Nonprofits that qualify as Section 501(c)(3) organizations need not pay federal unemployment taxes. However, they must pay state unemployment tax, subject to one exception discussed below. State unemployment taxes can be a real burden. They are based on your nonprofit’s payroll and claims history—employers with many claims pay higher taxes than those with few claims. Unfortunately, these taxes are likely to get worse. With unemployment still high, most states are currently paying out far more in unemployment benefits than they are receiving in revenue. Many have had to increase unemployment taxes to make up the shortfall.
A 501(c)(3) organization has the option of opting out of its state unemployment insurance program. Instead of paying a set amount of unemployment tax to the state every year regardless of how many of its employees file claims, it reimburses the state only for unemployment claims the state actually pays out to its former employees. This can save big money because nonprofits typically pay more in unemployment taxes than the state pays out for the nonprofit's former employees’ claims. In the past, many nonprofits have saved 30% to 40% over five to ten years.
But there are obvious risks to this approach. If your nonprofit is forced to lay off substantial staff, the unemployment costs it will have to reimburse the state could far exceed the unemployment tax it would otherwise have had to pay. This risk is doubtless greater now than in the past because so many nonprofits are experiencing declining funding. To mitigate these risks, thousands of nonprofits have joined grantor trusts that pool money from many organizations to pay off future claims. It is also possible to purchase private insurance to cover claims.
The reimbursement option works best for larger nonprofits with stable employment. Nonprofits with fewer than ten employees or that have regular layoffs, are usually not good candidates for opting out of state unemployment taxes. For more information, see the Unemployment Services Trust website.
For more information on compying with IRS nonprofit regulations, see Nolo's book, Every Nonprofit's Tax Guide.