What Is the FUTA Credit Reduction for California?
Navigate the FUTA credit reduction for California employers. Understand why your federal unemployment tax liability may be higher and how to manage it.
The Federal Unemployment Tax Act (FUTA) is a federal tax levied on employers to fund unemployment benefits. Employers receive a credit against their FUTA tax liability for contributions to state unemployment funds, which reduces their federal tax burden. However, this standard credit can be reduced for employers in specific states, leading to an increased FUTA tax obligation. This adjustment, known as a FUTA credit reduction, means businesses in affected states pay a higher federal unemployment tax rate.
Understanding the FUTA Credit Reduction
FUTA is an annual federal tax applied to a portion of wages paid to each employee. The FUTA tax rate is generally 6.0% on the first $7,000 of wages paid to each employee in a calendar year. Before any credits, the maximum FUTA tax per employee would be $420. However, most employers do not pay the full 6.0%.
Employers can claim a credit of up to 5.4% against their FUTA tax liability for timely contributions to their state unemployment insurance (UI) programs. For employers who pay their state unemployment taxes in full and on time, this credit effectively reduces their net FUTA tax rate to 0.6% (6.0% minus 5.4%).
A FUTA credit reduction occurs when a state’s unemployment insurance trust fund must borrow from the federal government. If a state has outstanding federal loans on January 1 for two consecutive years and fails to repay these loans by the statutory deadline, employers in that state become subject to a FUTA credit reduction. This reduction effectively lowers the 5.4% credit employers can claim.
The standard 5.4% credit is reduced by 0.3% for the first year a state is designated a credit reduction state. For each subsequent year the state’s loan remains unpaid, the credit is further reduced by an additional 0.3%. This cumulative reduction means that the longer a state remains indebted to the federal government, the higher the effective FUTA tax rate for its employers becomes.
California’s Credit Reduction Status
California has historically faced FUTA credit reduction due to its unemployment insurance fund borrowing from the federal government. Economic downturns increased the demand for unemployment benefits, leading to substantial federal loans. The state’s prolonged borrowing and inability to repay these advances by the deadline have resulted in its FUTA credit reduction status.
This ongoing situation means that employers operating within California are subject to a higher effective FUTA tax rate compared to businesses in states not experiencing a credit reduction. For the 2024 tax year, employers in California are subject to a FUTA credit reduction rate of 0.9%.
The U.S. Department of Labor annually assesses each state’s unemployment insurance loan balance to determine its credit reduction status for the upcoming tax year. California’s designation as a credit reduction state is subject to this yearly review, contingent upon its progress in repaying its federal UI loans. Employers can find official announcements regarding California’s FUTA credit reduction status through IRS notices and U.S. Department of Labor announcements.
Calculating and Reporting the FUTA Credit Reduction
For employers in California, the FUTA credit reduction directly impacts the calculation of their total federal unemployment tax liability. The standard effective FUTA tax rate of 0.6% is increased by the credit reduction rate applicable to California. For the 2024 tax year, with a credit reduction rate of 0.9%, the effective FUTA tax rate for California employers becomes 1.5% (0.6% + 0.9%). This means that for each employee, employers will pay 1.5% on the first $7,000 of wages, resulting in a maximum FUTA tax of $105 per employee, an additional $63 compared to states without a credit reduction.
Employers are required to adjust their FUTA tax deposits throughout the year to account for this increased rate. FUTA taxes are generally deposited quarterly, with a deposit required if the accumulated FUTA tax liability exceeds $500 by the end of a quarter. If the liability is $500 or less, it is carried forward to the next quarter until the cumulative amount surpasses this threshold. Deposits must be made by the last day of the month following the end of the quarter. All federal tax deposits, including FUTA, must be made by electronic funds transfer (EFT).
The FUTA credit reduction is formally reported on Form 940, Employer’s Annual Federal Unemployment Tax Return. Employers in a credit reduction state must complete Schedule A (Form 940) to calculate the precise credit reduction amount. On Schedule A, employers enter the FUTA taxable wages paid in California and multiply them by the applicable credit reduction rate. The total credit reduction calculated on Schedule A is then carried over and entered on Line 11 of Form 940, which increases the total FUTA tax due.
The increased FUTA tax liability is considered incurred in the fourth quarter and is due by January 31 of the following year, which is also the general deadline for filing Form 940. If all FUTA tax deposits were made on time, the filing deadline for Form 940 is extended to February 10.