2022 has been a challenging year for businesses, which have faced stubbornly high inflation, economic uncertainty, and a tightening labor market. On top of it all, FUTA taxes are increasing in certain states, known as credit reduction states. If you do business in one of these states, your payroll taxes are about to go up. Here’s what you need to know.
What is FUTA?
FUTA stands for Federal Unemployment Tax Act, which created a program to financially support workers after they’ve been terminated. When a former worker files an unemployment insurance claim, they usually receive wage replacement pay from the state’s unemployment agency. This continues until the worker finds work or reaches the end of their qualification period.
Employers fund this program by paying a federal tax of 6% on each employee’s first $7,000 in wages. Earnings above that wage threshold aren’t taxed. There’s also a state unemployment tax, which varies in every state. Businesses that pay their state unemployment taxes on time typically earn a federal tax credit of 5.4%—effectively lowering the FUTA rate to 0.6%. Employers use Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, to report these details.
The FUTA tax is just one of the payroll taxes employers pay regularly. Some payroll taxes are split between employers and employees, but the FUTA tax is the employer’s full responsibility.
Why FUTA rates will likely rise in certain states
During the pandemic, unemployment claims soared across the U.S. and depleted state unemployment insurance funds. Many states borrowed money from the federal government to keep up with their claims, and some states haven’t repaid that money in the expected time frame–these states are known as credit reduction states. Employers in credit reduction states will likely pay higher FUTA taxes soon.
What’s a credit reduction state?
A credit reduction state is a state that borrowed money to pay their unemployment benefits—and then didn’t repay the loan within the allowable time frame. States have two years to repay the borrowed money. If a state has an outstanding balance on November 10 of the second year, it becomes a credit reduction state until the loan is repaid.
Sounds like a state government problem, right? Well, not entirely. The federal government can reduce the FUTA tax credit for employers in that state, which means employers wind up paying a higher FUTA tax rate–even those who pay on time.
The credit is reduced by:
- 0.3% for the first year
- another 0.3% for the second year
- an additional 0.3% for each year thereafter
States that are likely to see tax increases
FUTA credit reductions aren’t a new thing. But employers haven’t had to worry about them since 2017, before COVID-19 hit. Now that we’re two years past 2020—when a lot of states needed to borrow money to pay unemployment claims—several states may be impacted by the credit reduction.
Although the list of credit reduction states isn’t available yet, According to the U.S. Department of Labor, the following states and territories are potential credit reduction states in 2022:
*Minnesota, New Jersey, and Pennsylvania have each repaid their loan balances. Employers in these states will only be subject to a credit reduction if the state resumes borrowing and doesn’t repay the entire balance before November 10, 2022.
How does the credit reduction affect employment taxes?
If you own a business in a credit reduction state, you’ll likely owe more taxes when filing Form 940. The FUTA credit rate will be reduced by 0.3% each year until your state government repays the loan. In the meantime, you’ll pay a higher FUTA tax rate.
You can calculate the credit reduction using the Schedule A (Form 940), but take a look at this example:
Let’s say your business qualifies for the full FUTA tax credit (5.4%), but it will be reduced by 0.3% this year.
Subtract the credit reduction (0.3%) from your FUTA credit rate (5.4%):
5.4% – 0.3% = 5.1% – This is your reduced FUTA credit
Then, subtract your reduced FUTA credit (5.1%) from the standard FUTA tax rate (6%) to find your effective FUTA tax rate:
6% – 5.1% = 0.9% – This is your effective FUTA tax rate
Here’s how much extra you wind up paying per worker over the course of a year in payroll taxes:
|Tax rate applied to wage base||Amount paid per year on wage base of $7,000|
The max FUTA tax is $42 per year, per employee, when the entire credit is in place. It rises to $63 if your state becomes a FUTA credit reduction state in 2022. That extra $21 might not seem like much, but it can add up, especially if you have a lot of workers who hit the minimum wage base of $7,000.
On top of the increased FUTA tax, you may have to help your state pay for interest owed on their unpaid government loans. The state may charge businesses in the form of an assessment or surcharge.
Some states are picking up the tab, though. Connecticut, for instance, is a credit reduction state and owes about $1 million in interest on unemployment program loans. The state announced it won’t charge a special assessment on employers to pay for it. However, employers will still have their FUTA tax credit reduced by 0.3%.
When is FUTA due?
Some employers must deposit quarterly FUTA taxes while others deposit annually. If your FUTA tax liability increased because of a credit reduction, then it’s considered incurred in the fourth quarter and is due by January 31 of the following year. You’ll submit the payment, along with Form 940, by January 31 each year for the previous calendar year. But if you paid all your quarterly deposits on time, then you have until February 10 to file the form.
FUTA payroll taxes may soon rise for employers in nine states and one U.S. territory. Employers who think they may be in a credit reduction state should plan accordingly for the lower credit. Head to the IRS website for a list of current credit reduction states, the applicable credit reduction rates, and an example in the Instructions for Schedule A (Form 940). You’ll also find information about the credit reduction and deposit rules.