Are you an employer that noticed a higher federal unemployment tax payment (known as FUTA) in January 2023 for your 2022 payroll taxes? Do you wonder why you had to make this payment (especially if you had paid your FUTA in full in prior quarters?)
This additional tax was required due to being in a credit reduction state. In 2022, there were 4 states named credit reduction states which include California, Connecticut, Illinois, New York as well as the Virgin Islands.
What does it mean to be a credit reduction state?
A state is a credit reduction state if it has taken loans from the federal government to meet its state unemployment benefits liabilities and has not repaid the loans within the allowable time frame. During the pandemic, high unemployment rates forced many states to borrow funds from the federal government, and they had until November 10, 2022, to repay their loans. The states unable to pay back the borrowed funds within the allowable time frame are being assessed the FUTA credit reduction.
What is the definition of credit reduction?
The standard FUTA tax rate is 6% on the first $7000 of wages paid to each employee. However, if the employer pays state unemployment tax, they generally receive a credit of 5.4% reducing the actual FUTA tax rate to six tenths of one percent (.6% which means you pay only 1/10th of the tax you would otherwise pay).
If a state has an outstanding loan balances on January 1 for two consecutive years and does not repay the full amount of its loans by November 10 of the second year, then the FUTA credit rate for employers in that state will be reduced until the loan is repaid.
The reduction is 0.3% for the first year the state is a credit reduction state, another 0.3% for the second year, and an additional 0.3% for each year thereafter that the state has not repaid its loan in full. Additional offset credit reductions may apply to a state beginning with the third and fifth taxable years if a loan balance is still outstanding and certain criteria are not met.
So for those in credit reduction states in 2022, the additional tax you will pay is increased 3 tenths of 1 % for up to an additional $21 per employee. This means rather than a maximum tax of $42 per worker, the most you’ll pay for each is $63.00 a 50% increase over what was expected.
If the loans aren’t paid back in 2023, the amount you’ll pay will be doubled from a maximum of $42.oo to $84.00. The rate will continue to increase each year until the loans are paid back.
The FUTA tax and additional credit reduction is reported on the annual 940 return. For those in credit reduction states, schedule A will be included showing the taxable wages for the year and the additional tax due.
If you are in a credit reduction state, it is best to plan that you will have to pay the additional amount next year as well and budget this into your cash flow planning. If your state pays it’s loan back before November 2023, you won’t have to pay the additional amount, and these funds will be available for other expenses. But failing to plan for this additional tax, especially for large employers, can significantly impact cash flow since we don’t find out the tax is due until shortly before the payment due date.
If you have additional questions about the FUTA credit reduction, you can find information on both the IRS and US Department of Labor websites.