FUTA Credit Reductions for California, Connecticut, Illinois, New York and U.S. Virgin Islands for 2022

The U.S. Department of Labor on November 10 announced that California, Connecticut, Illinois and New York will be subject to Federal Unemployment Tax Act (FUTA) credit reductions for 2022. Employers in these four states will pay an additional 0.3% in federal unemployment tax for wages paid to employees in these states, or up to $21 in additional tax for each employee, based on the FUTA taxable wage base of $7,000. The U.S. Virgin Islands has been subject to FUTA credit reductions for over 10 years and will continue to be subject to FUTA credit reductions for 2022. The credit reduction rate for the U.S. Virgin Islands will be 3.6%, an increase of 0.3% from 2021.

What are FUTA Credit Reductions?

Each employer covered by a state’s unemployment insurance program must pay FUTA tax at the standard tax rate of 6.0% on the first $7,000 of wages paid to each employee. The funds from the FUTA tax create the Federal Unemployment Trust Fund, administered by the U.S. Department of Labor. Generally, employers receive a credit of 5.4% when they file their Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, to result in a net FUTA tax rate of 0.6% (6.0% - 5.4% = 0.6%). However, when a state borrows money from the federal government to help pay for the unemployment insurance benefits for workers in their state and has outstanding loan balances on January 1 for two consecutive years, the FUTA credit rate for employers in that state will be reduced until the loan is repaid, unless the full amount of its loans is repaid by November 10 of the second year. The credit reduction is 0.3% for the first year the state is a credit reduction state, with an additional 0.3% for each year thereafter that the state has not repaid its loan in full. Additional offset credit reductions may apply if a loan balance is still outstanding and certain criteria are not met beginning with the third and fifth taxable years.

Impact on FUTA Tax Return

Employers in these credit reduction states will pay as much as $21 per employee in additional FUTA tax for employees in these states due to the credit reductions. The increased FUTA tax is considered incurred in the fourth quarter and is due by January 31, 2023, when the FUTA tax return for 2022 is due. For example, an employer in one of these credit reduction states would compute its FUTA tax liability for that state by reducing the 6.0% standard FUTA tax rate by a FUTA credit of only 5.1% instead of 5.4% (the standard 5.4% credit minus the 0.3% credit reduction) for an effective FUTA tax rate of 0.9% for the year. The employer will calculate the additional FUTA tax using the Schedule A for Form 940 and the additional FUTA tax is then added to the total FUTA tax liability on Form 940 for the year. For the U.S. Virgin Islands, the effective FUTA tax rate will be 4.2%, compared to 3.9% in 2021.

BDO Insights

The Connecticut Department of Labor announced in September 2022 that it would reduce the state unemployment tax rates by 0.2% for calendar year 2023 as part of the law that was passed earlier in the year. Although this rate reduction will not affect the FUTA tax increase caused by the FUTA credit reduction, it will help mitigate or offset the impact by reducing the state unemployment tax costs in 2023 for employers in Connecticut.

Employers in these credit reduction states should plan for the increased FUTA tax expense. Due to the large loan balances these states have, they may be at risk of another credit reduction of 0.3% for 2023 if balances remain on January 1, 2023, and are not repaid by November 10, 2023, with the additional tax due on January 31, 2024. This would raise the FUTA tax cost per employee for 2023 by as much as $21 for employees in these states, compared to 2022. At least one state -- Connecticut -- has indicated that it will likely continue to have an outstanding loan balance through 2025 based on its projections.

Like these five states, many other states have also borrowed money from the federal government to pay for the flood of unemployment insurance benefit claims caused by the COVID-19 pandemic, but they have since repaid their loans and therefore are not subject to the FUTA credit reductions for 2022. If those states resume borrowing, they may be at risk of a credit reduction in future years.