What is FUTA Tax?
FUTA stands for the Federal Unemployment Tax Act and FUTA Tax is a United States federal tax imposed on employers to help fund unemployment agencies at the state level. The tax is imposed solely on employers who pay wages to employees.
FUTA Tax is used to pay employees who leave employment involuntarily, and are eligible to claim unemployment insurance. The act requires employers to file Form 940 annually with the Internal Revenue Service (IRS). In some cases, the IRS may allow some employers to pay the tax in installments during the year.
How FUTA Works
Employers are required to pay the Federal Unemployment Tax if they spend at least $1,500 in wages during a single calendar quarter, but only on the first $7,000 of each employee’s wage in the current or previous year. Even if the employer records $1,500 or more in a single quarter and the other quarters fall below the threshold, the employer will still be required to pay FUTA tax. As of 2017, the FUTA rate stands at 6.0%, and employers can claim a credit of up to 5.4% of its taxable income if they also pay state unemployment taxes.
How to Calculate FUTA Tax
When calculating FUTA taxes, it is important to understand the kinds of incomes that need to be taxed. Ideally, the unemployment tax is calculated on taxable wages that fall under the first $7,000 per employee per year, and any amounts above $7,000 are not taxed. The taxable income comprises wages and salaries, commissions, bonuses, sick pay, vacation allowances, contributions to retirement plans, etc.
Other payments are also exempted from the taxation, but they vary from state to state. Check with your state unemployment office to know which payments are exempted from FUTA Tax. The tax amount is not deducted from the employee’s income, but the employer is responsible for it.
Let’s take the example of Company XYZ which employs ten individuals. Each of these employees earns an annual taxable income of $10,000, bringing the total wages to $100,000. In such case, the employees will be taxed on the first $7,000, and any amounts above the figure are exempted from taxation.
Therefore, the company’s annual FUTA tax will be 0.06 x $7,000 x 10 = $4,200. The employer will be required to submit $4,200 in FUTA taxes to the IRS. The company will also be required to remit any applicable state unemployment taxes to the state tax authority.
FUTA Credit Reduction
Some states are categorized as credit reduction states, and are, therefore, ineligible to claim maximum credit reduction. When these states are unable to pay unemployment tax to residents who lost employment involuntarily, they may borrow from the federal government to facilitate the unemployment insurance payments. The federal government is entitled to recover the unpaid loans from the states by reducing the amount of credit available to them.
The reduction schedule is 0.3% for the first year, and 0.3% for the consecutive years until the loan is fully repaid. Before the loan is fully paid, the states cannot benefit from the maximum credit reduction of 5.4%, and therefore pay higher FUTA taxes than other states. However, if a state’s fully paid these loans, it can claim the max tax credit reduction of 5.4%. It means that they will only pay 0.6% FUTA tax.
Payments Exempted from FUTA Tax
Various forms of payments are paid to employees that are exempted from the Federal Unemployment Tax Act. The payments include:
- Fringe benefits, which include the value of certain meals and lodgings, employer contributions to accident and health plans for employees, as well as employer reimbursements for qualified moving expenses.
- Group term life insurance
- Employer retirement/pension contributions to a qualified plan such as 401(k) plan and SIMPLE retirement account
- Dependent care for up to $500 per employee (or $2,500 for married couples filing separately) for qualifying person’s care
- Other payments such as payment made to an employee under worker’s compensation law because of a sickness or injury inflicted at work; non-cash payments and certain cash payments to H-2A Visa workers for agricultural labor; payments for services provided by spouse, parent or child under 21 years; and payments to non-employees who are treated as your employees by state unemployment agency
Example: Exempt incomes
Assume that Company XYZ company employs three staff John, James, and Peter. John earns an annual income of $30,000, including $2,000 in employer contribution to health insurance, James earns an annual income of $20,000 including $1,200 in contribution to a 401 (k), while Peter earns an annual income of $25,000 including $1,800 in employer contributions to a SIMPLE retirement account. It means that total payments exempted from FUTA taxes are $2,000 + $1,200 + $1,800 = $5,000.
Federal Unemployment Tax Deposits
Employers are required to make payments to the IRS by the last day of the month after the end of the quarter. The FUTA tax liability for the quarter must be $500 or more for the employer to make a deposit with the IRS. If it is less than $500, it is carried forward to the next quarter. The frequency of FUTA tax payments depends on the amount of tax owed and the number of employees. Employers are required to make payments to the IRS using the Electronic Federal Tax Payment system.
Let’s take the example of a company that owes the IRS $400 in Quarter 1, $350 Quarter 2, $490 in Quarter 3 and $550 in Quarter 4. Since the FUTA tax liability in Q1 is less than the required $500, the company will carry forward the $400 for Q1 to Q2. It will bring the total tax liability for Q2 to $750 ($400 + $350), which the company will be required to remit to the IRS by July 31 (last day of the next month).
The tax liability for Q3 is below the FUTA tax limit by $10. The tax liability will be carried forward to the last quarter of the year. It will bring the FUTA tax liability for Q4 to $1,040 ($490 + $550). The company will be required to remit the FUTA tax liability by January 31 of the following month.
Note: This article is for educational purposes only. Always consult a professional adviser before making any tax or investment decisions.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: