What is the Federal Unemployment Tax (FUTA)?
If you own a business, you have probably heard about a tax known as FUTA. It is good to know about this often misunderstood tax because it affects your business’s bottom line.
In addition, failure to pay the FUTA tax can result in harsh penalties, such as huge fines, potential criminal liability, or possible jail time.
So, what exactly is FUTA tax? How does it work? Who is required to pay it? Where does it go? How is it calculated?
In this article, we take a look at everything you need to know about FUTA tax.
The Federal Unemployment Tax Act (FUTA) is a federal legislation that gives the government the mandate to impose a tax on employers with the aim of collecting revenue which goes to the state unemployment programs. The tax is paid based on a percentage of total wages paid to employees.
The funds collected through the FUTA tax are used to pay unemployment compensation to employees who have lost their jobs. While the FUTA tax is based on the wages paid to employees, it is only imposed on employers, not employees.
This means that no portion of the tax is deducted from employee wages. The employer is required to deposit the FUTA tax on a quarterly basis. In addition, they have to file the IRS Form 940 at the end of each year.
The FUTA tax was created following the Great Depression of the 1930s. After witnessing the devastating effects of the Great Depression, President Franklin D. Roosevelt felt that was a need to come up with a federal system to protect workers who lost their jobs because of such an economic downturn.
In 1934, he formed the Committee on Economic Security, whose aim was to provide a soft landing for those who had lost their jobs due to the Great Depression and to prepare in case a similar downturn happened in future.
The committee’s top priority was to come up with some form of unemployment insurance, leading to the creation of the Social Security Act of 1935, which guaranteed workers an income to retired workers.
In 1939, the FUTA was born from the Social Security Act, guaranteeing a temporary and partial wage replacement for employees who had lost their jobs involuntarily.
In addition to preventing the need for welfare relief for employees who had lost their jobs, such a wage replacement program would also maintain their purchasing power, thereby helping keep the economy afloat during recessions.
WHO BENEFITS FROM FUTA?
FUTA is meant to provide financial relief to employees who have lost their jobs. However, not all employees are eligible for unemployment compensation.
Only employees who have lost their jobs involuntarily, through no fault of their own – such as through downsizing, because the business shut down, or quitting because of hazardous work environment – are eligible. Employees who have been fired because of non-performance or misconduct are not eligible to claim the benefits provided by FUTA.
Once a former employee claims unemployment insurance through the state unemployment agency, you (the employer) will receive something known as a “Notice of Unemployment Insurance Claim Filed.” The aim of this form is to find out whether the former employee is eligible for unemployment compensation.
The form requests basic information about the employee, including the reason behind their loss of work. If you confirm that your former employee is eligible, he or she will start receiving checks from the state unemployment agency. You also have the option of contesting the claim if you believe that your ex-employee is not eligible.
However, if you decide to contest the claim, you should have documentation to show the reason behind the termination of the employee’s employment.
IS FUTA THE SAME AS SUTA?
Many employers often confuse these two taxes, FUTA and SUTA. The confusion stems from the fact that both are unemployment taxes.
However, the FUTA is an unemployment tax collected by the federal government, while the SUTA is an unemployment tax collected by the state. Businesses are expected to pay both the FUTA and SUTA.
Unlike FUTA which is constant across all states, SUTA varies depending on the state. SUTA rates are determined based on factors like the size of the business, the length of time a business has been in operation, the unemployment rate within the state, the number of former employees who have successfully claimed unemployment compensation, as well as the industry the employer is in.
In some states, the SUTA is sometimes referred to as State Unemployment Insurance (SUI). It is also good to note that businesses that pay their SUTA in time are eligible for a tax credit on their FUTA payments.
WHO IS REQUIRED TO PAY FUTA TAX?
Any business that has employees is required to apply for a Federal Employer ID Number (EIN), which acts as registration for your business and allows you to make payments towards the federal unemployment insurance. As an employer, you are required to pay FUTA if:
- You paid wages amounting to or exceeding $1,500 in any calendar quarter of the year.
