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FUTA: An inside look at the federal unemployment tax act

During times when economic growth slows down, business profits can fall and job losses may increase, adding to the number of workers who may need to rely on unemployment instead. A recent, relevant example is when COVID-19 became a part of our daily language and the unemployment rate skyrocketed to an unprecedented 14.8%.

Business owners understand they have a great deal of responsibility, especially when it comes to operating and managing expenses. One of the biggest operating expenses is the cost of labor. There are a number of business-related taxes that must be paid, including any taxes related to the cost and benefit of having employees. The Federal Unemployment Tax Act is one of those employee-related taxes.

What is FUTA tax?

Created in response to the high unemployment rate from the Great Depression, the Federal Unemployment Tax Act, commonly known as FUTA, emerged in 1939. Designed to help states pay for unemployment benefits for employees who may leave their jobs, the FUTA tax is a piece of federal legislation that imposes a payroll tax on any business with employees.

The FUTA tax rate makes up part of the financing required for the Unemployment Compensation program. Each business with employees is required to pay annual or quarterly federal unemployment taxes on a portion of any employee wages that are paid out to cover the cost of the FUTA program.

Who pays FUTA tax?

When the Federal Unemployment Tax Act was enacted, the FUTA tax rate only applies to employers with eight or more employees. However, this nationwide system now pertains to any employer with at least one employee, who works at least one day out of the 20 calendar weeks in a quarter. The employer must pay FUTA tax if they pay at least $1500 in wages, during any calendar quarter. According to the IRS, those employers are required to file Form 940 annually.

FUTA tax rate 2021

The FUTA tax rate for 2021 is 6%. Working in conjunction with the unemployment tax from the state, the FUTA tax rate covers the cost of the Unemployment Compensation program. This program funds the unemployment benefits for qualified out-of-work employees.

The 2021 6% FUTA tax rate is applied to the first $7000 paid to each employee every calendar year. After that first $7000 of employee-earned wages, the employer is no longer required to pay any FUTA tax or federal unemployment taxes. Even though the FUTA tax is based on an employee’s wages, only the employer is responsible for paying the FUTA tax rate, as opposed to other payroll taxes like Social Security or Medicaid.

How to calculate FUTA tax

As only the first $7000 is applicable to the FUTA tax, it is important to understand how to calculate the FUTA tax, as well as understanding the potential tax exemptions.

After subtracting any exempt payments from the FUTA tax, a company owes the tax on the first $7000 paid out to each employee during the calendar year. Each quarter, you must determine how much of that first $7000 was paid during that quarter. For example, if your company has 15 employees and each employee earns a taxable wage of $14,000. The FUTA tax is applied to the first $7000 in wages paid for each employee. For the annual company FUTA tax, the calculation looks like this:

0.06 x $7000 x 15 = $63,000

A business is still liable to pay the FUTA tax if the amount paid to any employee is less than $7000. For example, if an employee is paid $2500, the calculation would look like this:

0.06 x $2500 = $150

The following are considered some of the payment and organizational exemptions to the FUTA tax:

  • Meals and lodging

  • Group term life insurance benefits

  • Dependent care benefits

  • Employer contributions to accident or health insurance plans for employees or employer contributions to employee retirement accounts like 401(k) accounts

  • Organizations exempt from income tax under section 501(c)(3) of the Internal Revenue Code

FUTA tax credit

As an incentive to encourage employers to pay the FUTA tax in a timely manner, the Federal Unemployment Tax Act offers a tax credit.

Any state that participates in the unemployment compensation program and has no outstanding federal loans, may be eligible for a tax credit up to 5.4 percentage points. All employers who pay their state unemployment insurance on time are eligible for the FUTA tax credit.

These potential tax credit points are from the state unemployment taxes which are paid against the 6% FUTA tax rate, making the minimum federal tax rate 0.6%. At the end of each calendar year, the Department of Labor will announce which states are eligible for the entire 5.4% tax credit. With Xero, a business can ensure invoices and taxes are paid on time, which contributes to the organization’s overall cash flow.

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