Unusual Advice: Should You Opt Out of the State Unemployment Insurance Tax?

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If your organization were counseled to stop using the alternative postal rate offered to nonprofits, it would seem like strange advice wouldn’t it? Since Congress and the U.S. Postal Service specifically provide a special rate for nonprofits to send their mail for 24 cents per piece instead of 44 cents, why wouldn’t you opt to pay less?

The choice seems obvious, but there is another alternative provided under federal law that many nonprofits are not currently using to their advantage—even though it could save them thousands of dollars.

Section 3303(e) of the Internal Revenue Code allows nonprofit organizations and local government entities to use an alternative method to pay for state unemployment compensation. They are allowed to opt out of the state unemployment insurance (UI) tax system and instead reimburse the state only for the unemployment benefits paid out to their own former employees. 

Given the choice, most for-profits would jump at this opportunity, because employers that pay into the state UI system typically pay about $2.00 in taxes for every $1.00 paid out in benefits to laid-off workers. But only 501(c)(3)s and local units of government can opt out and become a “reimbursing” employer, simply paying the state for their own agency’s unemployment claims—dollar for dollar—and saving valuable unrestricted funds.

In addition, because of the recent recession, many state unemployment funds have dried up and have begun borrowing from the federal government—with loans now totaling $37 billion. For employers, this will mean higher unemployment taxes in the coming years, regardless of their own employment practices.Nonprofits owe it to themselves to evaluate whether they should opt out of the state UI system. 

 “Nonprofits are getting smarter and savvier from the financial crisis . . . This is one cost they’re learning they can save on,” says Donna Groh, Executive Director of the Unemployment Services Trust (UST), a group of more than 2,000 nonprofits that have decided to opt out of the state UI system. Groh explains that this alternative is best for nonprofit employers with 10 or more full-time-equivalent employees.

When organizations look to UST to find out if they should opt out of the state unemployment system, UST evaluates the organization’s size as well as its unemployment-claim history. Nonprofits that have recurring seasonal unemployment aren’t typically a good fit, since they tend to have higher overall unemployment claims. But those that do not can really benefit from getting out of the state system, since that system is built to cover all employee claims, which drives up costs for everyone—even those employers who haven’t experienced any unemployment claims. Says Groh, “Last year UST members that opted out of the state unemployment tax system immediately saved an average $99.74 per employee, and they can expect to continue to save long-term.”

In addition to the nationally available services of UST, groups formed to offer unemployment services for nonprofits include First Nonprofit Companies of Chicago, 501(c) Services of Cupertino, CA, and the 501 Alliance, in Michigan.

Most states only allow nonprofits to exercise this alternative once annually, typically by November 30. You can find out if it is a smart alternative for your agency by visiting www.chooseust.org/savings-evaluation or websites of the other providers.

Philip Bond, CPA isVice President and CFO for Metro United Way, Louisville, KY, and a volunteer trustee for UST.

  • Ron Barrett

    As the author notes, this is only applicable to nonprofits with several employees in a state. Quite the opposite is true for smaller nonprofits or organizations with just a few employees in a state (i.e. paying the state UI is usually less expensive than reimbursing the state). Some cost-benefit analysis and possibly risk analysis is needed before deciding. Also, the 10-employee threshold is not a number that is appropriate for all organizations…it depends on payroll figures and other factors in each state. There’s not much available in terms of resources providing guidance on this, but I look forward to learning more about UST and the other companies listed in the article. Thanks.

  • terry

    As Executive Director for a small nonprofit, 35 FTE, we have saved thousands by opting out and only paying for unemployment as claims are made. Those who work for our agency our happy.
    Happy employees work harder and stay longer. Historically the ones who have left are those working part-time who need to take a full time position. in Michigan the Michigan Nonprofit Association is an excellent resource and has a wealth of helpful information on a number of issues including fiscal efficiency standards.

  • Michael

    Am I missing something in this statement..

    because employers that pay into the state UI system typically pay about $2.00 in taxes for every $1.00 paid out in benefits to laid-off workers.

    If true, state unemployment trust funds would be growing at double digit rates

  • Donna Groh

    Michael, the $2.00 figure is a national average over time. The excess of what one employer pays goes to cover the socialized expenses of employers that go out of business or have high claims related to a seasonal workforce, as examples. Currently that figure is higher in many states due to the recession. Also many states are raising rates and imposing surcharges in order to cover costs related to Federal loans (title XII) that have been necessary to pay benefits over the last few years. In most cases, direct reimbursing employers are exempt from those surcharges. The bottom line is that direct reimbursing employers only pay dollar for dollar for their own claims, rather than the higher tax rate to subsidize others.