How Nonprofits Should Classify Workers Correctly for Tax Purposes — and Avoid Costly Repercussions

Running a nonprofit organization means wearing many hats — fundraising, compliance, board management, and program execution, just to name a few. But one area that often gets overlooked is worker classification. Misclassifying staff, contractors, or volunteers can trigger serious tax consequences, IRS penalties, and even reputational damage.

In this guide, we’ll explain everything nonprofits need to know about properly classifying workers for tax purposes and staying compliant to avoid costly mistakes.

Why Worker Classification Matters for Nonprofits

Worker classification determines whether an individual is treated as an employee, an independent contractor, or sometimes a volunteer. This decision impacts:

• Payroll tax responsibilities (Social Security, Medicare, unemployment insurance, etc.)
• Eligibility for benefits such as health insurance or retirement contributions
• Recordkeeping and reporting obligations under IRS and Department of Labor rules
• Legal liabilities related to wage-and-hour laws and workplace protections

For nonprofits, the stakes are especially high. Resources are limited, and even small missteps can result in significant back taxes, interest, and penalties that cut into funds meant for mission-driven work.

IRS Guidelines for Worker Classification

The IRS provides a three-category test to help nonprofits determine whether a worker is an employee or contractor:

1. Behavioral Control – Does the nonprofit control how the worker performs their job? Employees typically follow set schedules, training, and oversight. Contractors usually decide how and when the work gets done.
2. Financial Control – Who controls the money? Employees are paid a salary or hourly wage, while contractors invoice for services and may incur unreimbursed expenses.
3. Type of Relationship – Is there a written contract? Does the worker receive employee-type benefits (health insurance, retirement, paid leave)? Is the relationship ongoing or project-based?

If the answer leans toward more control, benefits, and permanency, the IRS will likely consider the worker an employee.

Employee vs. Independent Contractor in Nonprofits

Employees

• Subject to payroll tax withholding (federal income tax, Social Security, and Medicare)
• Eligible for unemployment insurance and workers’ compensation
• May qualify for nonprofit-offered benefits

Independent Contractors

• Responsible for paying their own self-employment taxes
• Do not receive benefits or protections under most employment laws
• Require Form 1099-NEC reporting if payments exceed $600 in a year

Volunteers and Stipends: A Special Case

Nonprofits often rely on volunteers. Genuine volunteers who receive no compensation are not considered employees.

But here’s the risk: If a nonprofit offers stipends, gift cards, or “thank you” payments, the IRS may reclassify the individual as an employee, making the nonprofit liable for back payroll taxes.

Consequences of Misclassification

Misclassifying a worker can trigger:

• IRS penalties for unpaid employment taxes, plus interest
• Fines under state labor laws
• Loss of tax-exempt status if the IRS deems systematic abuse
• Reputational damage if donors or regulators question compliance practices

For example, if your nonprofit classifies program coordinators as contractors, but they work full-time under organizational supervision, the IRS could retroactively require you to treat them as employees and assess years of back payroll taxes.

Best Practices for Nonprofits

To minimize risk and ensure compliance, nonprofits should:

1. Use written agreements that clearly outline whether the worker is an employee, contractor, or volunteer.
2. Conduct regular audits of worker classifications, especially if roles or duties evolve.
3. Avoid paying volunteers in ways that could be construed as compensation.
4. Stay updated on IRS and state laws, which may differ in interpretation.
5. Consult professionals — tax advisors, accountants, or nonprofit attorneys — when in doubt.

Worker Classification Checklist for Nonprofits

Before making a hiring or contracting decision, ask yourself:

• Does the organization control how the work is done?
• Is the relationship ongoing or project-based?
• Does the worker receive benefits like employees do?
• Are you reimbursing the worker for expenses or providing equipment?

If several answers point toward “employee,” it’s safer to classify them as such.

Final Thoughts

Proper worker classification isn’t just a compliance issue — it’s about protecting your nonprofit’s mission. Every dollar lost to fines or back taxes is a dollar not spent on the communities you serve. By carefully following IRS rules and documenting decisions, your nonprofit can stay compliant, safeguard its tax-exempt status, and continue driving impact.

© 2025