Payroll in Practice: 12.18.2023

Question: A California employer has an employee whose employment is not subject to California state unemployment tax. Their employment is subject to federal unemployment tax. California is a credit reduction state for federal unemployment tax purposes for 2023. How does the credit reduction affect the taxes paid on this employee’s wages?

Answer: Wages paid for employment that are not subject to state unemployment insurance tax (SUI) are not included in the calculation of the Federal Unemployment Tax Act (FUTA) credit reduction.

Employers generally are allowed a credit of 5.4% against the 6% FUTA tax for amounts paid to a state unemployment fund. If the employer’s experience rate is lower than 5.4%, the employer may receive an additional credit for the difference between the employer’s actual state unemployment payments and the amount the employer would have owed if its experience rate was 5.4%.

The credit is reduced for wages that are not subject to SUI tax or if required state taxes were not paid by the due date for filing Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return.

The FUTA credit is also reduced for SUI taxes paid to credit reduction states. If a state unemployment system runs out of funds to pay unemployment benefits, the state may obtain loans from the federal government to pay the benefits. If a state has outstanding loan balances on Jan. 1 for two consecutive years and does not fully repay the loans by Nov. 10 of the second year, the FUTA credit rate is reduced for employers in that state until the loan is repaid.

The credit rate is reduced by 0.3 percentage points each year until the loans are fully repaid.

Three jurisdictions face credit reductions in 2023: California, New York, and the US Virgin Islands. California and New York have had credit reductions for two consecutive years. Their credit reduction is 0.6% leaving a credit of 4.8% (5.4% - 0.6%). The US Virgin Islands has a 3.9% credit reduction because it is in its 13th year of credit reduction, leaving a credit of 1.5% (5.4% -3.9%). Instead of the 0.6% (6% - 5.4%) tax rate that applies for most employers, the FUTA tax rate is 1.2% for employers in California and New York and 4.5% for employers in the Virgin Islands.

While the FUTA tax rate is nominally 6%, Form 940 computes the FUTA tax before any adjustments on Line 8 by multiplying the FUTA taxable wages by 0.6% to account for the maximum 5.4% credit.

The credit reduction computed on Form 940, Schedule A, Multi-State Employer and Credit Reduction Information, is based on only those FUTA taxable wages that were also subject to SUI tax for the given state. The credit reduction does not apply to wages that are not subject to SUI or are more than the FUTA wage base. The credit reduction amount is added to the FUTA tax liability on Line 11 of Form 940.

If all of an employer’s FUTA wages are excluded from SUI tax, the employer adds the entire 5.4% credit back on Line 9 of Form 940.

If some of the employer’s FUTA wages are not subject to SUI tax or if required SUI taxes were not paid or were paid late, the FUTA credit adjustments are computed using the worksheet in the Form 940 instructions and added to the FUTA tax on Line 10 of Form 940.

The adjustment for the credit reduction and the adjustments for wages exempt from SUI tax are separate from each other and neither adjustment is affected by the other.

For example, a California employer has four employees and does not pay SUI tax to any other state. During 2023, employees A, B, and C earned $25,000, $18,000, and $5,000 respectively and were subject to SUTA tax, while employee D earned $15,000 and was exempt from SUI tax. The California unemployment tax wage base is the same as the FUTA wage base at $7,000.

The amount of wages subject to the FUTA credit reduction for the four employees is $19,000 ($7,000 + $7,000 + $5,000 + $0). If the state wage base is more than $7,000, any SUI wages exceeding the $7,000 FUTA wage base are excluded from the computation.

Completion of Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return

The employer should insert “CA” on Line 1a, leave Line 1b blank because the employer did not pay SUI taxes in more than one state, and check the box for Line 2 because California is a credit reduction state.

Line 3, which is the total amount paid to employees, should be $63,000 ($25,000 + $18,000 + $5,000 + $15,000). Line 4 should be $0 because no payments were exempt from FUTA tax. Line 5, which is for payments exceeding $7,000 to each employee, should be $37,000 ($18,000 + $11,000 + $8,000), as should Line 6. Performing the calculations included on Form 940, the amount in Line 7 for total FUTA taxable wages should be $26,000 ($63,000 - $37,000), and the amount in Line 8 for FUTA tax before adjustments should be $156 ($26,000 × 0.006).

Line 9 does not apply and should be left blank. For Line 10, the employer must use the worksheet in the Form 940 instructions for calculating the adjustment for taxable FUTA wages excluded from SUI taxes. In addition to the information needed for Form 940, the employer will need to know its California experience rate to complete the worksheet. Assuming the employer timely paid its SUI taxes and has a California experience rating of 3.4%, the amount for Line 10 should be $378.

Line 11 adjusts for the credit reduction, and the employer should use Schedule A to calculate the adjustment amount. Since the employer had $19,000 in FUTA taxable wages and California has a 0.6% credit reduction rate for 2023, the credit reduction amount for Line 11 should be $114 ($19,000 × 0.6%).

Adding Lines 8, 9, 10, and 11, the amount for Line 12 is $648, which is the total FUTA tax owed by the employer after adjustments.

This column does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Patrick Haggerty is the owner of a tax practice in Chapel Hill, North Carolina, and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

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