Recently, we looked at some key points regarding nonprofit executive compensation. This week, we want to take a closer look at best practices for paying everyone else your organization employs.
Payroll for nonprofits is a complex issue. Certain rules and exceptions apply that are different than what applies to for-profit companies. As if that complication isn’t bad enough, many nonprofits seem bound and determined to create their own rules and exceptions that are categorically incorrect… and destined to get them in hot water with the IRS and/or their state.
Fortunately, the principles we discussed last week apply to ordinary employees, as well as executives: compensation must be reasonable, due diligence must be performed, and all decisions should be made at arms-length.
In addition to those things, other considerations should be made. This article is going to focus on two big issues: 1) payroll classification and, 2) types of payments.
This is a biggie…and it gets asked about by clients on a weekly basis. That is, “Should I pay my staffers as employees or independent contractors?” 95% of the time, the answer is employee, regardless of any other extraneous information that gets tossed into the mix.
It is a widely-held belief that an employer has the choice under which status to pay its workers. The most common justification is the savings the nonprofit will experience if it doesn’t have to cover payroll taxes. The problem is, it’s not your choice. Even if your staffer agrees to be treated as a contractor, it may still be contrary to IRS and state regulations. The IRS, in determining whether or not a worker is a contractor or employee, looks at several factors. They are:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? These include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.
- Type of relationship: Are there written contracts or employee type benefits, i.e., pension plan, insurance, vacation pay, etc.? Will the relationship continue and is the work performed a key aspect of the business?
The IRS also uses a multi-point test to evaluate such classification issues. Click here to see it.
So what are the consequences of improperly paying employees as contractors? Plenty! If the IRS reclassifies your workers from contractors to employees, your nonprofit will be held liable for both the employer’s and employees’ share of payroll taxes (Social Security and Medicare), plus very expensive penalties and interest. Then the state comes along to take their share. This type action, especially if it applies to multiple years, can put any business out of business.
By type of payment, we mean things like straight salary or wages versus bonuses and commission. The IRS calls the latter non-linear compensation…and it isn’t too fond of it in a 501(c)(3) setting. For-profit companies can do this virtually without limitation. But for nonprofits, the IRS considers this a potential open door to unreasonable compensation.
For example, Charity, Inc. hires two employees, John and Jane, who will be in charge of managing fundraisers. Each will be paid a small base salary, plus a percentage of the money raised at the event. Sounds reasonable, but the IRS says, “Not so fast!”
The reason makes sense when you consider the possible outcomes. Let’s presume that reasonable compensation, if fixed, for John and Jane is $45,000 per year. Let’s further presume that instead, John has a base salary of $20,000, and receives 10% of all money raised. John goes on to raise $125,000 this year, and is paid a total pay package of $32,500. It’s less than what his fixed compensation would likely be, so what’s the harm? Both he and the nonprofit are assuming the risk of John doing a poor or mediocre job.
The problem isn’t with John’s outcome. It’s Jane’s that is the problem. Jane also has a $20,000 base salary. But Jane has a stellar year, and raised $800,000 for her employer. As a result of her success, Jane is awarded $80,000 in commission, for a total annual salary of $100,000. The problem is, Jane’s job doesn’t really square with a 6-figure salary. The IRS could determine this to be excessive, should they examine the organization’s books.
Employees should be paid according to the job description of the position. Not only is non-linear compensation often unreasonable by IRS standards, it also opens the door to potential fraud, or at least improper conduct, as the employees have everything to gain by pushing the limits on fundraising.
This discussion barely scratches the surface. There are so many other critical issues from workers’ compensation insurance to employee benefits to hiring practices. Using compliant employment and compensation practices goes a long way to eliminating one of the biggest areas of IRS concern.
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