What Is a 501(c)(3) and Can It Pay Employees? Debunking Myths

When people hear “501(c)(3) nonprofit,” they often think of volunteer work, charitable activities, tax-exempt status, and charitable giving. However, a common misconception is that these organizations must operate solely with unpaid volunteers to keep their nonprofit status.

In reality, 501(c)(3) organizations can pay employees at all levels of other nonprofit organizations, from executives to administrative staff—all while qualifying as tax-exempt. The key is to ensure that compensation remains reasonable and aligns with federal law and Internal Revenue Service (IRS) guidelines.

This blog will debunk some of the most common myths surrounding nonprofit compensation, explain how 501(c)(3) organizations can legally pay employees, and highlight best practices for structuring salaries while maintaining compliance.

Understanding What a 501(c)(3) Is

A 501(c)(3) nonprofit is an entity that functions exclusively for charitable, religious, educational, scientific, or literary purposes. Recognized under the Internal Revenue Code, these organizations receive tax-exempt status for federal income tax purposes, meaning they do not pay federal income tax on the funds they receive.

The purpose of a 501(c)(3) is to serve the public interest rather than generate profits for private individuals. Unlike for-profit businesses, which exist to maximize earnings for owners or shareholders, nonprofits reinvest their revenue into advancing their mission. A significant benefit for donors is that contributions made to 501(c)(3) organizations are typically tax-deductible, providing an incentive for charitable giving.

Several types of organizations can qualify for 501(c)(3) status. Public charities, such as food banks, animal shelters, and educational institutions, rely heavily on donations and public funding. Private foundations, such as grant-making organizations, support charitable initiatives by distributing funds to other nonprofits. Religious organizations, including churches, temples, and mosques, also fall under this category and benefit from additional legal protections.

Holding 501(c)(3) status comes with notable advantages. These organizations are exempt from paying federal income tax, which allows them to allocate more resources toward their mission. They can also receive tax-deductible donations, making fundraising more effective. Additionally, 501(c)(3) nonprofits gain access to a wider pool of grants from foundations and government programs, further expanding their funding opportunities.

Myth #1: 501(c)(3) Organizations Must Be Fully Volunteer-Run

A common misconception is that 501(c)(3) nonprofit organizations must rely entirely on volunteers to maintain their tax-exempt status. Some assume that compensating employees could compromise a charitable organization’s mission or result in private interests benefiting from tax-exempt purposes, but this isn’t the case.

While volunteers are essential to many public charities, religious organizations, and social welfare organizations, 501(c)(3) orgs also need paid employees to handle daily operations, develop programs, and ensure financial stability. Volunteers often assist with specific charitable activities, but nonprofits need structured leadership and dedicated staff to function effectively within IRS guidelines.

Why Nonprofits Need Paid Employees

A tax-exempt organization must be well-managed to fulfill its charitable purposes and remain in good standing with the IRS. That’s why board members and leadership teams are there to ensure that the organization’s net earnings are used to further its mission statement, not to benefit individuals, political campaigns, or private foundations. They also oversee any paid positions, which are often administrative and essential for the organization’s day-to-day functioning.

For example, a food bank may rely on volunteers to distribute meals, but it also needs paid employees to manage public support, coordinate food supply chains, oversee annual tax returns, and ensure compliance with 501(c)(3) status. Without dedicated staff handling these essential functions, the food bank would struggle to operate efficiently or expand its impact.

Key responsibilities that nonprofit employees most often manage include:

• Planning for long-term growth while maintaining public accountability and transparency.
• Overseeing budgeting, fundraising, and financial reporting to ensure compliance with federal tax exemption and IRS regulations.
• Expanding services, securing grants, and managing charitable contributions to support ongoing programs, preventing community deterioration and lessening neighborhood tensions.

Myth #2: Paying Employees Jeopardizes Tax-Exempt Status

A common misconception is that compensating nonprofit employees could put a 501(c)(3) organization’s tax-exempt status at risk. Some believe that paying salaries makes a nonprofit operate like a for-profit business, but this misunderstanding does not align with IRS regulations.

The IRS allows 501(c)(3) organizations to pay employees as long as compensation is reasonable and supports the organization’s mission. Nonprofits must ensure that salaries align with industry standards and do not result in private financial gain for individuals. To maintain tax-exempt status, nonprofit compensation should meet the following guidelines:

• Comparable to Similar Organizations: Employee salaries should be consistent with compensation offered by other nonprofits of similar size, budget, and scope.
• Mission-Driven Compensation: Payments should contribute to the nonprofit’s ability to deliver services rather than provide excessive financial benefits to individuals.
• No Private Inurement: Funds should be reinvested in the organization’s operations (including salaries) rather than distributed as profits to employees, board members, or private stakeholders.

