Be Aware of Federal Unemployment Tax Return (FUTA) Credit Reduction States

If your manufacturing business has employees, it means you are paying wages and filing the annual federal payroll tax return. But do you know what you are paying for with this tax return? If your business has payroll in any U.S. Department of Labor (DOL) Federal Unemployment Tax Act (FUTA) credit reduction states, you may be paying more than you signed up for.

What is FUTA and the Annual Federal Payroll Tax Return?

The Federal Unemployment Tax Act (FUTA) is a federal law that imposes a payroll tax on most employers. The money raised through FUTA is allocated to state unemployment insurance agencies, which fund unemployment benefits for individuals out of work.

Employers who pay more than $1,500 in wages to their employees during any calendar quarter in a year are required to file Form 940, also known as the Employer’s Annual Federal Unemployment Tax Return. This form must be filed by January 31 annually, and any federal unemployment tax owed must be paid at the time of filing. A company’s FUTA tax liability is relatively straightforward to calculate. The tax rate is 6.0% of the first $7,000 of wages paid to each employee. Any wages above that amount are not subject to FUTA. For example, if you have two employees, employee A and employee B, who make $15,000 and $6,000 annually, respectively, your total FUTA tax would be $780 ($7,000 of employee A’s wages plus $6,000 of employee B’s wages times 6.0%).

Wages paid to employees are also subject to state unemployment tax. As a result, employers can receive a credit against their FUTA rate, reducing federal unemployment tax liability. Generally, employers receive the maximum credit of 5.4% when they file their Form 940, which means their FUTA rate drops from 6.0% to 0.6%. Using the same scenario as the example above, the employer is now only liable for $78 of federal unemployment tax instead of $780 ($7,000 of employee A’s wages plus $6,000 of employee B’s wages times 0.6%).

What Is FUTA Credit Reduction, and How Do States End up on the List?

When a state borrows money from the federal government to help pay for the unemployment insurance benefits for workers in their state and has outstanding loan balances on January 1 for two consecutive years, the FUTA credit rate for employers in that state is reduced until the loan is repaid, unless the full amount of its loans is repaid by November 10 of the second year. The U.S. DOL determines credit reduction states annually. Additional offset credit reductions may apply if a loan balance is still outstanding and specific criteria are not met beginning with the third and fifth taxable years.

If My Company Has Payroll in a Credit Reduction State, How Will This Impact Me?

The first year a state is on the credit reduction list, the credit against FUTA wages will decrease by 0.3%. This means that you will have to pay 0.3% more in taxes. For each subsequent year that the state remains on the credit reduction list, the credit against FUTA wages will decrease by another 0.3%, raising the tax liability again. For instance, New York was added to the credit reduction list starting in 2022. Employers who paid FUTA wages in NYS had to pay 0.3% more taxes in their 2022 Form 940. In preliminary reports released by the U.S. DOL for 2023, NYS still remains on the list. If the state fails to pay their loan in full by November 10, 2023, employers with payroll in NYS will be subject to a 0.6% credit reduction on their 2023 Form 940.

If we use the same facts as the previous example and add that the employer pays all wages in NYS, the effects on unemployment tax would be the following:

• • Unemployment tax for no credit reduction state (FUTA rate = 0.6%) = $78
  • Unemployment tax for 1^st year in credit reduction state (FUTA rate = 0.9%) = $117
  • Unemployment tax for 2^nd year in credit reduction state (FUTA rate = 1.2%) = $156

It’s important to keep these credit reductions in mind while planning for any year-end expenses. Although the percentages may seem small, for manufacturers that have large amounts of FUTA wages, these credit reductions can result in significant amounts of extra expense.

Contributing author: Abby K. Sweers, CPA, is a tax manager with the firm. Abby is responsible for preparing and reviewing various individual and corporate tax engagements, including tax planning and compliance. She specializes in the manufacturing and construction industries, multi-state entities and high-net-worth individuals. For more information on this topic contact Abby at asweers@dmcpas.com.