FUTA Credit Reduction: What Is It and Credit Reduction States

Businesses of all sizes face countless tax concerns, with the Federal Unemployment Tax Act (FUTA) being one such consideration. Employers must contribute to FUTA to alleviate the state’s financial burdens regarding reemployment assistance.

One aspect of FUTA that can affect your business is the FUTA credit reduction, which comes into play when a state has unpaid federal loans. This can result in higher FUTA taxes for employers in those states.

Here’s what business owners need to know about the FUTA credit reduction and how Mosey can help manage state compliance.

What Is FUTA?

The Federal Unemployment Tax Act (FUTA) was created to help fund unemployment compensation programs for workers who lose their jobs. It ensures that states have sufficient funds to pay unemployment benefits. FUTA is different from other payroll taxes like Social Security and Medicare, as it is only paid by employers, not employees.

The tax collected from employers through FUTA goes into a federal trust fund, which provides financial assistance to state unemployment insurance programs. If a state’s unemployment fund runs low, the state can borrow money from the federal government to cover unemployment claims.

However, if the state does not repay the loans in a timely manner, employers in that state may face a FUTA credit reduction.

Who Pays FUTA Tax?

All businesses that meet specific criteria are required to pay FUTA taxes.

According to the Internal Revenue Service (IRS), businesses must pay FUTA tax if they meet at least one of the following employee tests:

General Test: Employers must pay FUTA taxes if they paid wages of $1,500 or more to any employee during a calendar quarter in the year.
Household Employee Test: Individuals or businesses who paid $1,000 or more in cash wages to household employees (such as nannies or gardeners) during any quarter.
Farmworker Test: Agricultural businesses that paid $20,000 or more in wages to farmworkers in any quarter or employed 10 or more farmworkers for part of a day across 20 weeks of the year.

Nonprofit organizations with 501(c)(3) status are generally exempt from paying FUTA taxes, even if they must pay other payroll taxes like Social Security and Medicare.

If you operate a nonprofit, it’s best to consult with a local nonprofit tax professional regarding compliance issues specific to your organization.

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How Does FUTA Work?

The standard FUTA tax rate is 6% on the first $7,000 of wages paid to each employee annually. That means the maximum FUTA tax an employer would pay for an employee earning at least $7,000 is $420. However, most employers qualify for a tax credit of up to 5.4% if they pay their state unemployment taxes on time, effectively reducing the FUTA tax rate to 0.6%.

For example, if an employer qualifies for the 5.4% credit, they would only owe $42 in FUTA tax per employee per year (0.6% of $7,000). Still, there’s one exception. Employers in California and New York have approximately twice the FUTA liability, coming in at about $84 per employee.

What Is a FUTA Credit Reduction?

A FUTA credit reduction occurs when a state or territory borrows money from the federal government to cover unemployment benefits and does not repay the loan by the deadline. The federal government penalizes these states by reducing the tax credit employers can claim, which increases the amount of FUTA tax they owe.

For instance, if a state has not repaid its loan within two years, employers in that state may face a credit reduction of 0.3%. Each additional year the loan remains unpaid increases the credit reduction by another 0.3%, totaling 0.6%. This reduction raises the FUTA tax rate for employers in the affected state, costing them more in federal unemployment taxes.

What Are the FUTA Credit Reduction States?

Credit reduction states can change yearly depending on each state’s ability to meet FUTA obligations or repay unemployment loans. As of 2024, the credit reduction states include:

California
New York
Connecticut
U.S. Virgin Islands (USVI)

These states and territories did not repay their outstanding loans by the required deadline, so employers in these regions are subject to a credit reduction for 2024.

Here’s what the credit reduction looks like for these states:

California, New York, and Connecticut: Employers face a 0.9% credit reduction.
USVI: Employers face a 3.9% credit reduction (since the USVI has had outstanding loans for several years).

These states have outstanding loans that have not been repaid by the November deadline and are experiencing an increase (at 0.3% per year) for each year of loans that have not been repaid. For employers in these regions, this increases the amount of FUTA taxes they owe for each employee.

Other states have previously faced credit reductions in past years, but they managed to repay their loans before the deadlines in 2023. For example, states like Illinois avoided a credit reduction in previous years by making timely repayments.

How Do Credit Reductions Affect Businesses?

If your business is located in a credit reduction state, you’ll have to pay more in FUTA taxes. This can increase your overall payroll expenses, which may affect your budgeting and financial planning. For businesses with a large number of employees, these additional costs can add up quickly.

Additionally, credit reduction states may indicate broader economic challenges, such as high unemployment rates or insufficient state funding for unemployment benefits. This can signal a higher tax burden for employers in the affected regions.

What Can Employers Do To Plan Ahead?

If you’re a business owner or HR professional in a credit reduction state, it’s important to stay informed about the status of your state’s federal loans and repayment plans. By understanding the potential for credit reductions, you can better prepare for increased tax liabilities.

Keep an eye on the financial health of your state’s unemployment trust fund and whether it repays its federal loans on time. Budget for potential increases in FUTA taxes, especially if your state has outstanding loans.

If you’re unsure how credit reductions will affect your business, consider working with a tax professional to plan for the additional costs and ensure compliance with tax filing deadlines.

How To Pay FUTA Taxes

FUTA taxes are paid quarterly and can be deposited through the Electronic Federal Tax Payment System (EFTPS), an electronic payment system managed by the U.S. Department of the Treasury.

Employers must deposit FUTA taxes by the end of the month following each quarter unless the total FUTA tax owed for that quarter is $500 or less. In that case, the employer can roll over the amount to the next quarter.

The deadlines are:

Q1 (January - March): Deposit by April 30
Q2 (April - June): Deposit by July 31
Q3 (July - September): Deposit by Oct. 31
Q4 (October - December): Deposit by Jan. 31

At the end of the year, employers must file Form 940 to report their annual FUTA tax liability. This form is due by Jan. 31 of the following year. Even if you paid your FUTA taxes quarterly, you still need to file Form 940 to show that your business has fulfilled its obligations.

Stay Compliant With Mosey

The FUTA credit reduction is an important consideration for businesses operating in impacted states. If your business is located in a credit reduction state, you’ll face higher FUTA tax rates, which can increase your overall payroll costs. By staying informed and planning ahead, you can ensure that your business remains compliant with federal tax obligations and avoids penalties.

Mosey’s compliance management system is designed to help business owners keep track of state and local compliance requirements, including determining your tax liability. Schedule a demo with Mosey to learn how we can help you track key compliance issues that impact your business and stay on top of your requirements.

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