Alternative Financing Methods of Unemployment Benefits for 501(c)(3) Nonprofits: Benefits & RisksJanuary 8, 2020
By: Ben Jonas, Unemployment Risk Advisor& Broker Relations Manager, 501(c) Services
501(c)(3) nonprofits are within their legal right to opt-out of State Unemployment Insurance programs per the Federal Unemployment Tax Act, Section 3309. The section provides as follows:
The State law shall provide that a governmental entity, including an Indian tribe, or any other organization (or group of governmental entities or other organizations) which, but for the requirements of this paragraph, would be liable for contributions with respect to service to which paragraph (1) applies may elect, for such minimum period and at such time as may be provided by State law, to pay (in lieu of such contributions) into the State unemployment fund amounts equal to the amounts of compensation attributable under the State law to such service. The State law may provide safeguards to ensure that governmental entities or other organizations so electing will make the payments required under such elections.
This unique federal statute enables 501(c)(3) nonprofits to take greater control of their budget while reducing their unemployment benefit costs significantly. State Unemployment Insurance (SUI) programs operate as risk pools; in short, they collect contributions – in the form of taxes – from each program participant and those contributions make up the pool of risk from which most benefits are paid. Some of those SUI participants, such as 501(c)(3) nonprofits, pay taxes that exceed the actual unemployment benefits that are paid on their behalf. The reverse is also true; other participants take far greater from the fund than they contribute, and some even have a negative balance with the state program.
Nonprofit organizations that participate in the tax can assess the real value of participating in an SUI program by comparing how much they contribute versus how much is paid to their employees in the form of unemployment benefits. Consider this basic example: A 501(c) (3) nonprofit with 75 full-time employees in New York State contributes $45,000 to the SUI Fund in the form of a lump-sum tax payment. New York pays $17,000 a year on average out of the fund to this nonprofit’s separated employees. That’s a $28,000 over-contribution to New York every year, and an example of why nonprofits should review their contributions if they are participating in an SUI program.
UNEMPLOYMENT GRANTOR TRUSTS
Unemployment Grantor Trusts, numbering almost a dozen across the country, began to pop up on the West Coast a decade after the IRS allowed 501(c)(3)s to reimburse states for the cost of unemployment benefit claims. Grantor Trusts, often created by small groups of nonprofits, is designed to help nonprofits better manage and reduce SUI liabilities and costs by sharing administration costs and working with expert claims managers. Grantor Trusts also make reimbursement payments on behalf of their nonprofit members, as well as provide claims management and HR consulting to help mitigate unemployment risk.
The cost to participate in these programs is based on claims experience (volatility and average expense over three to five years), anticipated funding expectations and turnover trends as well as other variables. Fundamentally, the overall total cost of risk will be lower with Grantor Trusts because they provide loss control services (e.g., expert claims management and job placement) that keep unemployment benefit/compensation claim costs as low as possible. Some Unemployment Grantor Trusts make available Custom Stop-Loss insurance and First Dollar insurance that protect nonprofits from catastrophic claims, and, in the case of First Dollar insurance, provide the nonprofit a less-expensive but fixed-cost solution compared to the SUI tax system. Unforeseen high claims are a significant risk for organizations that are effectively self-insuring the cost of unemployment benefits. Nonprofit organizations should consider admitted insurance products as the most secure solution because they are backed by state guaranty funds and have been vetted by state regulators
Unemployment Grantor Trusts typically operate by creating individual, segregated accounts for their members. This is a key consideration, and nonprofit organizations considering joining a Grantor Trust should carefully review the agreement for language that states their funds are a part of a risk pool. An essential value add of Grantor Trusts is the handling and administration of state unemployment reimbursement invoices in which trusts pay state unemployment benefit bills on behalf of all their members from their accounts. Organizations working with Grantor Trusts have the luxury of not having to deal with state bureaucracies or having to audit the state to ensure accuracy.
Monies held in trust are the exclusive property of the member organizations. Typically, members can access their individual accounts if they’re needed for operations. If an organization leaves a Grantor Trust, they take their remaining funds with them. This differs from the state system, which creates individual accounts but retains exiting nonprofits’ reserves. Employers – for-profit or non-profit – cannot access those funds at all. Switching to Reimbursable Employer status and joining an unemployment program can be beneficial for diversely funded nonprofits (those not solely dependent on one stream of funding) employing more than 25 full-time employees and experiencing low turnover because it gives the organization yet even more control over its budget.
REIMBURSEMENT AVOIDS TAX INCREASES
Another reason to exit the SUI tax system is tax rate variability. For example, most states dramatically raised their SUI taxes to cover rising unemployment during the Great Recession and other less disruptive economic slowdowns. Reimbursable Employers are not subject to SUI tax increases. During the Great Recession most states were forced to borrow money from the federal government to cover the billions of dollars in unemployment claims being paid to out-of-work Americans. These states were then forced not only to increase SUI rates but create additional SUI fees that directly addressed paying down the federal loans. In most states, these additional SUI fees did not apply to those employers who had reimbursable accounts. Since the recession, most SUI programs have stabilized. However, it is generally believed that most state programs are still not healthy enough to handle even a slight economic dip without again being forced to borrow federal dollars, which means returning to increased SUI tax rates.
(For further reading on this topic, see https://www.501ctrust.org/many-state-unemployment-insurance-trust-funds-still-insolvent/)
NOT FOR EVERYONE
For nonprofits with fewer than 25 employees, gross payrolls less than $1 million or organizations that rely heavily on one source of funding, the SUI tax system is probably more cost-efficient. Nonprofit organizations that pay the tax today may discover that the tax system is the best place for them. These organizations should continue to perform an unemployment costs analysis on a yearly basis because making a change in the future could prove greatly beneficial. Reimbursement should be addressed as a long-term financial decision. It’s not a short-term strategy for beating the system.
All states have deadlines to change status from taxpayer to Reimbursable Employer, generally between November and January. Some states such as California and Minnesota allow nonprofits to switch in any quarter, though the optimum time is before first quarter payroll taxes are due.
Those organizations that are considering leaving the state pool should make themselves aware of the length of time they must remain outside the tax system as a Reimbursable Employer before being allowed to return as an SUI taxpayer. The time period is usually one to two years but can be as long as five years.
There is a risk of becoming a Reimbursable Employer. However, gaining greater control of a nonprofit’s limited financial resources is the true value of this option.