- You had at least one employee for some part of a day or more in at least 20 different weeks during the year. This includes full-time, part-time and temporary employees.
- You paid wages amounting to or exceeding $1,000 in any calendar quarter of the year to a household employee. A household employee is defined as any employee performs any type of household work in a local college club, a sorority chapter, a local fraternity or a private home.
- You paid cash wages amounting to or exceeding $20,000 in any calendar quarter of the year to farmworkers.
- You employed at least 10 farmworkers or some part of a day or more (even if not at the same time) in at least 20 different weeks during the year.
You should take note that you do not pay any FUTA on independent contractors, since they are not considered as employees. This is one of the reasons that small businesses prefer hiring independent contractors instead of employees.
In addition to not providing pay benefits, businesses that hire contractors are not required to pay payroll taxes like FUTA.
HOW MUCH IS FUTA TAX?
Like I mentioned earlier, FUTA tax is based on employee wages. The FUTA tax rate for 2018 is 6%. The tax is only applicable to the first $7,000 paid to each employee within a calendar year. This means that you should stop paying the FUTA tax once you have paid more than $7,000 to an employee. The $7,000 threshold is referred to as the wage base. Based on the 6% tax rate, the largest amount of FUTA tax you are required to pay per employee in a given year is $420 (0.06 x $7,000).
I also mentioned that employers are required to pay both FUTA and SUTA. Employers who pay SUTA can take a tax credit which is deducted from the amount of FUTA tax they are supposed to pay. The maximum allowed of tax credit allowed is 5.4% of the taxable income.
This means that the effective FUTA tax rate for employers who qualify for the highest amount of tax credit is reduced to 0.6% (6% minus 5.4%). Therefore, the minimum amount of FUTA that an employer can pay per employee in a given year is $42 (0.006 x $7,000).
COMPENSATION PAYMENTS EXEMPTED FROM FUTA TAX
While FUTA tax is based on payments made to employees, there are some payments that are exempted when calculating the FUTA tax. These include:
- Group term life insurance benefits.
- Contributions made by the employer towards an employee’s retirement account, such as a 401(k).
- Fringe benefits offered to employees, including things like contributions to employee health plans, insurance premiums, meals and lodging, mileage reimbursements, reimbursements of qualified moving expenses, and so on.
- Wages that are paid by the business owner to a spouse.
- Any wages that are paid to a child by the parent or vice versa, provided the child is below the age of 21.
- Payments that are made for services which were not performed within United States territory.
- Any money that is earned by an employee after they have died. In this case, these funds are handed to the employee’s estate and are taxable.
In addition to these payments, there are other conditions which exempt employers from paying FUTA tax. For instance, companies that are exempted from paying income tax under 501(c)(3) are not required to pay any unemployment tax. Wages paid to employees are also not subject to FUTA tax if they come from a foreign government’s international organization. Wages coming from any United States governmental agency are also exempted from the FUTA tax.
There are several other conditions that exempt employers from paying FUTA. For instance, payments made by a hospital to interns are not subject to the FUTA tax. Similarly, payments made by a school to a student of the same school are exempted from FUTA tax, as well as payments made by media companies to newspaper distributors who have not attained the age of 18.
In addition, non-profit organizations are not required to pay FUTA tax on wages paid to their employees. The best thing is to check with your state office to confirm any types of employee wages or benefits that are exempted from the FUTA tax.
HOW TO CALCULATE FUTA TAX
To calculate how much you might expect to pay as FUTA tax, you should start by first calculating the total amount that is taxable under FUTA. To do this, you should follow the following steps:
- Add the gross pay of all employees plus any other cash and non-cash benefits offered to employees.
- From this figure, deduct any payments and benefits that are exempted from the FUTA tax (discussed above).
- From this amount, deduct any payments that are above the $7,000 wage threshold for the year for each employee to find out your total FUTA taxable wages.
