How to Set Up Payroll for a Nonprofit

Setting up payroll for a nonprofit organization requires attention to federal, state, and local regulations. Accurate payroll practices maintain the nonprofit’s tax-exempt status and avoid penalties. The process involves initial registration to ongoing tax reporting.

Initial Setup and Registration Requirements

Payroll processing begins with foundational steps. Nonprofits must obtain an Employer Identification Number (EIN) from the IRS, a unique identifier for tax purposes. The EIN can be obtained online.

Nonprofits must register with state agencies. This includes registering for unemployment insurance, state income tax withholding, and any local payroll taxes. The process involves online portals where information is submitted to ensure compliance.

Classifying workers as employees or independent contractors is important. The IRS provides guidelines, and misclassification can lead to penalties. An employer-employee relationship exists when the organization controls what work is done and how. An independent contractor controls their own work methods and offers services to the public.

Most states mandate workers’ compensation insurance for work-related injuries or illnesses. Nonprofits secure this coverage through a state fund or private insurer, depending on state regulations. Requirements and methods for obtaining workers’ compensation vary by state, but securing this insurance is a step before hiring employees.

Gathering and Managing Employee Data

After initial registrations, collect and organize employee information. This data is for accurate payroll processing and tax compliance. Employee onboarding requires completing forms for payroll and employment verification.

Form W-4, Employee’s Withholding Certificate, informs employers how much federal income tax to withhold. The form’s information, such as filing status, helps calculate the federal income tax deduction.

Form I-9, Employment Eligibility Verification, verifies an employee’s identity and work authorization. Employees must present documents from Lists A, B, or C to fulfill I-9 requirements. List A documents establish identity and work authorization; List B documents establish identity; List C documents establish employment authorization. Employers must complete Section 2 of Form I-9 within three business days of the employee’s first day of work.

Nonprofits must gather compensation details, including salary or hourly rate, and pay frequency. Direct deposit information, if offered, also needs to be collected. Employees may authorize deductions, such as health insurance premiums, retirement plan contributions, or wage garnishments. Each deduction requires employee authorization or documentation for proper withholding. Maintaining accurate records of employee data, including personal information, compensation, and tax forms, is important for compliance.

Executing Payroll Processing

Running payroll involves calculating employee earnings, applying deductions, and disbursing payments. Employee data collected during onboarding determines gross pay, which is total earnings before deductions. From this gross amount, mandatory and voluntary deductions are calculated.

Mandatory deductions include federal income tax withholding, determined by Form W-4. Federal Insurance Contributions Act (FICA) taxes, including Social Security and Medicare, are also withheld. For 2025, the Social Security tax rate is 6.2% for both the employee and employer, applied to wages up to $176,100, while the Medicare tax rate is 1.45% for both parties with no wage limit. An additional Medicare tax of 0.9% applies to wages exceeding certain thresholds. State and local income taxes, and other local taxes, are also deducted based on jurisdiction rules. After deductions, the remaining amount is the employee’s net pay.

Nonprofits have options for processing payroll. Manual processing involves calculating wages and deductions using spreadsheets and issuing payments, which can be time-consuming and prone to error. Payroll software offers an automated solution, calculating taxes, deductions, and net pay, and often includes direct deposit and tax form generation. These systems can streamline the payroll process and reduce the risk of calculation errors.

Many nonprofits use third-party payroll service providers. These providers handle payroll aspects, including calculations, tax deposits, and year-end reporting. They offer direct deposit services and ensure adherence to federal and state tax laws, beneficial for organizations with limited internal accounting resources. Using a service provider ensures timely and accurate payroll, reducing the administrative burden.

Fulfilling Tax and Compliance Reporting

After payroll, tax deposit and reporting obligations must be met for compliance. Employers must deposit federal income tax withholdings, Social Security, and Medicare taxes to the IRS. Deposit frequency—monthly or semi-weekly—depends on the organization’s total tax liability. Deposits are made electronically through the Electronic Federal Tax Payment System (EFTPS).

State and local tax deposits, including state income tax withholdings and unemployment taxes, have rules and schedules that vary by jurisdiction. Nonprofits must adhere to these deadlines to avoid penalties.

Quarterly reporting to the IRS uses Form 941, Employer’s Quarterly Federal Tax Return. This form reports wages paid, federal income tax withheld, and employer and employee portions of Social Security and Medicare taxes. Form 941 is due by the last day of the month following the end of each quarter: April 30 for Q1, July 31 for Q2, October 31 for Q3, and January 31 of the next year for Q4. Many states require quarterly wage reports and unemployment tax returns.

Annual reporting includes providing employees with Form W-2, Wage and Tax Statement, by January 31 each year. This form details annual wages and taxes withheld. Employers must file copies of W-2s with the Social Security Administration (SSA) along with Form W-3, Transmittal of Wage and Tax Statements, by January 31. Form W-3 summarizes total wages and withholding amounts for all employees. Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, is due by January 31 of the following year. This form reports the FUTA tax, which is 0.6% on the first $7,000 of each employee’s wages, after considering a credit for state unemployment taxes paid. Corresponding state annual reconciliation forms must be filed. Maintaining records of payroll data, tax forms, and deposit confirmations is important for required retention periods, which can vary.