Last week 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 already. Certain rules and exceptions apply that are different than what applies to for-profit payrolls. 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. If you haven’t read last week’s post, I suggest you do so before you proceed…it will help.
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.
Payroll classification. 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 NPO 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 is still contrary to IRS and state regs. 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 20-point test to evaluate such classification issues. Click here to see it, courtesy of our friends at BizFilings.
So what are the consequences of improperly paying employees as contractors? Plenty! If the IRS reclassifies your workers from contractors to employees, your NPO 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 chunk. This type action, especially if it applies to multiple years, can put any business out of business. For more information, see the IRS’s page on the topic.
Type of payment. 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 organizations can do this all day long. But for nonprofits, the IRS considers this an open door to unreasonable compensation. For example, Charity, Inc. hires two employees who will be in charge of managing fundraisers. They will be paid a small base salary, plus a percentage of the money raised at the event. Sounds reasonable, but the IRS says, “No…not reasonable!” Employees should be paid according to the job description of the position. Not only is non-linear compensation usually 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’ comp insurance to employee benefits to hiring practices. Frankly, it makes a lot of sense to trust a competent professional to assist with your organization’s payroll. It is a really good form of cheap insurance. For more information, see our payroll services page.