The Federal Unemployment Tax Act (FUTA) is legislation that was passed in 1939 and designed to help individual states pay for unemployment benefits for workers who have been terminated and meet necessary qualifications. The tax is paid by the employer and remitted to the federal government. It is separate and in addition to any state unemployment insurance an employer owes.
FUTA taxes have varied over time but for the current calendar year, 2022, the basic FUTA rate is 6%. When employers pay their state unemployment taxes, they are automatically eligible to receive a credit of up to 5.4% (depending on their state unemployment tax rate) against the basic FUTA tax rate of 6%. This means that the effective FUTA tax rate most businesses will see is much lower than the basic rate, or as low as 0.6%. FUTA taxes are based on employee payroll and are remitted on a wage base of up to $7,000 annually.
These calculations can get complicated, especially as businesses grow or operate with employees in multiple states. At Justworks, we handle the filing of unemployment taxes associated with payroll for our customers.
In times of need, states are eligible to request loans from the federal Unemployment Trust Fund to help administer unemployment benefits when they have depleted their own state unemployment trust funds. A FUTA Credit Reduction occurs when a state has taken loans from the federal government to meet its state unemployment benefits liabilities and has not repaid these loans within the allowable time frame. If a state has outstanding loan balances on January 1 for two consecutive years and does not repay the full amount of its loans by November 10 of the second year, then the FUTA credit for employers in that state will be reduced until the loan is repaid.
Time frame to determine a FUTA credit reduction: Any state that took a loan in 2020 would become subject to a FUTA Credit Reduction in 2022 if those loans are not repaid by November 10, 2022. This rate is retroactive to January 1, 2022.
The level of the FUTA Credit Reduction is determined by the duration of the outstanding loan balance with the federal government. The longer a state has an outstanding balance the higher the credit reduction penalty is resulting in a higher overall FUTA tax rate for employers in that state.
During 2020, many states' unemployment programs experienced severe strains due to the historic level of unemployment claims caused by the COVID-19 pandemic. The resulting increase in unemployment benefits liabilities caused states to deplete their own reserve balances. In turn, many states requested and accepted loans from the federal government in order to maintain their ability to pay out unemployment benefits at the levels required during the pandemic.
COVID-19 is not the first instance of widespread state borrowing. In fact, many of the states that had previously borrowed funds from the federal Unemployment Trust Fund after the Great Recession had only recently repaid their loan balances. That being said, the Virgin Islands was the only territory that held an outstanding balance in 2020.
To put this all together, states that accepted new loans in 2020 would not be subject to a FUTA Credit Reduction unless their balances were still unpaid by 2022. Similarly, employers in these states would not see any impact to their effective FUTA tax rate until these credit reductions kicked in. This is beginning to happen now.
Currently there are nine states with outstanding balances. This means that employers in these states are now in a position where they will face a FUTA Credit Reduction and may pay a higher effective tax rate.
With 2022 being the first year of overdue state balances, the credit reduction for those states will be 0.3%. This will result in an net effective FUTA tax rate of 0.9% for employers in those states (vs the lowest possible of 0.6%).
Looking past 2022, depending on the overall size of a state’s loan from the Federal Unemployment Trust Fund and its broader financial decision making, outstanding balances can last for many years. This can result in yearly penalty increases to the FUTA Credit Reduction and therefore an effective FUTA tax rate that increases year over year for employers in those states. For example, after the Great Recession in 2009 there were 20 states that began to see FUTA Credit Reductions in 2011. Some of these states carried a balance with the federal government and a penalty status for years. California remained in that position up until 2017, which resulted in employers in the state facing a net effective FUTA tax rate of 2.7% that year.
Over the next several weeks, we will be communicating with customers operating in California, Colorado, Connecticut, Illinois, Massachusetts, Minnesota, New Jersey, New York, and Pennsylvania to explain how a FUTA Credit Reduction of 0.3% will impact them this year.
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