- Subtract the amount of tax credit you qualify for from the FUTA tax rate. For instance, if you qualify for the maximum tax credit, this would be 6% – 5.4% = 0.6%.
- Multiply your answer from step 4 with the figure you got in Step 3. This will give you your net quarterly FUTA tax liability.
To make it easier to understand, let’s use an example. Let’s assume that a business has two employees, Mike and Sophie. Mike earned $400, while Sophie earned $450. Once you pay both of them their latest paychecks, Mike’s total earnings to date will be $4,000, while Sophie’s total earnings to date will be $7,200.
Since Mike has not reached the threshold, you will need to pay FUTA on his entire $400 paycheck. However, Sophie’s earnings will have exceeded the threshold by $200, which means you will only need to pay FUTA for just $250 of her latest paycheck ($450 – $200).
Any further payments made to Sophie will not be subject to the FUTA tax. Therefore, your total FUTA taxable wages is $650 ($450 + $200). Assuming that you are qualified for maximum tax credit, your net quarterly FUTA tax liability would be $650 x 0.006 = $3.90.
HOW DOES ONE QUALIFY FOR FUTA TAX CREDIT?
Remember, not all employers qualify for the FUTA tax credit. Different employers also qualify for different tax credits rates. So, what determines whether an employer qualifies for tax credit?
Below are some of the factors that determine whether you qualify for FUTA tax credit:
- Any company that is subject to State Unemployment Tax Act (SUTA) is generally eligible for FUTA tax credit, provided it abides by the other conditions discussed below.
- Companies are required to pay all owed SUTA tax for a calendar year by the due date of their Form 940 in order to be eligible for FUTA tax credit.
- Companies that are subject to FUTA tax but exempted from SUTA tax are not eligible for FUTA tax credit.
- Companies where all employees are individually subject to FUTA tax but exempted from SUTA tax are not eligible for FUTA tax credit.
- If some employees of your company are exempted from SUTA tax, then their wages should are not subject to FUTA credit. Eligibility for FUTA credit for the entire company depends on the number of employees who are either subject to, or exempted from SUTA tax.
CREDIT REDUCTION STATES
The SUTA tax collected by States is used to cover unemployment benefits for unemployed workers within the state. Sometimes, however, States do not have enough money to cover these costs, forcing them to borrow money from the federal government (the money collected through FUTA tax).
The borrowed money is given as a loan which must be repaid to the federal government. If a state is unable to repay this loan within two years, it gets listed as a credit reduction state.
This means that employers who are subject to FUTA tax within the state will not enjoy the maximum FUTA tax credit, which in turn means that the FUTA tax paid in credit reduction states is higher.
For instance, if a state has a credit reduction of 0.5%, instead of receiving the maximum FUTA credit of 5.4%, the maximum credit within the state will be 4.9% (5.4% – 0.5%).
Therefore, employers in this state will have an effective FUTA tax rate of 1.1% (6% – 4.9%), compared to 0.6% for states without tax reduction. Currently, the states under tax reduction include California and The U.S Virgin Islands.
WHEN SHOULD FUTA TAX DEPOSITS BE PAID?
FUTA tax payments should be paid into the federal unemployment tax fund at the IRS at the end of each calendar quarter. However, the IRS gives several breaks to small businesses that are subject to FUTA tax.
One of these breaks concerns the payment of FUTA tax deposits. The IRS requires businesses to pay the FUTA tax once the amount owed exceeds $500.
This means that for many small business, whose FUTA taxes are usually below $500 for every quarter, it is not necessary to make the FUTA tax deposits every month. Instead, the payment is carried over to the next quarter. The payments can keep being carried over to the next quarter until the end of the year, or until the business accumulates over $500 in FUTA taxes.
