Classifying Employees Correctly

Misclassifying workers is a common mistake made by employers of all kinds – nonprofits included. Doing so can result in serious consequences, including back wages and taxes owed, as well as violations of federal and state employment laws with associated penalties. These mistakes can also result in dissatisfied employees, risking a negative effect on the nonprofit’s mission. 

In recent years the IRS has been stepping up its enforcement of employee classification, creating one more compelling reason for nonprofits to reexamine whether workers are properly classified as employees and independent contractors, and as exempt or non-exempt employees. 

Why does it matter?

Misclassifying a worker can result in the nonprofit owing significant penalties, back taxes, and back pay. Nonprofit employers need to know first whether each worker is an independent contractor or an employee. If determined to be an employee, the nonprofit must then determine whether the employee is “exempt” or “non-exempt” from overtime.

The correct classification is determined by two layers of definitions: federal and state.  Therefore, both state and federal Department of Labor (DOL) regulations may apply. Many states follow the federal Fair Labor Standards Act (FLSA) definitions, but in others, different definitions and wage/hour rules may apply, just as different states have different minimum wage rules.

Independent contractor or employee?

A typical misclassification scenario is that a nonprofit classifies a worker as an independent contractor when in fact the federal DOL, federal IRS, or state wage and hour laws would define that worker as an employee.

  • The IRS has its own rules governing classifying workers as employees or independent contractors, distinct from the federal Department of Labor and state rules.
  • A good overview of the IRS rules can be found in this IRS "tax tip" from August, 2022.
  • More help on the differences between independent contractors and employees (IRS Publication 1779)
  • If the state or federal DOL finds that the nonprofit has misclassified the worker, the nonprofit can be responsible not only for unpaid wages, including overtime, but also state/federal withholding taxes, as well as potential penalties.

Practice Pointers

  • Position descriptions should be prepared for employees, but not for independent contractors.
  • Instead of a position description, independent contractors should sign a written contract with the nonprofit describing the scope of work. These agreements are also a good way to document that independent contractors/consultants understand that they are responsible for their own income taxes and insurance coverage.
  • IRS guidance can help distinguish between employees and independent contractors; state law definitions should be checked also.
  • Reporting payments to independent contractors. (IRS)

Exempt or Non-Exempt?

Another common misclassification scenario occurs when a nonprofit considers a worker to be exempt from payment of overtime, when in fact federal or state wage and hour laws would classify the worker as non-exempt. This misclassification could result in the employer owing the worker compensation for overtime, and potentially also owing penalties to the state or IRS.

Practice Pointers

  • Even if workers are "salaried" they could still be entitled to overtime for hours worked over 40 in a single work week under the federal rules
  • Each state has its own wage and hour rules that govern which workers are entitled to overtime in that state and what makes an employee exempt from overtime, so be sure to review the applicable wage and hour regulations/guidelines in your state. Quite a few states automatically follow federal wage and hour (and overtime) regulations. 
  • Manage employees’ expectations about their compensation  and make sure they know whether they are, or are not, entitled to overtime pay. One way to do this is by including a category of “worker classification” on position descriptions, for example: “Regular, full-time, exempt” or “Temporary, part-time, non-exempt.”
  • Most employment lawyers advise employers to have a policy that workers may only work overtime with advance authorization from their supervisor - which limits surprises and budget overruns.
  • When preparing budgets for grant proposals, consider whether to anticipate overtime in the budget.

Additional Resources

Disclaimer: Information on this website is provided for informational purposes only and is neither intended to be nor should be construed as legal, accounting, tax, investment, or financial advice. Please consult a professional (attorney, accountant, tax advisor) for the latest and most accurate information. The National Council of Nonprofits makes no representations or warranties as to the accuracy or timeliness of the information contained herein.