NOTE: In the early part of 2021, some HUGE changes happen under the Biden administration, please read below to be aware of those new "classification" law and how this could impact your organization!
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?
Changes to the Classification Tests!!!
Those of you not operating an organization in California may not know about their 2020 employee classification law that replaced the traditional classification test with the ABC Test. It has made it very tough to classify a worker as an IC in CA. What this new "classification test" pretty well boiled down to is ... if your worker didn't own their own business and get paid from other organizations for work similar to what you were paying them for ... you have to treat them as employees.
The Biden administration expressed their desire to "pattern" the federal standard for classifying ICs closer to CA's ABC Test. So earlier this year, the U.S. Department of Labor stopped Trump administration rules that utilized a five-part test for classifying worker and would have made it easier to identify and properly classify workers as ICs and started classifying ICs under the ABC Test.
Now the ABC Test is not only used by the U.S. Department of Labor, but also by most of the states in the US. For now, the IRS still uses the classification outlined above (The Common Law Test).
See this article for the difference between the ABC Test and the Common Law Test I outlined above and which method each states uses : Employee or Contractor? The Complete List of Worker Classification Tests By State
So how will this affect you? Well, unless your musician, custodian, or nursery worker owns their own business and does a similar "job" for other business and organizations, you should be paying them as employees.
The issue I am concerned about is that many small churches and nonprofits can not afford to hire a payroll company to pay their workers (with today's laws I strongly recommend churches and nonprofits use a payroll or bookkeeping firm that knows how to handle their particular payroll or at least use a payroll software like Gusto [link at the bottom of this page])....so they just give workers/volunteers "love offerings".
AND I've been telling you for years that those "love offerings" for doing a service for an organization is "taxable" for the recipient and you as a church/nonprofit administrator must issue them 1099-NECs for "offerings" that equal $600 or more for the calendar year.
See where I'm going with this?
By reporting their love offerings on a 1099-NEC ... you are classifying them as ICs ... AND misclassifying workers is a crime that can result in very serious financial penalties or worse!
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.
Church Accounting Package
A set of 4 ebooks that covers the following topics...
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?
IRS Publication 15, Circular E (Employer’s Tax Guide)
If you want to DIY your payroll, I highly recommend you look at using Gusto! It is very user friendly and their support is awesome! Plus they know how to set up and maintain payrolls for churches and nonprofit organizations.
Note: I am a "partner" of Gusto, but as I have told you before ... I never recommend anything that we or our clients have not tried and love =)