Are Churches Exempt from State Unemployment Taxes?

Churches are exempt from state unemployment taxes. Federal law lets states leave church employment out of their unemployment insurance systems, and every state does. The exemption also reaches organizations operated primarily for religious purposes under a church’s control, along with religious elementary and secondary schools. The tradeoff is real: employees of an exempt church cannot collect state unemployment benefits if they lose their jobs, unless the church has voluntarily opted into coverage.

Why the Exemption Is the Same in Every State

The Federal Unemployment Tax Act pulls church employment out of the system in two steps. Services performed for any 501(c)(3) organization are excluded from FUTA’s definition of “employment.”¹ Section 3309(a) then requires states to extend unemployment coverage to most nonprofit employers as a condition of the FUTA tax credit, but Section 3309(b) explicitly exempts churches and certain church-related entities from that requirement.²

States conform because they have to. Employers receive a federal tax credit of up to 5.4 percent for contributions paid into a state fund, but only if the state’s unemployment law has been certified as meeting federal requirements.³ A state that tried to tax church employment would put its employers’ credit at risk. So the church exemption is effectively uniform nationwide.

Which Church Entities Are Covered

Section 3309(b)(1) creates three categories of exempt employers.

The first is the church itself, meaning a church, a convention of churches, or an association of churches. The Supreme Court held in St. Martin Evangelical Lutheran Church v. South Dakota that “church” refers to the congregation or hierarchy that hires and directs employees, not just the building. Schools and other operations without a separate legal existence from the church fall under this exemption as well.⁴

The second category is organizations operated primarily for religious purposes and operated, supervised, controlled, or principally supported by a church. The key word is “primarily.” Day-to-day operations must be religious in nature, not educational, medical, or charitable work with a religious flavor.²

The third is religious elementary and secondary schools. A K-12 school operated primarily for religious purposes, recognized as a 501(c)(3), and exempt from income tax qualifies even when it is separately incorporated from its sponsoring church.²

The Internal Revenue Code uses the word “church” without defining it. The IRS instead applies a list of characteristics drawn from agency practice and court decisions, including a distinct legal existence, a recognized creed and form of worship, a formal code of doctrine, ordained ministers, established places of worship with regular congregations, and programs of religious instruction. No single factor decides the question; the agency looks at the combination.⁵ Christian churches, synagogues, mosques, and temples all fit within this framework.

What the Exemption Does Not Cover

The line between “exempt church entity” and “taxable nonprofit with religious ties” catches more organizations than most people expect.

Religiously oriented organizations that lack affiliation with a particular church do not qualify. The Department of Labor has taken the position that these nonaffiliated entities must be covered under state unemployment law, and states that fail to cover them risk their FUTA certification.⁶ A faith-based hospital, nursing home, or social service agency that operates independently of any church falls into this bucket, even if its mission is deeply religious.

Church-affiliated entities whose primary purpose is something other than religion also lose the exemption. A separately incorporated hospital run by a denomination serves a medical purpose first. A church-linked daycare focused on childcare rather than religious instruction has the same problem. The same goes for a separately incorporated thrift store, a coffee shop open to the public, or a community health clinic operated by a congregation: workers in those operations may be covered even when the church’s own staff is exempt. The test is always whether the operation is primarily religious or primarily something else that happens to be run by religious people.

Getting this wrong is expensive. When a state determines that a church-related entity should have been participating in unemployment insurance, it can assess back taxes, interest, and penalties, and those numbers add up quickly when applied per worker over multiple years.

What the Exemption Means for Employees

The exemption belongs to the employer, and this is where it hurts. When a church is exempt and has not elected coverage, its workers cannot file for state unemployment benefits if they are laid off or terminated. There is no federal backstop and no alternate program. A church secretary let go after fifteen years has no unemployment claim to file.

Anyone taking a job at a church should understand that unemployment insurance is not part of the compensation package by default. Ask whether the church has elected coverage. If it hasn’t, that safety net is not there.

How a Church Can Opt In

Exempt churches and church-controlled organizations can voluntarily join their state’s unemployment insurance system. Most states allow employers to elect coverage for employment categories that would otherwise be excluded.⁷ Once a church elects coverage, its employees become eligible for benefits under the same rules that apply to any other worker in the state.

Federal law requires states to give nonprofit organizations a choice between two financing methods: paying regular unemployment taxes like any employer, or reimbursing the state dollar-for-dollar for benefits actually paid to former employees.⁷ For churches that opt in voluntarily rather than being required to participate, states have flexibility in how they handle the choice. Some let the church pick; some require one method or the other.⁸

The Contributory Method

The church pays quarterly unemployment taxes on its payroll, just like a for-profit employer. Rates vary by state and are influenced by claims history. New employer rates across states range roughly from 1 percent to over 10 percent of taxable wages. Costs are predictable, but the church pays even in years when no former employee files a claim.

The Reimbursable Method

The church pays nothing upfront and instead reimburses the state for the actual dollar amount of any benefits paid to its former employees. This saves money in years with few claims, but a single high-cost layoff can produce a large, immediate bill. Some states require reimbursable employers to post a surety bond or security deposit.

The reimbursable method suits churches with stable staffing and low turnover. The contributory method makes more sense where employment fluctuates or cash reserves are thin. Some states lock employers into the reimbursable method for a set period once they choose it, and liability for benefits can extend for years after a church switches away from it. Opting in is not a decision to reverse casually, so review the state’s rules and talk to a professional familiar with nonprofit employment law before electing either method.

1
Office of the Law Revision Counsel. 26 U.S. Code 3306 – Definitions
2
Office of the Law Revision Counsel. 26 USC 3309: State Law Coverage of Services Performed for Nonprofit Organizations or Governmental Entities
3
Department of Labor (Doleta). Conformity Requirements for State UC Laws – FUTA Tax Credit System
4
Library of Congress. St. Martin Lutheran Church v. South Dakota, 451 U.S. 772 (1981)
5
Internal Revenue Service. Definition of Church
6
U.S. Department of Labor. Unemployment Insurance Program Letter No. 28-87
7
Department of Labor (Doleta). Unemployment Insurance: Chapter 1 Coverage – Section: Voluntary Coverage of Excluded Employment
8
U.S. Department of Labor. Nonprofit Organizations Not Required by Federal Law to Be Covered