What Is a FUTA Credit Reduction State?

A “FUTA credit reduction state” is a designation for states that have not repaid loans taken from the federal government’s Unemployment Trust Fund. These loans cover state unemployment benefit liabilities when a state’s unemployment insurance (UI) fund is depleted. When a state receives this designation, employers within that state face a reduction in the credit they can claim against their Federal Unemployment Tax Act (FUTA) tax, increasing their FUTA tax liability. This mechanism ensures federal loans are repaid, impacting businesses in affected states.

Federal Unemployment Tax and the FUTA Credit

The Federal Unemployment Tax Act (FUTA) imposes a federal tax on employers to help fund unemployment benefits and state workforce agencies. This federal tax is set at a standard rate of 6.0% on the first $7,000 of wages paid to each employee annually. This $7,000 threshold is known as the FUTA taxable wage base. The maximum FUTA tax an employer would pay per employee before any credits is $420 ($7,000 x 6.0%).

Employers can reduce their FUTA tax liability through a credit mechanism. Employers typically receive a credit of up to 5.4% against the FUTA tax if they pay their state unemployment taxes on time and in full. This credit reduces the effective FUTA tax rate from 6.0% down to 0.6% (6.0% – 5.4% = 0.6%). The maximum FUTA tax per employee for most employers becomes $42 ($7,000 x 0.6%).

This FUTA credit encourages employers to contribute to their state’s unemployment insurance programs, the primary source of funding for unemployment benefits. The federal government uses FUTA funds to cover administrative costs for state UI programs, provide a federal share of extended unemployment benefits, and offer loans to states when their UI trust funds are insufficient. Employers report and pay their FUTA tax annually by filing IRS Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return.

Why States Become Credit Reduction States

States become “credit reduction states” when their unemployment insurance (UI) trust funds face financial difficulties. Each state operates its own UI program, funded by state unemployment tax (SUTA) contributions from employers. These funds are held in state accounts within the federal Unemployment Trust Fund and pay unemployment benefits to eligible workers.

During periods of high unemployment, such as economic downturns, a state’s UI trust fund can become depleted as benefit payouts exceed incoming tax revenues. When a state’s fund is insufficient to cover its unemployment benefit obligations, federal law allows it to borrow funds. If these federal loans are not repaid by a specific deadline, typically November 10 of the second consecutive year the loan is outstanding, the state enters “credit reduction status.”

This designation is mandated by federal law, which dictates that employers in such states will have their FUTA credit reduced. The purpose of the credit reduction is to facilitate the repayment of these federal loans. States that continually fail to repay their loans face increasing credit reductions over time, leading to higher FUTA tax burdens for their employers.

Calculating the Credit Reduction Impact on Employers

When a state is a credit reduction state, the FUTA credit available to employers is reduced. Employers cannot claim the full 5.4% credit against the FUTA tax. The reduction amount typically increases by 0.3% for each year the state remains in credit reduction status. For example, a state in its first year of credit reduction would see the FUTA credit reduced by 0.3%, making the effective FUTA rate 0.9% (6.0% – 5.1% credit).

This reduction directly impacts the amount of FUTA tax employers must pay. The increased FUTA tax is calculated against the FUTA taxable wage base of $7,000 per employee. If a state has a 0.9% credit reduction, the effective FUTA rate for employers becomes 1.5% (0.6% standard effective rate + 0.9% reduction). This increases the FUTA tax per employee from $42 to $105 ($7,000 x 1.5%).

The Internal Revenue Service (IRS) notifies employers of their state’s credit reduction status and the applicable percentage. This information is provided through official announcements and publications, often appearing on Schedule A of Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return. Employers in credit reduction states must account for this higher tax liability when filing their annual FUTA returns, with any increased FUTA tax considered incurred in the fourth quarter and due by January 31 of the following year.

State Pathways to Restoring Full FUTA Credit

A state can exit credit reduction status and restore the full FUTA credit for its employers by repaying outstanding federal unemployment insurance loans. States can achieve this repayment through various financial strategies.

One common method involves increasing state unemployment tax (SUTA) rates on employers, which generates additional revenue for the UI trust fund. States may also issue bonds or utilize general state funds to pay back the federal loans. The goal is to eliminate the loan balance owed to the federal Unemployment Trust Fund. Once federal loans are repaid, the state’s credit reduction status is lifted.

Upon repayment, employers become eligible for the full 5.4% FUTA credit. This reduces their effective FUTA tax rate back to the standard 0.6%, alleviating the increased tax burden experienced during the credit reduction period. This process incentivizes states to manage their UI trust funds responsibly to avoid future credit reductions.