However, if a business is liable for FUTA taxes exceeding $500 in one quarter, then the business needs to make a payment of the taxes before the last day of the month that comes after the end of the quarter. For instance, if your company has a FUTA tax liability of $400 for Quarter 1 (which ends on March 31), then it is not necessary for the company to make a deposit for that quarter. I
nstead, the FUTA tax liability is carried over to Quarter 2. If the company has a FUTA tax liability of $300 for Quarter 2 (which ends on June 30), then the accumulated FUTA tax liability would be $700, which means that you would need to make a deposit for Quarter 2. This deposit should be made before July 31.
If the FUTA tax liability for Quarter 3 is below $500, the liability would once again be carried over to Quarter 4. If the liability accumulates and exceeds by the end of the year (which is also the end of Quarter 4), you would need to make a deposit before the 31st of January the following year, or by the time you submit Annual Unemployment Tax Report on Form 940.
Form 940 of the previous year should also be filed by the 31st of January.
However, if a company paid all its quarterly payments for the previous year on time, form 940 can be filed by the 10th of February. If the due date of the FUTA tax deposit falls on a holiday or a weekend, the deposit should be made on the first business day that comes after the weekend or holiday.
How to complete form 940
CONSEQUENCES OF NON-COMPLIANCE
Sometimes, some employers fail to pay their FUTA tax, either by accident or deliberately. Failure to pay FUTA tax might lead to some negative consequences, both for the employer and the employees.
For employees, failure of your employer to pay FUTA can have cause delays to your unemployment benefits application, since the tax issue has to be cleared before your claim can be approved. Some states might even deny your claim.
Failing to pay FUTA taxes is a crime punishable by law. Employers who fail to pay FUTA taxes are usually fined. However, if the amount of tax owed is high, or if the employer is unable to pay the fines, there is a possibility that the employer might get jailed.
The possibility of getting jailed is particularly high in cases where the employer tries to hide their non-compliance by misleading employees, or legal counsel about their accounting practices.
KEY ACTION STEPS
Now that you know what FUTA tax is and how to calculate your FUTA tax liability, let’s take a look at some steps you should take to ensure that you properly manage your FUTA tax obligations. Below are the steps you should take to ensure that you meet your FUTA tax obligations:
Getting started: If you just started a new business, you should apply for your federal employer ID number, stating the number of employees within your payroll. This will let the IRS know that you have an obligation to report and pay FUTA tax.
Know important dates: Like I mentioned earlier, FUTA tax deposits should be made on a quarterly basis, with the due date being the last day of the month following the end of each quarter. For instance, the deposits for the 1st quarter (which ends on March 31st) should be made by the 30th of April. The payments for the four quarters are due on 30th April, 31st July, 31st October and 31st January. In addition to the due dates for the quarterly deposits, you should also be aware that you are required to file Form 940 before the 31st of January. Being aware of these tax dates can help you plan in advance and avoid missing deadlines.
Calculate how much you need to pay: I have already showed you how to calculate your FUTA tax obligations. In addition, you should educate yourself on payments that are exempted from FUTA tax to avoid paying FUTA on unnecessary employee payments.
Consider automating your FUTA payments: Calculating, reporting and paying FUTA tax can be a hectic process. However, you can automate the process by using tax management software which automatically calculate, pay and report your FUTA taxes. Examples of software you can use to automate your FUTA payments include:
- Patriot Software
By now, you should have a clear understanding of what FUTA tax is, how much it is, how to calculate it, how to pay it, how to report it, and the consequences for non-compliance. To give a recap, the FUTA tax is a tax imposed on employers by the federal government with the aim of collecting money for funding state unemployment programs. The tax is only paid by employers, though it is charged based on employee wages.
The current rate for FUTA tax is 6%. Employers are also entitled to a maximum tax credit of 5.4%, which reduces the effective FUTA tax rate to 0.06%. However, employers in tax reduction states are not eligible to receive the maximum tax credit.
The FUTA tax should be paid on a quarterly basis, and should be accompanied by filing of the Annual Unemployment Tax Report on Form 940. Failure to pay FUTA tax can negatively affect unemployment benefits claims for employees and lead to harsh penalties for employers, including fines and the possibility of jail time.
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