The Compliance Challenge of Nonprofit Payroll
Managing Payroll Compliance: Functional Expense Allocation and Tax Rules for Nonprofits
Managing payroll for a nonprofit is uniquely complex due to the need to properly classify workers (employees vs. contractors vs. volunteers) and the critical requirement to track and allocate employee salaries based on job function (functional expense allocation) to ensure compliance with grant funding rules. Getting worker classification right is essential for correct federal and state payroll tax withholding, but the true compliance and financial challenge lies in tracking how an employee’s time is split between, for example, administrative work and a grant-funded program. Nonprofits can effectively navigate these complexities by accurately tracking employee time by function and leveraging an external payroll service to handle the processing, tax management, and distribution, ensuring maximum fund utilization and adherence to reporting standards.
Key Takeaway
What is the biggest compliance challenge for nonprofit payroll?
The biggest compliance challenge is the mandatory tracking and allocation of employee salaries based on the specific job function they perform.
Why must a nonprofit track employee time by job function?
A nonprofit must track employee time by job function to ensure that grant funds are utilized correctly and that expenses are accurately reported to funders and the IRS.
Does a nonprofit need to pay federal payroll taxes?
Yes, a nonprofit must withhold and pay federal and state payroll taxes for its employees, just like any other employer.
Payroll’s Unique Compliance Landscape
Payroll presents a distinct set of compliance challenges that are magnified within a nonprofit organization. Unlike a standard for-profit business, a nonprofit frequently deals with a mix of individuals: employees who receive regular wages and benefits, contractors who are paid for specific services, and volunteers who provide unpaid time. Correctly classifying each person is the first hurdle. Misclassifying an employee as a contractor, for example, can lead to serious penalties from the IRS for improper withholding and payment of federal and state payroll taxes. It’s important to remember that, yes, nonprofit employees do pay payroll taxes, and the nonprofit organization itself is also responsible for paying its portion of those taxes.
The Necessity of Functional Expense Allocation
Beyond classification, a key regulatory practice for nonprofits is functional expense allocation. This is the requirement to track and report expenses—including employee salaries—based on the specific job function they are performing. This matters immensely when an employee occupies multiple roles, such as splitting time between opening the mail (an administrative task) and managing a field service project (a program activity). You must allocate that employee’s salary and related costs (like payroll taxes and benefits) based on the percentage of time they spend doing each role.
“The biggest compliance challenge is the mandatory tracking and allocation of employee salaries based on the specific job function they perform.”
Maximizing Funds Through Accurate Tracking
The reason functional allocation is so vital is directly tied to grant funding and transparency. Consider an employee who spends two days a week on general administrative tasks and three days running a specific, grant-funded service project. The two administrative days would typically be covered by general operating funds. However, the salary for the three program days may be eligible to be covered by the grant funds. If the organization isn’t meticulously tracking the employee’s time by job function, it runs the risk of either underutilizing valuable grant funds (by paying for the program time out of unrestricted money) or, worse, misusing grant funds (by paying for administrative time with restricted program money). Applying functional expense allocation helps the nonprofit both maximize its funds and comply with best practices for transparency required by the IRS and grantmakers.
Expertise and External Services
Navigating the complexities of worker classification, tax compliance, and the critical functional allocation of payroll requires specialized knowledge. While an experienced nonprofit accountant is essential for setting up the proper internal systems and allocations, the actual mechanics of running payroll are often best handled by experts. Most nonprofits choose to contract with an external payroll service like Paychex, ADP, or Onpay. These services specialize in handling payroll distribution, filing and paying all federal and state payroll taxes, and providing support when complex questions arise. This outsourcing simplifies the distribution process, guarantees tax deadlines are met correctly, and frees up the internal accounting team to focus on the specialized allocation and reporting that only they can provide.
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Thomas serves a wide range of clients with a special interest in nonprofit organizations. He works with his clients to address various needs, including the development and implementation of a strong internal control environment and various other accounting, tax, and system issues with the ultimate goal of helping organizations achieve their missions.