What is the Federal Unemployment Tax Act (FUTA)?

Posted at April 2, 2020 » By : » Categories : Accounting, Payroll, & Taxes »
federal unemployment tax

You think that you are operating your business by the book, but then you receive a notice from the government that you failed to pay taxes required by the Federal Unemployment Tax Act. You’ve never heard of the Federal Unemployment Tax Act, so how would you know that you weren’t in compliance with it?

What is it? Why do you have to pay it? And when is it due? These and a dozen other business questions race through your mind.

Relax. All is not lost. You can quickly learn all you need to know about federal unemployment tax and how to keep your business in good standing with the government.

We’ll walk you through the basics. By the end, you’ll understand how to calculate your tax liability and how and when to pay it.

What is the Federal Unemployment Tax Act and What is FUTA?

FUTA is the abbreviation for the Federal Unemployment Tax Act. The Tax Act is a provision that gives the United States government legal authority to collect taxes from businesses with employees.

The government uses the revenue to help fund state unemployment agencies through the Federal Unemployment Trust Fund. In turn, the state agencies pay out-of-work people who qualify for unemployment insurance.

How Often is the Federal Unemployment Tax Due and Who Pays It?

Employers pay the tax either quarterly or annually. FUTA revenue is a payroll tax, but the name can be a bit misleading. Unlike Social Security tax, the federal unemployment tax doesn’t come from an employee but the employer. The government refers to it as a payroll tax because it bases the amount due upon a worker’s income.

How Do You Calculate the Federal Unemployment Tax Rate?

The typical federal unemployment tax rate is 6% of the first $7,000 that the employer pays to the employee.

So, if an employee earned $7,000, his employer would pay $420 ($7,000 x 0.06). However, if a worker earned $70,000, his employer would still owe only 6% of the worker’s first $7,000, which again equals $420.

Of course, if an employee made less than $7,000, his employer would pay less than $420. Suppose a worker earned $3000. His employer would pay $180 in federal unemployment tax ($3000 x 0.06).

Which Businesses Have to Abide By the Federal Unemployment Tax Act?

Businesses are required to pay federal unemployment tax if they paid their employees $1,500 or more within a calendar quarter during the calendar year. Employers report the tax amount during the year’s first calendar quarter on the Internal Revenue Service (IRS) Form 940 (Employers Annual Federal. Unemployment Tax Return). Calendar quarters are the following:

  • First quarter: January, February, and March
  • Second quarter: April, May, and June
  • Third quarter: July, August, and September
  • Fourth quarter: October, November, and December

Employers must also pay if they maintained an employee for 20 weeks or more during the calendar year. The rule applies whether the employees are full-time or part-time workers.

Do All Employers Have to Pay the Federal Unemployment Tax on Employees?

Employers do not pay taxes on the salaries of some workers. For example, family-operated businesses receive special consideration. Employers don’t pay federal unemployment taxes on the income of their spouses, children younger than 21, and parents.

Businesses that use only independent contractors are exempt. Nonprofit groups and recognized religious organizations are also usually exempt from paying this tax. But it’s a wise idea to verify your status with your particular state tax agency or with your accountant.

Is There a Way to Lower the Federal Unemployment Tax Rate?

If a business operates in a state that requires it to pay state unemployment tax, it may be in line for a considerable discount on its federal tax obligation. Employers can receive a tax credit of as much as 5.4%, which means that they would only be responsible for paying a FUTA rate of 0.6% rather than the standard 6%.

So, if an employee made $70,000, his employer would no longer have to pay $420 ($70,000 x 0.06). With the discounted rate, his federal unemployment tax bill for that employee would only amount to $42 ($70,000 x 0.006).

The maximum tax credit is not available in states that have a balance remaining on a loan from the Federal Unemployment Trust Fund. A state can apply for an advance if it needs help paying unemployment insurance benefits. However, the loan can only carry a balance for two years without impacting the tax credit.

Know if Your State is a Credit Reduction State

If a state has a loan balance at the start of the calendar year that remains until the beginning of the second year, the state must pay off the loan by November 10 of the second year. If not, the available FUTA tax credit will become less, and the state is designated a credit reduction state.

The credit will continue to shrink each additional year that the balance remains. The available credit reduces by 0.3% for each year until the state pays the outstanding balance. But additional penalties may be added during year three and year five.

