How Do Nonprofits Pay Employees? A Founder's Guide

The question behind "how do nonprofits pay employees" is usually a different question wearing a disguise. It is really this: "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. I build HR software for small teams, and below is the order in which I would walk another founder through it.

This guide covers where salary money legitimately comes from and the reasonable compensation rules that govern what you can pay yourself. It also covers the one real tax break, the exemption from federal unemployment tax (FUTA) for 501(c)(3) organizations, and the state unemployment election most organizations never hear about. Last come the Fair Labor Standards Act (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 legitimate expense like any other, 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. At a 501(c)(3) public charity or a 501(c)(4), paying an insider more than that lets the IRS treat the excess as an "excess benefit transaction" under section 4958.

The excise taxes fall on individuals. Under 26 U.S.C. 4958, the person paid owes 25 percent of the excess benefit, plus 200 percent more if it is not corrected in time, and board members who knowingly approved it owe 10 percent, capped at $20,000 per transaction.

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. Under 26 CFR 53.4958-6(c)(2)(ii), an organization with annual gross receipts, including contributions, of less than $1 million satisfies it with data on compensation paid by three comparable organizations in the same or similar communities for similar services.

Three. That number is achievable with a few hours and the publicly available Form 990 filings of 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.

All three conditions have to be visible in one document that was written at the time, because that document is the whole safe harbor. This is the shape of it: who is being paid, who was in the room and who left it, the three peer organizations with the figures actually relied on, and the vote. Attach it to the minutes.

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 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.

Founding the organization points the same way. Under 26 CFR 53.4958-3, anyone with ultimate responsibility for running the organization has that influence whatever the title, and having founded it is listed among the facts tending to show substantial influence.

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, their vote may pass the IRS conflict-of-interest test on paper, but 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.

Do Nonprofits Pay Taxes Beyond Payroll?

A 501(c)(3) pays no federal income tax on the revenue that flows from its exempt purpose, and that is the whole of the exemption. Employment taxes on wages still apply. So does tax on unrelated business income, meaning a trade or business regularly carried on that is not substantially related to the mission.

Those rules catch ordinary side revenue: selling advertising or running an enterprise that has nothing to do with why you were granted exemption. An organization must file Form 990-T once gross income from an unrelated business reaches $1,000, and pay estimated tax if the annual liability will reach $500 (IRS).

State sales tax and local property tax exemptions are a separate matter from the federal determination. They are granted state by state, usually on application, and the IRS letter by itself does not deliver them. Ask your state revenue department and your county assessor rather than assuming the federal status travels.

Do Nonprofit Employees Pay Taxes?

Yes. Wages from an exempt organization are ordinary taxable wages, so the employee owes federal income tax and the 7.65 percent employee share of FICA, plus state income tax wherever the state levies one. The exemption belongs to the organization, not to the paycheck.

Calling the payment a stipend changes nothing. If the person is an employee, the money is wages, it belongs on a W-2, and withholding applies. A summer program coordinator paid a flat monthly amount out of a grant is in exactly that position.

Do Ministers Pay Taxes?

Ministers pay tax on what they earn, through a different channel than the rest of your staff. A minister employed by a church is generally its common-law employee for income tax purposes and receives a W-2, yet ministerial earnings sit outside FICA: nothing comes out of the check for Social Security or Medicare and the church owes no match. Those earnings land in the self-employment tax base instead (IRS Topic 417).

Withholding is optional here as well. A minister's salary for ministerial services is not subject to federal income tax withholding, so a minister generally covers income and self-employment tax with quarterly estimated payments, unless they sign a voluntary withholding agreement with the church (IRS Publication 517).

That leaves one person on your payroll whose tax setup resembles nobody else's, so confirm your system can handle it before the first run.

Is the Clergy Housing Allowance Taxable?

A designated housing allowance is excluded from a minister's gross income for income tax, and it is still counted for self-employment tax. That split is what catches people: the same dollars that escape income tax sit inside the self-employment tax base.

IRS Publication 517 caps the exclusion at the smallest of the amount actually used to provide the home, the amount the church officially designated, and the fair rental value of the home including furnishings and utilities. The excluded amount also cannot exceed reasonable pay for the minister's services.

The designation has to happen before the money is paid, in something durable such as minutes, a resolution, or the employment agreement. A designation written after the fact buys nothing.

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 state unemployment tax (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.

Federal law requires states to offer that choice. Under 26 U.S.C. 3309(a)(2), a covered nonprofit that would otherwise owe contributions may elect to pay amounts into the state fund in lieu of them.

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. Some states also require a surety bond or deposit before they approve the election.

South Carolina requires a bond, a money deposit, or government securities unless the nonprofit owns more than $2 million in real property. Washington may require a bond or deposit of any nonprofit other than a hospital, college, or university.

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.

The election is also hard to undo. Section 3309 lets each state set a minimum period for it, and Washington, for one, holds a reimbursing employer to the method for at least two calendar years, so it 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.

One exception applies: a nonprofit that runs a hospital, a facility providing medical or nursing care for residents, a school, or a preschool. DOL Fact Sheet 14 lists those as covered enterprises in their own right, with no $500,000 test.

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.

W-2 Employee or 1099 Contractor?

The pull toward misclassification at a small nonprofit 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.

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.

There are three lines you cannot cross, per DOL Fact Sheet 14A. Genuine volunteers typically neither displace paid employees nor do work that would otherwise fall to regular staff.

Volunteers also generally may not work in commercial activities the nonprofit runs, such as a gift shop. And a paid employee 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.

Federal grants put that rule in writing. Under 2 CFR 200.430, salary charged to a federal award must rest on records that accurately reflect the work performed, and budget estimates alone do not qualify as support.

Those four practices are one workbook. The first tab captures time by program in the week the work happens, the second turns a month of that time into the percentage split actually charged to each fund, and the third holds the written allocation method the other two are applied under.

The tooling question here is honest: this is a time tracking and records problem before it is a payroll problem.

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. An organization whose gross receipts are normally $50,000 or less files the 990-N, the electronic notice. Below $200,000 in gross receipts and $500,000 in total assets, the 990-EZ is available. At or above either figure, the full Form 990 is required. A private foundation files Form 990-PF whatever its size.

The IRS annual filing requirements are the place to confirm which one applies to you. Whichever form you land on, put the due date on one person's calendar.

Common Nonprofit Payroll Mistakes

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, with employee records that hold the classification decision and the compensation approval together, and document management so board-approved compensation letters live where the employee record lives, next to offer letters signed with built-in e-signature.

Onboarding workflows carry the rest of it. The W-4 and the I-9 go on the new hire's first-day list as tasks, and the completed forms are kept in their employee file, while the forms themselves are completed outside the platform. The handbook acknowledgment gets signed before day one rather than chased down in the week after.

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 small nonprofit where everyone is doing three jobs.

Frequently Asked Questions