Everything You Need to Know About the FUTA Tax

Posted 5 years ago in Taxes
by Tim Chaves

Whether you’re a new business owner or you’ve been around for a while, you need to know the ins and outs of the FUTA tax.

You’ve likely got tons of questions: What is the the FUTA tax? Why do I need to pay it? What does it support? How much is it?

Here’s everything you need to know about the Federal Unemployment Tax Act—and trust me, you need to know it. As someone with employees, understanding the FUTA tax ensures that you’re compliant with the IRS

What is the FUTA Tax?

The Federal Unemployment Tax Act (FUTA) is an act that imposes an unemployment tax on employers. Employers submit FUTA payments quarterly and report these taxes on IRS form 940. Typically, the rate is 6% of the first $7,000 paid in wages (per employee).

The FUTA tax funds the federal government’s oversight of each state’s unemployment program

This act was implemented in 1939 by Franklin D. Roosevelt, after the effects of the great depression. Because of the economic downturn, many people were unemployed and had absolutely no protection once they were let go. The government wanted to make sure that people who were involuntarily unemployed had the right to a temporary and partial wage replacement. The purpose of this tax was to decrease the need for welfare and promote purchasing power to keep the economy on the rise. The FUTA tax—deemed helpful and successful throughout the 1900s—is what businesses pay today.

Who has to pay the FUTA tax and how do I know if I qualify?

Employers are the only people who have to pay the FUTA tax.

It’s fairly easy to figure out if you are obligated to pay. In fact, to see if you qualify, you can take a look at these tests below: the general test, the household employees test, and the farmworkers test. If it turns out that the tests below describe your business, you will pay Federal Unemployment Tax.

General test (this doesn’t apply to farmworkers or household workers):

  • If you paid wages of $1,500 or more to employees during any calendar quarter in 2018 or 2019.
  • If you had one or more employees for at least some part of a day in any 20 or more different weeks in 2018 or 2019 (full-time, part-time, and temporary employees count)

Household employees test:

  • You’re subject to the FUTA Tax if you paid cash wages of $1,000 or more to any household employees in any calendar quarter in 2018 or 2019. (A “household employee” is defined as anyone who works in a private home, local college club, or local fraternity or sorority.) 

Farmworkers test:

  • If you paid cash wages of $20,000 or more to farmworkers during any calendar quarter in 2018 or 2019.
  • If you employed 10 or more farmworkers during some part of the day (whether or not at the same time) during any or more different weeks in 2018 or 2019.

Is anyone exempt from paying the tax?

Although most employers pay the tax, there are a few exempt businesses and organizations:

  • Indian tribes: As of December 21, 2000, Indian tribes are not required to file form 940 (FUTA Tax form). Tribal employers are exempt unless the tribe chooses not to participate in the state unemployment system.
  • Tax-Exempt organizations: Religious, scientific, charitable, educational, and other organizations described in section 501(c)(3).
  • Employers of state or local governments: Services delivered by employees of a state or political subdivision.

What is the FUTA tax rate?

The FUTA tax rate is 6.0% and applies to the first $7,000 you paid to each employee during the year.

If you break this down, this means that you will only pay a maximum of $420 per employee. Additionally, there is a chance that you can receive a credit up to 5.4%, which can reduce your tax rate to 0.6%. Some employers even receive additional credit if they have a state experience rate lower than 5.4%.

Overall, it’s important to make contributions to your state unemployment fund by the due date so your rates stay as low as possible, which in turn saves your business money. 

Note: the 6.0% tax rate can change if you are in a credit reduction state. If you are in a credit reduction state, you will have different credit standards. 

How does a state qualify as a credit reduction state?

When states cannot afford to pay unemployment benefits for their residents, they will often take out a Federal Unemployment Trust Fund Loan with the federal government. A state becomes a credit reduction state when they have an outstanding loan balance with the federal government. Essentially, if a state isn’t able to repay its unemployment benefit loans, they are considered a credit reduction state.

The IRS gives specific reporting instructions for calculating the credit reduction on Form 940 to make the application process easier.  

Does this credit reduction affect an employer’s taxes?

Yes, it unfortunately does affect employers’ taxes. The state will require employers to provide more compensation on Form 940 to help pay the difference until the state eventually pays back the loan.

Generally speaking, employers may receive a credit of 5.4% when they file Form 940; however, if you are in a credit reduction state, your credit will be altered to a lower percentage on a specific schedule. According to the IRS, the reduction schedule is 0.3% for the first year, another 0.3% for the second year, and an additional 0.3% for each year that the loan is not paid. Additional credit reductions may apply in later years if the loan is still outstanding and criteria isn’t met.

So, what does this mean for you? Well, your credit will be reduced. This means that your maximum credit will not be 5.4%, it will reduce to a different percentage based on the longevity of your state’s loan. For example, let’s say that your current credit is 5.4% and your state decreases credit by 0.3%, you would simply subtract 0.3 from 5.4 and you will end up with a 5.1% credit.

When do I deposit my FUTA tax?

Employers are required to use the Electronic Federal Tax Payment System to make all federal deposits. Form 940 covers a calendar year, but you may have to deposit your FUTA tax before filing your return. If you have FUTA tax liabilities, you need to make deposits on a quarterly basis and file Form 940. According to the IRS, if your FUTA tax is more than $500 for the calendar year, you must deposit at least one quarterly payment. 

You need to deposit your taxes by the last day of the month after the end of the quarter. If the due date lands on a weekend or a legal holiday, you will make your deposit on the next available business day. Here’s an easier way to look at it:

If your undeposited FUTA tax is more than $500 on:Deposit your tax by:
March 31April 30
June 30July 31
September 30October 31
December 30January 31

How do I report my FUTA taxes?

The IRS makes it easy to submit your FUTA Tax return. Simply fill out Form 940 (following the instructions provided if needed). The IRS requires employers to mail Form 940 to specific locations, depending on what state you reside. Go here to check out your state’s official FUTA mailing address.

The due date for filing Form 940 is January 31st; however, if you deposited all FUTA tax deposits when they were due, you have until February 10th.

Anything else?

Federal Unemployment Taxes aren’t the only payroll taxes you’ll be responsible to pay. Most businesses are required to submit State Unemployment Taxes as well (according to your state’s SUTA). SUTA rates can range from 0.05% to 14% so be sure to check your state’s current policy (similar exemptions apply). 

You can keep both FUTA and SUTA tax rates low by filing on time, minimizing turnover, and responding to unemployments claims. Whenever possible, it can help to consult payroll or tax experts. Good luck!

About Tim

Tim is Founder and CEO of ZipBooks. He keeps his desk really nice and neat.

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