Prohibited Compensation Practices

Maintaining strong financial policies helps 501(c)(3) organizations ensure fair employee compensation while adhering to federal regulations. Regularly reviewing salaries, documenting pay decisions, and maintaining financial transparency are essential steps in responsible nonprofit management.

While nonprofits can pay employees, they must avoid compensation practices that violate IRS regulations. Excessive salaries, unjustified bonuses, and financial perks that do not serve the organization’s charitable purpose can lead to IRS penalties or loss of tax-exempt status. The IRS also prohibits nonprofits from misusing funds for political campaign activities or offering compensation structures that do not align with the organization’s public benefit mission.

Even executive salaries are permissible if they are reasonable, well-documented, and proportionate to the org’s financial standing. However, if a nonprofit—particularly a smaller organization—pays an excessively high salary that is inconsistent with its financial reports or budget, it could raise compliance concerns.

Myth #3: Nonprofit Leaders Should Work for Free

Some believe nonprofit executives, directors, and board members should accept little to no pay because their work is mission-driven. However, leading a 501(c)(3) nonprofit organization requires significant experience, time, and responsibility. Expecting skilled professionals to work without fair compensation makes it difficult to attract and retain qualified leadership, which can weaken a nonprofit’s ability to fulfill its mission and sustain long-term operations.

Providing reasonable salaries allows nonprofits to recruit experienced professionals who can effectively manage programs, oversee financial compliance, and secure necessary funding. These leaders play a vital role in ensuring that charitable services are delivered efficiently and that the organization remains in good standing with the IRS. Nonprofit executives must:

• Manage Charitable Programs and Compliance: Leaders ensure that the organization adheres to its tax-exempt purpose and meets all legal obligations.
• Secure Funding and Maintain Financial Stability: Effective fundraising through grants, donations, and sponsorships is critical to sustaining operations.
• Oversee Budgeting and Regulatory Compliance: Responsible financial management and transparency help nonprofits avoid IRS scrutiny and maintain donor trust.

Why Nonprofits Should Offer Fair Compensation

To remain competitive and attract strong leadership, 501(c)(3) organizations must provide industry-standard salaries. Compensation should reflect the responsibilities of the role, the size and scope of the organization, and comparable salaries in the nonprofit sector. Key reasons for fair pay include:

• Competing for Skilled Professionals: Nonprofits must attract qualified leaders who can manage operations, oversee teams, and drive community outreach.
• Ensuring Long-Term Stability: Strong leadership fosters organizational continuity, enhances public trust, and maintains the effectiveness of charitable programs.
• Reducing Turnover and Disruptions: Underpaying executives often leads to high turnover, which increases recruitment costs and disrupts service delivery.

While nonprofit salaries may not match those of for-profit executives, compensation should be determined based on job responsibilities, financial capacity, and industry benchmarks. The IRS examines nonprofit salaries during audits and requires organizations to justify their compensation structures. To ensure compliance, nonprofits should:

• Base Salaries on Industry Comparisons: Compensation should align with similar roles in organizations of comparable size and mission.
• Document Salary Decisions: Board meeting minutes should formally record justifications for executive pay.
• Disclose Compensation on IRS Form 990: Transparent reporting ensures financial accountability and maintains donor confidence.

For instance, a nonprofit hospital CEO overseeing a large healthcare system must manage patient care, regulatory compliance, fundraising, and budgeting. Just as corporate executives earn salaries reflecting their level of responsibility, nonprofit leaders should receive compensation that aligns with their duties and the scale of the organization they manage.

The Impact of Fair Salaries on Nonprofit Success

Organizations that compensate employees fairly are better positioned to deliver high-quality programs, secure funding, and sustain long-term success. Offering competitive salaries enables 501(c)(3) organizations to attract and retain skilled professionals who can effectively lead operations, expand services, and fulfill the nonprofit’s mission. Leadership plays a direct role in driving impact, ensuring financial stability, and maintaining compliance with IRS tax-exempt regulations.

A well-compensated leadership team also strengthens donor confidence by demonstrating responsible financial management. When salaries align with industry standards and are transparently reported, nonprofits reinforce public trust and accountability. Conversely, failing to provide reasonable compensation can lead to high turnover, operational inefficiencies, and lost funding opportunities.

