Misclassification of workers is a big concern for many small churches and nonprofits. If your organization is ever found in violation, the payroll tax liabilities including penalties and interest can be financially devastating.
Many small nonprofits and churches have the misconception that they are not under the same labor and employment laws the for-profit organizations are under. This can be a very costly mistake.
For churches, ministers are almost always considered employees of their churches and should be issued a W-2. However they are handled differently than "regular" employees. See this page for more instruction on handling a minister's payroll: Clergy Tax
Musicians, nursery workers and custodians are harder to properly classify. I have heard a range of different opinions, but it really comes down to your organization's unique circumstances. Most "experts" agree if the individual works full time for your organizations, they are usually considered employees.
There are exceptions to this rule though. For example, if you have a custodian that just works a couple hours a week on their own schedule and works unsupervised...that person may be classified as an independent contractor and issued a 1099 from your organization (if paid $600 or more in a calendar year). Same thing applies to nursery workers and musicians that just work a couple of hours a week.
To determine how to properly classify your worker, look at the degree of control and independence that exist between your organization and the individual preforming the service:
See these three categories spelled out in more detail on the IRS site in this article: Independent Contractor (Self-Employed) or Employee?
I know properly classifying these workers as employees can be an expensive and hard task for churches and nonprofits, especially the smaller ones that may not have the knowledge or personnel to process a payroll.
You have to complete and process payroll forms such as W-4s, I-9s, 941s, W-3 and W-2s, etc. In most states, churches are exempt from unemployment payroll taxes, but some are not, so a careful review of your state’s employment laws is always a necessity.
In many cases it is well worth the extra funds to hire a payroll processing company...AS long as they can prove they are familiar with church and clergy payroll tax regulations. Check with your local churches to see who they would recommend.
With all of the payroll requirements is no wonder that many small churches choose to classify their workers as independent contractors; however, as I stated above ... such a misclassification of workers can be devastating for any church that ever has a the misfortune of being audited and found in violation. Remember, a blaring red flag for the IRS is an individual who receives one 1099 from the same organization every year.