FUTA

FUTA is the Federal Unemployment Tax Act, chapter 23 of the Internal Revenue Code, and by extension the tax that chapter imposes. Section 3301 provides: "There is hereby imposed on every employer (as defined in section 3306(a)) for each calendar year an excise tax, with respect to having individuals in his employ, equal to 6 percent of the total wages (as defined in section 3306(b)) paid by such employer during the calendar year with respect to employment (as defined in section 3306(c))." Section 3306(b)(1) then excludes from "wages" everything paid to an individual after the first $7,000 in the year. FUTA is the federal half of the unemployment insurance system's financing; the states impose their own unemployment taxes, and the federal tax is designed around a credit for paying them.

The interaction between the federal tax and the state taxes is the mechanism, and it runs through section 3302. Subsection (a) lets an employer credit against the FUTA tax "the amount of contributions paid by him into an unemployment fund maintained during the taxable year under the unemployment compensation law of a State," and subsection (b) adds an "additional credit" so that an employer whose state charges it a reduced experience rate is not penalized federally for the state's generosity. Subsection (c)(1) then caps the total: "The total credits allowed to a taxpayer under this section shall not exceed 90 percent of the tax against which such credits are allowable." Ninety percent of 6 percent is 5.4 percentage points, which is why every employer's guide quotes a 5.4 percent credit and a 0.6 percent net. The IRS puts it this way: "If you're entitled to the maximum 5.4% credit, the FUTA tax rate after credit is 0.6%," and it conditions the full credit on having paid the state tax in full, by the Form 940 due date, on the same wages that are subject to FUTA, in a state that is not a credit reduction state. Contributions paid late earn a credit of only 90 percent of what they would otherwise have earned.

The credit reduction is the part that changes from year to year, and it is deliberately not fixed here. When a state's unemployment fund runs dry, it can borrow from the federal government under Title XII of the Social Security Act. Section 3302(c)(2) provides that employers in a state that still has a balance of those advances "as of the beginning" of two consecutive January firsts lose part of the credit: in the second consecutive year, by "5 percent of the tax imposed by section 3301" on the wages attributable to that state, and by an additional 5 percent of the tax for each further consecutive year, with steeper add-ons possible from the third and fifth years. Five percent of a 6 percent tax is 0.3 percentage points of wages, so a first-year credit reduction raises the net federal tax from 0.6 percent to 0.9 percent, and it keeps climbing until the state repays. The Department of Labor's Employment and Training Administration administers the loans and publishes the list of credit reduction states and the percentages, which are not final until November 10 of the year, the date by which a state can repay and avoid the reduction. DOL's page, which expands the acronym as the "Federal Unemployment Insurance Tax Act," states the baseline the same way: "employers in states without a further credit reduction will have a FUTA tax rate of .6%." Chapter 23's own name has no "Insurance" in it.

Who owes the tax is defined by three tests in section 3306(a), and they are tests of the employer, not of any one worker. Under the general test an employer is a person who "during any calendar quarter in the calendar year or the preceding calendar year paid wages of $1,500 or more," or who "on each of some 20 days during the calendar year or during the preceding calendar year, each day being in a different calendar week, employed at least one individual in employment for some portion of the day." For agricultural labor the figures are $20,000 in a quarter or 10 individuals on 20 days in different weeks. For domestic service in a private home the test is having "paid wages in cash of $1,000 or more for such service" in a calendar quarter of this year or last, and a household employer who meets it is not thereby an employer for any other kind of work. Once the test is met, every dollar of wages up to $7,000 per employee for the year is FUTA wages, including wages paid to the employee who tripped the test. A successor employer that takes over a business may count wages the predecessor paid toward each employee's $7,000.

The compliance rhythm is light compared with the other payroll taxes. FUTA is reported annually on Form 940, "Employer's Annual Federal Unemployment (FUTA) Tax Return," due at the end of January, with ten extra days for an employer whose deposits covered the year's tax on time. During the year the deposit rule at 26 CFR 31.6302(c)-3 requires a deposit by the end of the month after a quarter only once the tax for the period plus undeposited tax from prior periods exceeds $500; below that, the liability rolls forward and is paid with the return. Because section 3301 imposes the tax on the employer, nothing is withheld from wages, nothing appears on a pay stub or Form W-2, and a self-employed person, who has no employer, owes no FUTA on their own earnings even though they may owe it on wages they pay to staff. State unemployment tax, often called SUTA, is the separate levy each state imposes on employers to fund its own benefit payments, at rates and wage bases the state sets; it is the tax whose payment earns the federal credit, and it is not this page's subject.

1. Determine employer status. Apply the general, agricultural or household test for the current year and the prior year. Meeting any test makes the business a FUTA employer for the whole year.

2. Compute FUTA wages. For each employee, count wages paid in the year up to $7,000, including wages a predecessor paid where the successor employer rule applies. Certain payments the Code excludes from wages are left out.

3. Apply the rate and the credit. Multiply FUTA wages by 6 percent, then claim the credit for state unemployment contributions paid on time, up to 5.4 percentage points, reduced if the state is on the Department of Labor's credit reduction list for the year.

4. Deposit and file. Deposit by the end of the month after any quarter in which the undeposited liability exceeds $500; otherwise carry it forward. File Form 940 by the end of January and pay any balance with it.

Take an example. A design studio has four employees who were paid $52,000, $31,000, $6,000 and $44,000 during the year. Its FUTA wages are $7,000, $7,000, $6,000 and $7,000, or $27,000 in total, because everything above $7,000 per person is excluded. The gross tax is 6 percent of $27,000, or $1,620. The studio paid its state unemployment tax in full and on time, so it claims the maximum credit of 5.4 percent of $27,000, or $1,458, and owes a net $162, which is 0.6 percent of $27,000. Because $162 never exceeded the $500 deposit trigger during the year, no quarterly deposit was required; the studio pays the $162 with its Form 940 in January. Had the studio's state been a credit reduction state in its first year of reduction, the credit would shrink by 0.3 percentage points of FUTA wages, adding $81 and bringing the net tax to $243.

Pros

• The figures are statutory and stable: a 6 percent rate, a $7,000 wage base and a 5.4-point maximum credit that have not moved in decades.
• The net cost is small, $42 per employee per year at the full wage base for an employer in good standing.
• It is reported once a year and deposited only when the accumulated liability passes $500, a lighter rhythm than FICA and income tax withholding.
• It falls on the employer alone, so nothing has to be explained on an employee's pay stub.

Cons

• The credit is conditional. Paying state unemployment tax late cuts the credit, and operating in a credit reduction state raises the federal tax for reasons outside the employer's control.
• The employer tests reach small operations quickly: $1,500 of wages in one quarter, or a single part-time employee for 20 weeks, is enough.
• The $7,000 wage base is unindexed, so the tax is concentrated in the first weeks of each employee's year and hits high-turnover employers hardest per dollar of payroll.
• Household and farm employers face separate tests that are easy to overlook alongside the FICA rules.