Skip to main content

STATE UNEMPLOYMENT INSURANCE TAX EXEMPTION FOR 501(c)(3)s EXPLAINED

By February 17, 2021February 18th, 2021Blog

If you employ people—and what nonprofit doesn’t—odds are you’ll someday be faced with an unemployment claim.

In all 50 states, 501(c)(3) organizations must pay for unemployment insurance benefits—and they can do it one of two ways:

  • Pay state unemployment insurance taxes
  • Reimburse the state only for benefits paid to former employees

Unfortunately, many nonprofits don’t realize they have the second option. Let’s weigh the pros and cons of both.

(Additional reading: Will Taxes Increase on Employers to Repay Massive Unemployment Spending?)

Paying state unemployment insurance taxes

Advantages

You know the state unemployment insurance (SUI) tax rate for the coming year and can project the annual cost based on your taxable payroll. If claims add up to more than your taxes, the state  will still cover them, though you can probably expect a tax hike in subsequent years.

During years of unusually high unemployment, paying SUI taxes provides good security for nonprofits that suffer funding cuts and decreased donations.

Disadvantages

Depending on the state, unemployment taxes currently range from as little as 0.1 percent to more than 10 percent of each employee’s taxable wages, a percentage which can vary from $7,000 to $48,100 per employee.

Due to the COVID-19 pandemic, SUI tax rates are on the rise in many states as they rebuild their depleted state unemployment insurance pools. This means a nonprofit is probably paying more in taxes than the state is paying for its claims. Nationally, nonprofits typically pay $2 in taxes for every $1 in claims.

Employer reimbursement

Advantages

Section 3309 of the Federal Unemployment Tax Act enables 501(c)(3) organizations to opt out of the tax system and reimburse the state only for unemployment claims the state has paid to a nonprofit’s former employees. Since the national average for nonprofits is more than twice the amount in taxes for every dollar paid in claims, most 501(c)(3)s save money by becoming reimbursing employers.

A real-world example: One human service agency in California, with a gross annual payroll of $1.6 million, has an unemployment tax rate of 4.8 percent. Its state unemployment insurance taxes are more than $45,000, even though actual claims have not exceeded $12,000 annually. Assuming similar tax rates and claims history, this agency could save more than $300,000 by choosing to go the reimbursement route over the next 10 years.

More than 100,000 501(c)(3)s in the USA reimburse their unemployment rather than paying SUI taxes. 

Disadvantages

But before jumping on the reimbursement bandwagon, remember that employers are then responsible for all unemployment claims paid to their former employees by the state. A reimbursing employer can only anticipate liability for claims and could face an unwelcome surprise. Your organization could owe an unexpectedly large tax bill.

Also, reimbursing employers don’t get “relief of charges.” This means if your employee resigns, goes to work elsewhere, was terminated, then files for unemployment, your nonprofit could be charged for a portion of that employee’s benefits, even though the employee voluntarily left you.

The successful reimbursing employer tracks annual unemployment claims costs and budgets appropriately for unemployment expenses. If your organization is considering becoming a reimbursing employer, management should learn about the “base period” and benefit year in your state in order to set aside an adequate amount to cover all employees eligible for unemployment benefits (generally a claim can be paid over a maximum of 26 weeks).

A third way

Third-party reimbursement options

Approximately 5,000 nonprofits belong to different grantor trusts throughout the country. These trusts offer additional benefits that an organization may not be able to get on its own. Initially, they help the nonprofit file the paperwork with a state to become a reimburser, then handle the payments owed to the state.

Other features vary, but may include these:

  • Member-owned reserve accounts
  • Stop-loss insurance (protection from unusually high claims)
  • Claims management services to reduce costs
  • Training workshops and personnel services programs
  • Representatives from the nonprofit membership typically govern the trusts.

Reaching an educated decision for your unemployment coverage

Bottom line on unemployment coverage: Weigh your options.

Since 501(c)(3) organizations have the choice, it makes financial sense to assess whether paying SUI taxes, reimbursing on your own, or joining a trust is the optimal and most fiscally responsible path to take.

Pick the state unemployment tax option if:

  • Your nonprofit has fewer than 10 employees.
  • Your organization experiences regular layoffs, such as a Head Start program or performing arts group.

Pick the reimbursement option if:

  • Your group has stable employment and comparatively low unemployment claims based on size.
  • Your nonprofit has an annual gross payroll of $1 million or more. (Most can realize substantial savings in 5 to 10 years—the goal of reimbursing is to save money while maintaining financial stability).
  • Your staff understands the state unemployment system and have the bandwidth to devote to claims management, including the ability to keep good documentation and act quickly to manage any claims. States have strict response requirements for unemployment claims.
  • You are able to anticipate potential unemployment claims realistically and designate funds in your annual budget for them.

Pick a grantor trust if:

  • You want to reduce nonprofit staff time by getting help in establishing a reserve account and handling payments to the state.
  • You need to reduce your nonprofit’s exposure with stop-loss insurance protection.
  • You seek claims management services to keep costs low while providing high-level unemployment expertise.

Whatever you choose, pay attention to the calendar

All states have deadlines to change status from taxpayer to reimburser, generally between November and January. Some states – like California – allow nonprofits to switch in any quarter, though the optimum time is before first quarter taxes are due.

To learn your state’s deadline, contact the state unemployment department. Also, check for the length of time you must remain outside the tax system as a reimburser before being allowed to return as a SUI taxpayer. The time period is usually a few years.

How 501(c) Agencies Trust can help

501(c) Agencies Trust is the oldest national grantor trust. Created and overseen by a board of nonprofit trustees, we are the most experienced organization of this kind with an industry-leading team built to help the nonprofit sector through unemployment tax and claims savings.

We are happy to perform an unemployment tax savings audit for your organization. Contact us today for assistance.

Leave a Reply

X