FUTA: What Is FUTA? | Overview of the Federal Unemployment Tax
If you’re a business owner, you need to pay several employment taxes. FUTA is the federal unemployment tax. Continue reading to learn exactly what it is, where the money goes, and what you have to do.
What is FUTA?
FUTA stands for Federal Unemployment Tax Act. It’s one of the payroll taxes that the government collects in order to provide benefits to workers. Other payroll tax examples include Social Security and Medicare. The purpose of FUTA is to provide unemployment benefits for workers who lose their jobs through no fault of their own.
How Much is the FUTA Tax?
The standard FUTA tax rate is 6% of the first $7,000 in wages you pay to each employee during the year. The 6% rate can be reduced as discussed later.
The first $7,000 means exactly that — not spread out over the year. For example, if you pay an employee $7,000 per month, you pay $420 in FUTA taxes in January and $0 in FUTA taxes in February through December.
Year means calendar year to match up with the personal tax return year. If your business uses a different tax year, FUTA is still based on the calendar year.
Who Has to Pay FUTA Taxes?
The general rule for FUTA taxes is that you must pay FUTA if you meet one of the following two conditions.
You paid wages of $1,500 or more to your employees during any quarter during the current or previous year.
You had one or more employees working for you in 20 or more weeks during the current year or 20 or more weeks during the previous year. This includes all full-time, part-time, and temporary employees.
There are separate rules for household employees and farmworkers. Note that wages include W-2 wages that you pay yourself (such as through a C-corporation) but do not include owner’s draws that may be subject to other self-employment taxes.
When and How Do You Pay FUTA?
You report FUTA to the IRS using Form 940 — Employer's Annual Federal Unemployment (FUTA) Tax Return. Form 940 is due on January 31st. You get an additional ten days to file if you already deposited the taxes owed and owe nothing.
You must make quarterly electronic payments if your FUTA liability for that quarter exceeds $500. If your liability is less than $500, you can make a deposit or carry the funds over to the next quarter. If you carry the funds over, you must pay in the quarter in which your total liabilities (including carryovers) reaches $500. If your total liability for the year is less than $500, you can wait until you file your Form 940 to pay. The due date for quarterly payments is the last day of the month following the end of the quarter.
Are There Separate State Unemployment Taxes?
Even though the federal unemployment tax goes towards state-run programs, states may still charge additional unemployment taxes. The state tax is based on the wages you paid to an employee in the taxing state.
In Washington, the unemployment-insurance tax rate varies from 0.1% to 5.7%. The rate is determined by a formula with two parts. The first part is based on the amount of unemployment benefits paid to your former employees. The second is based on overall unemployment benefits paid, such as companies going out of business in a recession. In 2019, you pay the unemployment insurance tax on the first $49,800 in wages for each employee. This wage base changes each year based on the average wages in Washington.
What if You Do Business in Multiple States?
If you do business in multiple states, the general rule for unemployment taxes is that you pay based on where the employee works most of the time. This is different from income taxes, which may be split between states under certain circumstances.
Some states have reciprocity agreements so that you can file all unemployment tax returns and make all payments to the state you're headquartered in. The states would then share the information and funds according to their agreement.
What is the FUTA Credit Reduction?
To offset state unemployment taxes, the federal government offers a credit equal to up to 5.4% of wages subject to federal unemployment taxes. Assuming the maximum credit, this brings the effective FUTA rate from 6% to 0.6%.
Unlike other taxes, the credit isn’t based on what you pay to the state. Instead, it’s based on whether your state is covering unemployment benefits on its own or is receiving additional funds from the federal government. If your state is running a deficit, the credit may be reduced in 0.3% increments depending on how long the state has run a deficit and until the deficit is covered. The United States Department of Labor posts a list of FUTA credit reductions for each state.
Can You Take a Deduction for FUTA?
Yes, you can deduct the amount you pay in FUTA on your income tax return. Payroll taxes, including FUTA, are a deductible business expense.
Can You Withhold FUTA From an Employee’s Pay?
FUTA is solely the responsibility of the employer. You do not deduct FUTA from your employees’ wages. This is different from Social Security and Medicare taxes because those are split between the employer and employee by law. If you withhold FUTA, it would be the same as underpaying your employees.
Assuming you pay above minimum wage, you technically could offer a lower wage to offset the cost of FUTA or other employer-responsibility taxes. This complies with the tax requirements, because you’d be reporting the lower wage on the W-2 and paying FUTA out of your funds. Of course, you’d also have to consider market conditions and whether employees would look for an employer paying a higher wage.
How Can You Reduce Your FUTA Expenses?
Because FUTA is capped at the first $7,000 in wages, there are two ways to reduce the amount of tax you pay. The first is by reducing employee turnover. If an employee who you already reached the FUTA cap on leaves in May and a new employee replaces them in June, you have to pay FUTA for the new employee up to $7,000.
The second way to reduce FUTA is to use fewer employees working more hours. For example, one full-time employee will cost you half the FUTA of two part-time employees assuming that all employees made at least $7,000 each.
What Happens if You Don’t Pay FUTA Taxes?
The penalties for late payment of FUTA taxes start at 2% of the amount owed if you’re one day late, increase to 5% after six days, and go up to 10% if you’re 16 days late. There is an additional penalty of 15% if you fail to pay within ten days of receiving an IRS notice. You may also be subject to a 5% per month failure to file penalty if you don’t file your Form 940 on time.
In addition to monetary penalties, willful failure to pay unemployment taxes can constitute a criminal offense. This can include situations where your business was struggling financially and you chose to pay your rent before FUTA. The IRS doesn’t have to prove bad faith such as falsifying a tax return. This is different from not paying income taxes where it’s an entirely civil matter if you properly filed your tax return. The logic is that employment taxes never belonged to you and were the property of your employees and the government.
Further, the IRS can hold any owners, managers, or others personally liable for FUTA and other employment taxes when that person caused the tax to not be paid. This is true even if the business is a corporation or other entity that typically has a shield against personal liability.
Get Help With Your FUTA Taxes
With employee turnover, varying tax rates, and other employment taxes to deal with, federal unemployment tax can be hard enough to track. Add in one or more states, and the likelihood of a simple mistake or oversight turning into an accounting nightmare becomes even more likely.