To fund unemployment compensation benefit programs, employers are subject to federal and state unemployment taxes based on various factors. These factors include the amounts employers pay their employees, the type and age of the business, and the unemployment claims filed against the business.
Employers must pay federal and state unemployment taxes in order to fund the unemployment tax system. Unemployment compensation is designed to pay benefits to workers when they lose their jobs through no fault of their own.
Federal unemployment tax liability
The Federal Unemployment Tax Act (FUTA) imposes a payroll tax on employers, based on the wages they pay to their employees. Unlike some other payroll taxes, the business itself must pay the FUTA tax. You do not withhold the FUTA tax from an employee's wages.
Is your business required to pay the FUTA tax? It is required to do so if during the current or the preceding calendar year you meet either of the following tests:
- you pay wages totaling at least $1,500 to your employees in any calendar quarter; or
- you have at least one employee on any given day in each of 20 different calendar weeks (the 20 weeks need not be consecutive, the "one employee" need not be the same individual and a "calendar week" is a period of seven successive days beginning with Sunday and ending at the close of the following Saturday; however, short weeks at the beginning and end of a calendar year are counted as calendar weeks).
Once you meet either of the tests, you become liable for the FUTA tax for the entire calendar year and for the next calendar year as well.
Assuming you first met the 1-in-20 test in December 2013, you would have been responsible for the tax with respect to the wages you paid during the entire 2013 calendar year as opposed to just the wages you paid after you met the test. In addition, you would then continue to be liable for the FUTA tax during the 2014 calendar year, even if you fail to meet both the wages-paid test and the 1-in-20 test during that year.
Computing the FUTA tax.
The FUTA tax is imposed at a single flat rate on the first $7,000 of wages that you pay each employee. Once an employee's wages for the calendar year exceed $7,000, you have no further FUTA liability for that employee for the year.
The FUTA tax rate is 6 percent. That is the tax rate that applies to the first $7,000 in wages paid to each of your employees during the year.
Credit for state unemployment taxes.
You can generally claim credits against your gross FUTA tax to reflect the state unemployment taxes you pay. If you paid all your state unemployment taxes on time, and before the due date of your FUTA tax return, you'll be allowed to claim a credit equal to 5.4 percent of your federally taxable wages. This will effectively reduce the FUTA tax rate to 0.6 percent..
Keep in mind that the fact that your actual state tax rate is below 5.4 percent doesn't matter — the federal credit is fixed at that rate.
What if you are unable to pay your state taxes by the due date for the federal return? You do have a recourse. If you secure a filing extension for the federal return you can preserve your right to the maximum allowable credit. Assuming the filing extension for the federal return is granted, you will get the full credit if you pay the state taxes by the extended due date for the federal return.
You should also be aware that you may be penalized for your state's borrowing practices, despite following the rules and paying your state unemployment tax bill in full and on time.
When your state has outstanding federal loans for two consecutive Januarys, your allowable credit is reduced. This reduction is 0.3 percent for the first year and an additional 0.3 percent for each succeeding year until the loan is repaid. A state that has not repaid money it has borrowed from the federal government is called a credit reduction state.
Check with the agency that administers your state's unemployment tax to determine if your allowable credit is reduced.
How do you determine your state unemployment tax liability? Each state operates its own unemployment compensation program that is funded largely by taxes on employers, so you should expect to pay some state unemployment taxes in addition, of course, to any federal unemployment tax you may owe. What your state unemployment tax liability is depends on a variety of factors.
State unemployment tax employer liability
Similar to how the federal unemployment compensation program is funded, in order to fund each state's unemployment compensation program almost all the states impose unemployment taxes directly on employers. Also similar to the federal system is the fact that except for a few states, you do not withhold these taxes from your employees' wages.
If you have employees in Alaska, New Jersey, or Pennsylvania you will also be withholding unemployment taxes from your employees' wages because these three states assess unemployment taxes on employees.
Are you liable for your state's unemployment taxes? In most states, if you're subject to the federal unemployment tax, you're automatically liable for the state unemployment tax. In the remaining states, broader tests for taxability are applied. What this means is that if you have employees in the states with the broader tests for taxability, you may end up paying state unemployment taxes even though you're not obligated to pay the federal tax.
Computing your state unemployment tax liability
Calculating what you owe in state unemployment taxes is simply a matter of multiplying the wages you pay each of your employees by your tax rate. However, every state limits the tax you must pay with respect to any one employee by specifying a maximum wage amount to which the tax applies. Once an employee's wages for the calendar year exceed that maximum amount, your state tax liability with respect to that employee ends.
State unemployment tax rates are individually assigned to each employer each year, and every state uses an experience-rating system of some kind to determine an employer's applicable tax rate for the year. Although these systems vary in how they're actually administered, they share the goal of assigning lower tax rates to employers whose workers suffer the least involuntary unemployment and higher rates to employers whose workers suffer the most involuntary unemployment.
What if you're new to the system because you've only recently hired your first employees? You'll pay tax at a fixed rate until you've contributed to the state's unemployment compensation program for a specified period of time (generally one to three years, depending on the state) and established "experience" with your employees and unemployment.
Keeping the number of unemployment insurance claims filed by former employees to a minimum can produce significant payroll tax savings. For example, in all states the most favorable unemployment tax rates are 1 percent or less.
Let's assume that you're in a state where the taxable wage base is the first $9,000 paid to each employee and that you earn a favorable rate of 0.1 percent. If the generally applicable rate is 6 percent, you're essentially saving $531 ($9,000 x 5.9%) for each employee who earns $9,000 or more.
How can you achieve and maintain a favorable experience rating? One key way is to hire only those employees whom you really need and who are qualified for the job. Also, you should monitor all unemployment insurance claims made against your account and should be prepared to contest any claims you believe to be improper.
Consult our unemployment tax laws by state map for information about your state's rules.