Nonprofits exist to serve communities, and experienced leadership is essential to achieving that purpose. Without fair salaries, organizations may struggle to recruit and retain the talent necessary to maintain financial health, navigate regulatory requirements, and execute their programs effectively. By investing in qualified professionals, nonprofits can build sustainable organizations that maximize their impact and continue serving the public good.

How 501(c)(3) Organizations Can Structure Employee Compensation

Nonprofits and private interests must establish clear and reasonable salary structures to comply with regulations and maintain public trust. Thoughtful compensation decisions should be transparent, aligned with industry standards, and properly documented to ensure accountability.

Role of the Board in Compensation Oversight

A nonprofit’s board of directors plays a central role in reviewing and approving employee compensation, particularly for executive leadership positions. To prevent conflicts of interest, salary decisions should be made by independent board members who do not have a financial stake in the outcome. Many organizations establish a compensation committee to conduct thorough reviews of salaries, ensuring that payments remain appropriate and mission-aligned.

Formal approval of compensation should be recorded in board meeting minutes, creating an official record of how salary decisions are made. This documentation not only reinforces transparency but also helps nonprofits demonstrate compliance in the event of an IRS audit.

Using Reliable Data for Salary Benchmarking

Nonprofits should set salaries based on comparative data from organizations of similar size and scope. Relying on industry benchmarks ensures that compensation remains reasonable and within legal guidelines. Several resources provide valuable data for salary comparisons, including:

• The Bureau of Labor Statistics (BLS): Provides national wage data across various job sectors, including nonprofit roles.
• Guidestar (Candid), The NonProfit Times, and the National Council of Nonprofits: Offer comprehensive salary surveys tailored to the nonprofit sector.
• IRS Form 990: Larger nonprofits publicly disclose executive compensation in their annual tax filings, allowing other organizations to compare salaries within similar operational budgets.

A written salary policy outlining the methodology for determining compensation can serve as a valuable internal guideline for future decisions, ensuring consistency and fairness across all positions.

Preventing Excessive Salaries and Compliance Issues

The IRS prohibits excessive compensation, which is defined as salaries significantly above industry standards or payments that provide undue private benefits. If a nonprofit’s salaries deviate from typical nonprofit pay scales, the organization must document a clear justification, such as:

• Additional responsibilities assigned to the role
• Management of a larger operating budget
• Expansion of programs and services requiring greater expertise

Failure to justify compensation appropriately can result in IRS scrutiny. If the IRS determines that salaries are excessive, the organization may face penalties, including intermediate sanctions such as fines for both the nonprofit and the recipient of the overpayment. Repeated violations could put the organization’s tax-exempt status at risk.

Ensuring Public Accountability and Financial Stability

Public disclosure of executive salaries helps maintain transparency and trust with donors, stakeholders, and the IRS. Form 990, the annual tax filing required for federal tax exemption for most 501(c)(3) organizations, publicly reports executive compensation. If salaries appear excessive, the IRS may impose fines or, in extreme cases, revoke tax-exempt status.

A nonprofit’s budget must balance fair compensation with mission-driven initiatives to ensure long-term sustainability. Salaries should reflect the organization’s financial health without compromising services, and operating expenses should be factored into financial planning. Responsible fundraising strategies help maintain program effectiveness while supporting staff compensation.

Donors and grant providers expect responsible financial management from religious organizations, making salary transparency a key factor in building trust. Compensation should align with the organization’s goals, regulatory compliance, and long-term stability, allowing nonprofits to develop a dedicated workforce while effectively fulfilling their mission.

Nonprofits Can Pay Employees—Chisholm Law Helps You Do It Right

501(c)(3) organizations have the legal right to compensate employees while maintaining their tax-exempt status, but they must do so within IRS guidelines. Myths suggesting that nonprofits must operate entirely with volunteers or that paying employees jeopardizes tax exemption create unnecessary confusion.

In reality, fair compensation is essential for attracting and retaining skilled professionals who can manage operations, secure funding, and ensure compliance with nonprofit regulations. By implementing transparent salary structures, benchmarking compensation against industry standards, and maintaining thorough documentation, nonprofits can offer competitive pay while upholding their mission.

At Chisholm Law, we can help your 501(c)(3) organization navigate legal and financial complexities to ensure compliance while supporting your workforce. If your nonprofit needs guidance on structuring compensation, maintaining tax-exempt status, or ensuring financial transparency, we’re here to assist. Contact us today to safeguard your organization’s future while compensating employees in a way that aligns with legal requirements and nonprofit best practices.

*Past results do not determine future outcomes