After year three, the federal government could slap the state with a credit reduction called the 2.7 add-on. And in the fifth year, the state could be subjected to a Benefit Cost Rate formula which further reduces the available credit.

From 2009 to 2019, 42 different states or U.S. territories have received at least one year for the designation of a credit reduction state. However, the U.S. Virgin Islands is the only territory that entered 2020 with a longstanding federal loan balance.

How Do I Know if My State is a Credit Reduction State?

To verify whether your state or U.S. territory is in arrears, visit the website of the U.S. Department of Labor (DOL). The DOL publishes the names of credit reduction states each year after the November 10 deadline.

It also lists any states and U.S. territories that stand on the verge of receiving the status of credit reduction states, meaning that they have crucial balances to pay before the current year’s November 10 deadline.

What Effect Will Doing Business in a Credit Reduction State Have on My Company?

The penalties imposed on employers in a credit reduction state mean that employers can’t hope to qualify for the full FUTA discount tax rate. Let’s see what this does to the federal unemployment tax on our fictional employee earning $70,000.

Remember, if the state did not owe the federal government, the employer might qualify for the full FUTA discount of 5.4% So, instead of paying the standard federal unemployment tax rate of 6% of the employees first $7,000 ($420), he would pay only 0.6% ($42). But, if his state is in arrears, and receives a penalty reduction of its tax credit, the employer would have to pay more than $42.

Let’s say the state is in its first year of being a credit reduction state. The federal government removes 0.3% from the tax credit. Therefore, instead of getting a discount of 5.4%, the best a business could hope for is a 5.1% tax credit (5.4% -0.3%).

An employer would then have to pay 0.9% (6% -5.1%) of the first $7,000 that his worker earned. In this case, that would be $63 ($7,000 x 0.009).

Here’s a look at how doing business in a credit reduction state for three consecutive years could affect your federal unemployment tax even without the additional year three penalty taken into consideration.

  • Typical year: Instead of paying a 6% FUTA tax, a business pays only 0.6%, receiving a maximum discount of 5.4%
  • 1st Year: A business pays 0.9%, receiving a maximum discount of 5.1%
  • 2nd Year: A business pays 1.2%, receiving a maximum discount of 4.8%
  • 3rd Year: A business pays 1.5%, receiving a maximum discount of 4.5%

When Do I File My Federal Unemployment Tax Form?

Employers must file their Form 940 by January 31. If January 31 occurs on a weekend or a legal holiday recognized by the District of Columbia, the form is due on the next business day. If you are up-to-date on your FUTA payments, you don’t have to file Form 940 until February 10.

When Do I Pay My FUTA Taxes?

Some employers will pay their federal unemployment tax annually, but most will have to pay quarterly. If your FUTA tax liability for an entire year is less than $500, you can choose to wait until the filing deadline of January 31 to make your deposit. However, if your FUTA tax liability exceeds $500 for the year, you have to make at least one quarterly payment.

If you owe $500 or less of federal unemployment tax during a quarter, you don’t pay for that quarter, but you carry the amount into the next quarter. You continue to carry the amount into each succeeding quarter until your tax liability finally surpasses $500.

You then pay the calculated amount of FUTA tax by the last day of the month following the end of the quarter. Your payment schedule would resemble the following:

  • January, February, and March (first quarter) tax deposit is due on April 30
  • April, May, and June (second quarter) tax deposit is due on July 31
  • July, August, and September (third quarter) tax deposit is due on October 31
  • October, November, and December (fourth quarter) tax deposit is due on January 31

If your payment is greater than $500, the IRS requires you to send your payment by electronic funds transfer. You can use the free Electronic Federal Tax Payment System (EFTPS) offered by the U.S. Department of the Treasury.

To increase the chance that your payment arrives on time, the EFTPS advises scheduling your payment no later than 8:00 PM the evening before your due date.

You Don’t Have to Tackle the Federal Unemployment Tax Act Alone

Now you know the answer to the question: What is FUTA? You also now understand that paying the federal unemployment tax is one of the requirements of being an employer.

However, handling payroll responsibilities and financing may not be one of your favorite aspects of running your business. You’re not alone. Many other business owners have chosen to use experienced experts like Your FundingTree to take care of such matters.

If you want to focus on other areas of running a business and leave matters related to the Federal Unemployment Tax Act to someone else, consider us. Contact us today and discover how more enjoyable it is running your company when there’s someone else taking care of calculating your federal unemployment tax rate.