N below that, and failing to file for three consecutive years triggers automatic revocation of exempt status.