There’s been an ongoing conversation in the nonprofit sector for more than four decades about state unemployment insurance taxes. And some are wondering if the subject matter is just a bad version of Groundhog Day.
“I’m amazed at the confusion,” remarked Alan Lesher, CFO, of YMCA of the Inland Northwest in Spokane, Washington. “You would think it’s a no brainer. It’s just another tax 501(c)(3)s don’t have to pay.”
Since 1972, 501(c)(3) nonprofits have been exempt from paying state unemployment insurance taxes. But most of these nonprofits still pay the taxes even though many could save considerable money by opting out of them.
“When you first bring up the tax alternatives it’s not unusual for a CFO to think you’re trying to sell a scam,” laughed Cynthia Koral, chief marketing officer for 501(c) Services – a provider of full-service alternatives to state-run unemployment insurance programs for nonprofits. “This is not a pyramid scheme and I’m not Bernie Madoff. The IRS says they can do this.”
The relationship between state unemployment taxes and nonprofits is unique but not rocket science. There is a legitimate unemployment insurance tax alternative for many nonprofits.
“All employers share the burden of the national unemployment insurance benefit system,” explained Bo Garner, assurance manager with PBMares – a Mid-Atlantic accounting and business consulting firm. “Fortunately for 501(c)(3)s, the federal government believes that they have low turnover and should only have to reimburse the unemployment system, not pay into it.”
The current unemployment system began with the Social Security Act of 1935 and has been amended a few times since its creation. Basically, how it works is that employers are charged a payroll tax that funds large state-managed benefits pools. From these pools, separated employees are paid unemployment benefits until they find new work or their benefits period ends.
An interesting feature of the unemployment insurance benefits system was added in 1972. The law was amended so that not all employers are required to pay the per-employee tax assessed by the states. One of those employer types is 501(c)(3) charities.
“Per the IRS, 501(c)(3)s are only required to reimburse for unemployment claims paid out to separated employees by the state,” explained Garner. “Yet most nonprofit executives and board members either aren’t aware of this tax option or don’t see it as a legitimate cost saving measure.”
The result of 501(c)(3)s continuing to pay the tax is massive overpayments into the state unemployment issuance system by those employers. Those tax payments are dollars that could be used for missions.
“We audit hundreds of 501(c)(3)s annually,” said Koral. “It’s been our experience that upwards of 86 percent of nonprofits overpay their unemployment tax liability.”
Meaning, if the charities stopped paying the assessed tax and just reimbursed the state for claims, they would pay considerably less.
“Our estimates indicate 501(c)(3)s annually overpay into state unemployment systems by 78 percent,” said Koral. “That figure decreases for smaller organizations, say those with payrolls under $5 million, and it increases for large organizations, or charities with payrolls up to and over to $20 million.”
It’s those overpayment figures that have made nonprofit executives like Lesher advocates for nonprofit unemployment insurance tax reimbursing.
“That’s what really bothers me,” said Lesher. “Depending on the size of an organization’s payroll and their state tax rate, we are talking about a lot of money. We estimate that we have reduced our unemployment tax liability by more than $160,000 annually.”
“Now not every organization sees those kinds of savings,” continued Lesher. “Some save less and some save more, but I often think about small agencies like a local SPCA. They may only save $5,000 a year, but that equals a lot of services for a local pet community. It’s all relative.”
“I don’t think the sector is ignorant,” remarked Garner. “I just think they’re mission focused, and not informed. They are constantly chasing funders, managing programs and trying to keep costs down to maximize effectiveness.”
“But that’s why we inform our clients of this option. Right there in their payroll taxes are funds they don’t have to fundraise for. They’re potentially just giving the money to the state. No one should be too busy to research a cost savings option like this.”
When a 501(c)(3) decides to discontinue the paying of state unemployment insurance taxes, they have a few options to handle the new unemployment claims they will begin to receive from the state.
“Unemployment reimbursers have three options to replace the tax,” explained Koral. “They can handle the claims in-house which means they are basically self-insuring their unemployment; they can join a grantor trust that is set up to help them, and others, manage the claims; or they can actually buy a custom insurance policy that pays the claims.”
Each option, as spelled out by Koral, has its own risks and rewards.
“The most expensive, least risky way to handle unemployment is to pay the taxes,” said Koral. “The option that returns the most money to the organization is the self-insurance option, but that option also carries the most risk. That’s why many reimbursers choose the trust or the custom insurance policy route. Through those two options, you get a good balance of savings and risk.”
When thinking about the money his organization has saved over the past decade, Lesher agrees with Garner, “Every board and CFO at a 501(c)(3) should consider doing this – at least run the numbers. It’s not a waste of time to do a bit of math and see what is possible. It’s a fiduciary responsibility in my opinion.”
For those board members or executives that want to review the possible savings, Koral has a few suggestions, “The math is easy. Look at how much your organization has paid in state unemployment insurance taxes for the past five years. Compare that total to the actual unemployment claims you have incurred over the same period. Most nonprofits are going to see a figure they would love to have returned to their budgets.”
Garner also recommends getting the organization’s accounting firm involved, “Ask your CPA. They should be able to walk you through it all. Or contact an unemployment alternatives provider directly. They’ll run a simple audit and provide you with your options.”