Nonprofits that qualify as Section 501(c)(3) organizations need not pay federal unemployment taxes. However, most nonprofits must choose either to pay into their state unemployment tax program or self-insure by reimbursing the state for unemployment claims paid out to their former employees. While self-insuring often saved money for nonprofits in the past, with the COVID-19 pandemic, reimbursement costs for unemployment claims will likely far exceed unemployment taxes they would otherwise owe.
One option is for 501(c)(3) nonprofits to pay state unemployment taxes for their employees like other for-profit businesses. State unemployment taxes are based on your nonprofit's payroll and claims history--called the "experience rating." Employers with many claims pay higher unemployment taxes than those with few claims.
As a result of the coronavirus (COVID-19) pandemic, an unprecedented number of employees are filing for unemployment throughout the country. Congress enacted the Coronavirus Aid Relief and Economic Security Act (CARES Act) to provide employees an additional $600 per week in unemployment benefits through July 31, 2020 under the Federal Pandemic Unemployment Compensation program. These benefits are 100% funded by the federal government and will not impact employers' experience ratings. Several states have also acted to prevent experience ratings from spiking because of increased applications for regular unemployment benefits. Nevertheless, some nonprofits could experience increases in their experience ratings.
A 501(c)(3) organization has the option of opting out of its state unemployment insurance program and choosing to self-insure. 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. In ordinary times, 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.
However, these are not ordinary times. As a result of the coronavirus (COVID-19) pandemic, most nonprofits have laid off substantial staff. As a result, the unemployment costs they will have to reimburse the state will likely far exceed the unemployment taxes they would otherwise have had to pay.
Under the CARES Act, the federal government will reimburse 50% of unemployment compensation paid by self-insured 501(c)(3) nonprofits between March 13, 2020 and December 31, 2020. Reimbursement is available for all unemployment claims made during this time period, not just COVID-19 related claims. However, this means that self-insured nonprofits will still have to pay for 50% of claims. Nonprofit organizations are attempting to get the states to waive reimbursement for this 50%.
To mitigate the financial risks inherent in being self-insured, 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. Due to the avalanche of claims, these trusts could be in financial difficulty. Insurance premiums for those nonprofits that have it will likely rise. For more information, see the Unemployment Services Trust website.
Nonprofits that have opted for the reimbursement option should consider whether they would be better off joining their state unemployment insurance program.
For more information on complying with IRS nonprofit regulations, see Nolo's book, Every Nonprofit's Tax Guide.