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
The "classification" most churches and nonprofit organizations struggle with is usually with their musicians, nursery workers, secretaries, custodians, etc. Let me make it simple for you. If in doubt, classify them as employees. No one gets in trouble for classifying an individual as an employee when they could have been paid as an independent contractor (IC) with a 1099. BUT you can get in very BIG trouble for misclassification of workers as independent contractors when the IRS classify them as an employee. AND the IRS considers most of the positions mentioned above as employees!
I know that classifying them as employees is definitely costlier and more time consuming (more on that below)...BUT you will save a lot of heartache and money down the road when you classify them properly the first time.
To determine how to properly classify your worker, look at the degree of control and independence that exist between your organization and the individual performing the service using these 3 categories that the IRS uses in worker classification:
See those three categories spelled out in more detail on the IRS site in this article: Independent Contractor (Self-Employed) or Employee?
Ok ...let's break this down into some simpler language and apply the "categories" to churches and nonprofits.
Does your organization control the "how, when, and where"?
Take a nursery worker for example, you tell them to be at the church or nonprofit at set times, they use your facility, your equipment, and you tell them how to do the job. The IRS would consider them employees.
Custodians: they sometimes set their own hours...but they use your supplies to clean your place and you tell them how to do the job. Unless they clean multiple places with their own supplies such as an outside cleaning company...the IRS will probably classify them as your employee.
Organists: do they play just at your church? They are probably employees.
See the difference? If you hire a nursery worker from a company such as care.com that does similar jobs for other organizations, those individuals are NOT employees and can be paid as IC or directly to the company...BUT if you hire Sis Smith from the church and PAY her ... you probably better set her up and pay her as an 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.
At the very least, use a good payroll software like Gusto.
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 ... a misclassification of workers can be devastating for any church that ever has the misfortune of being audited and found in violation.
Willful failure to comply with classifying a worker correctly as an employee and withholding and reporting payroll taxes can result in criminal and civil penalties. In addition, those taxes that were suppose to be withheld and remitted becomes the responsibility of the you the employer. Even worse, you, one of your responsible employees, or even officers of the church may become personally liable for the taxes and penalties involved.
Remember, a blaring red flag for the IRS is an individual who receives one 1099 from the same organization every year!
ONE last very big tip ... if you realize you have been classifying a worker incorrectly ... contact a knowledgeable CPA or tax professional BEFORE issuing a 1099 and W-2 in the same year for an individual as doing so is another red flag! There are ways to correct a misclassification, but you should hire an expert to help.
ECFA's article: Church Employees or Independent Contractors?