Are Nonprofits Exempt From Federal Unemployment Tax?

Federal Unemployment Tax, commonly known as FUTA, is a payroll tax imposed on employers to fund unemployment compensation programs. These funds contribute to a federal unemployment trust fund, which then provides money to states for administering their unemployment insurance programs and paying benefits to eligible workers.

Federal Unemployment Tax Exemption for Nonprofits

Most nonprofit organizations recognized under Internal Revenue Code (IRC) Section 501(c)(3) are exempt from Federal Unemployment Tax (FUTA). This exemption distinguishes charitable, educational, and religious entities from other types of employers. The exemption applies to the federal tax only.

The standard FUTA tax rate is 6.0% on the first $7,000 of wages paid to each employee annually. Most employers receive a credit of up to 5.4% for timely contributions to state unemployment funds, effectively reducing their FUTA rate to 0.6%.

Organizations not classified as 501(c)(3) entities, such as 501(c)(4) social welfare organizations or 501(c)(6) business leagues, are generally subject to FUTA unless other specific exemptions apply. Even for 501(c)(3) organizations, this federal exemption does not extend to other federal payroll taxes like Social Security and Medicare (FICA taxes), which they must still pay. The FUTA exemption for 501(c)(3) organizations is permanent and cannot be waived.

Alternative to FUTA: State Unemployment Tax Reimbursement

While 501(c)(3) nonprofits are exempt from FUTA, they still have obligations regarding state unemployment insurance (SUI) or State Unemployment Tax Act (SUTA) programs. Instead of paying regular state unemployment taxes, many states offer these exempt organizations an alternative known as the “reimbursement method.” This method allows the nonprofit to directly reimburse the state for unemployment benefits paid to their former employees, rather than contributing to the state’s unemployment fund on a periodic basis.

Under the reimbursement method, an organization essentially self-insures its unemployment claims. If a former employee files for unemployment benefits and is deemed eligible, the state pays the benefits, and then the nonprofit is billed for the exact amount paid. This contrasts with the traditional “contributory method,” where employers pay a percentage of their payroll into the state fund, and their tax rate is often adjusted based on their claims history.

Electing the reimbursement method involves notifying the state unemployment agency, usually by completing a specific form. This choice remains in effect for a minimum period, often three calendar years, before it can be changed. While this option can lead to cost savings for organizations with stable employment and low turnover, it also carries the risk of unpredictable, large, lump-sum payments if many former employees claim benefits.

State-Specific Unemployment Tax Requirements

Despite the federal FUTA exemption, nonprofit organizations remain subject to state-specific unemployment insurance laws and requirements. Each state administers its own unemployment insurance program, and these programs dictate how nonprofits fulfill their obligations. Many states provide the reimbursement method as an option for 501(c)(3) organizations, but the specific rules, eligibility, and administrative processes can vary significantly.

Nonprofits must register with their respective state unemployment agencies, usually upon hiring their first employee. This registration establishes their employer account for state unemployment purposes. Regardless of whether an organization chooses the contributory or reimbursement method, accurate wage reporting and timely submission of required forms are universal obligations.

Some states may require reimbursing employers to post collateral, such as a surety bond or cash deposit, to ensure they can cover potential unemployment benefit payouts. Additionally, state laws define the wage base (the maximum amount of an employee’s wages subject to state unemployment tax) and the tax rates for contributory employers, which can differ widely. Organizations should consult their specific state’s unemployment agency to understand their unique requirements and available options.