What is FUTA?
According to the Department of Labor, the Federal Unemployment Tax Act (FUTA) authorizes the IRS to collect a Federal employer tax used to fund state workforce agencies which cover the cots of administering Unemployment Insurance and Job Service programs in all states. Employers pay this tax annually by filing IRS Form 940. FUTA also pays ½ of the cost of extended unemployment benefits during periods of high unemployment, and provides funds that states may borrow from, if necessary, to pay unemployment benefits.
Why is the FUTA Tax Credit Reduced?
To reward states that repay their FUTA loans, the federal government established a FUTA tax credit that lessens the amount of interest paid when a state consistently repays their loans on time.
If, however, a state has an outstanding loan balance on January 1st of two consecutive years and has not repaid the required amount by November 10th of the second year, employers in that state risk losing a portion of their FUTA tax credit for that year. Each year the payment remains outstanding beyond the second year of the loan, the state credit is reduced by 0.30%.
For instance, in the first year of the state FUTA tax credit loss, the effective FUTA tax rate increases from 0.6% to 0.9%. If the state continued to have an outstanding loan balance in the third year of the loan, the tax rate would again increase by 0.3%, making the effective FUTA tax rate for that year 1.2%.
How does a FUTA credit reduction affect employers in these states?
The result of being an employer in a credit reduction state is a higher tax due on the Form 940.
For example, an employer in a state with a credit reduction of 0.3% would compute its FUTA tax by reducing the 6.0% FUTA tax rate by a FUTA credit of only 5.1% (the standard 5.4% credit minus the 0.3% credit reduction) for an effective FUTA tax rate of 0.9% for the year.
Any increased FUTA tax liability due to a credit reduction is considered incurred in the fourth quarter and is due by January 31 of the following year.
Employers who think they may be in a credit reduction state should plan accordingly for the lower credit. The IRS includes the credit reduction states, the applicable credit reduction rates, and an example in the Schedule A (Form 940) (PDF), Multi-State Employer and Credit Reduction Information. The Instructions for Form 940 (PDF) also has information about the credit reduction and deposit rules.
Based on the statutory Title XII loan repayment requirements, the states listed below with rates listed in the “Actual” column did not repay their outstanding Title XII loan balance by November 10, 2012. Employers in each of these states will lose a portion of their FUTA tax credit on the 2012 Federal 940 which will result in a higher effective FUTA tax rate as indicated for all employment in that state. The rates listed in the “Potential” column for 2013 and 2014 are projected under the assumption that the Title XII loans on those states will not be repaid by November 10th of the column year.
|State||Effective FUTA Tax Rate|
*The state of South Carolina expects to be able to make loan payments large enough to qualify for credit reduction exemptions in 2012, 2013, and 2014. If the payments are made by November 10th of the applicable years and the USDOL approves, the FUTA effective rate will be reduced to 0.6% again.
**The Virgin Islands have a regular FUTA credit reduction of 0.6% for this year because of its passing 3 consecutive January 1st and not repaying by November 10th. An additional 0.9% was also tacked on because of the 2.7 add-on provision which is triggered when the state’s tax effort as a percentage of total wages falls below levels calculated by the USDOL. In this case, the Virgin Islands percentage of total wages was 0.23% of total wages when 0.39% was needed to avoid the additional penalty. This penalty brings the 2012 effective FUTA tax rate to 2.10%.