What Qualifies for a FUTA Exemption?

The Federal Unemployment Tax Act (FUTA) is a federal law that works in partnership with state unemployment systems to provide financial support to workers who have lost their jobs. This is an employer-paid tax, meaning the funds are not withheld from an employee’s wages. The tax collected is used to fund state workforce agencies and provide a reserve of funds for states to borrow from if needed. While most employers are required to pay FUTA tax if they meet certain thresholds, the law provides specific exemptions for certain kinds of organizations and for payments made for particular types of services.

Exempt Organizations

Certain organizations are entirely exempt from paying FUTA tax on all employee wages, regardless of the number of employees or the amount paid. The most common of these are organizations that have received specific classifications from the Internal Revenue Service (IRS) or are governmental bodies.

A primary category of exempt organizations includes those recognized as exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code. This classification applies to entities organized and operated exclusively for:

• Religious, charitable, scientific, or literary purposes
• Testing for public safety
• Fostering national or international amateur sports competition
• The prevention of cruelty to children or animals

This FUTA exemption is specific to 501(c)(3) organizations and does not extend to other nonprofits, like 501(c)(4) social welfare groups or 501(c)(7) social clubs.

Services performed for a state or its political subdivisions, such as a county or city, are exempt from FUTA. This exemption extends to instrumentalities of states or their political subdivisions, which are entities that carry out governmental functions but may be organized as separate bodies. Federally recognized Indian tribal governments and their subdivisions are another category of employer exempt from FUTA tax, which acknowledges their status as sovereign entities.

Exempt Types of Employment and Payments

Even if an employer is not an exempt organization, some employment relationships and forms of compensation are excluded from FUTA tax calculations. These exemptions are based on the nature of the service or payment.

Payments made to independent contractors are not subject to FUTA tax. An independent contractor is a worker who is in business for themselves and is not an employee under common-law rules. The IRS assesses worker classification based on evidence of control and independence, which falls into three categories: behavioral control, financial control, and the relationship of the parties. Misclassifying an employee as an independent contractor can lead to significant back taxes and penalties.

The law also provides exemptions for services performed by certain family members, though the rules vary based on the business structure. For a sole proprietorship, wages paid to a spouse or a child under 21 are not subject to FUTA tax. Work performed by a parent for their child is also exempt. These family employment exemptions are narrower for corporations and partnerships, where such relationships do not create a FUTA tax exemption.

Certain payments made to employees are not included in the FUTA tax base. These include employer contributions to qualified retirement plans, payments for employee health plans, and contributions for certain other fringe benefits.

Filing Requirements and Documentation for Exempt Status

Organizations that qualify for a full FUTA exemption have different compliance responsibilities than taxable employers. An organization completely exempt from FUTA, such as a 501(c)(3) charity, is not required to file Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return.

Any organization claiming exempt status must maintain proper documentation. For a 501(c)(3) organization, this includes the determination letter from the IRS that recognizes its tax-exempt status. This letter should be kept as proof of its FUTA exemption for an IRS inquiry or audit.

If an organization mistakenly paid FUTA taxes, it can seek a refund from the IRS. To do so, the employer must file an amended Form 940 for the year the error occurred.

State Unemployment Tax Considerations

A federal FUTA exemption does not automatically grant an exemption from state unemployment tax (SUTA), as each state administers its own separate program with its own laws. The criteria for SUTA exemptions can be different and more restrictive than the federal rules. For instance, while 501(c)(3) organizations are exempt from FUTA, many states require them to participate in the state unemployment system.

These states often provide an option for the 501(c)(3) organization to either pay state unemployment taxes like other employers or to elect to become a “reimbursing employer.” As a reimbursing employer, the organization does not pay quarterly SUTA taxes. Instead, it must reimburse the state unemployment insurance fund on a dollar-for-dollar basis for any unemployment benefits paid to its former employees. This choice requires careful financial planning, as a spike in claims could lead to a large liability.

Organizations should consult their state’s unemployment agency to understand their specific obligations.