On November 11th, 2022 the US Department of Labor announced that five jurisdictions faced FUTA tax credit reductions for their failure to repay federal unemployment insurance loans administered during the COVID-19 pandemic.
As one of the five jurisdictions listed, Illinois has earned the classification of a “credit reduction state.” Unfortunately for employers across the state, this categorization has a direct impact on payroll. As a result, it's important for business owners to understand the impact of the state’s FUTA tax credit reduction.
In this article we will explore everything Illinois employers should know about the state’s FUTA tax credit reduction, including how it directly impacts their business and payroll.
- Understanding FUTA Tax Credits and Reductions
- How Illinois Became a Credit Reduction State
- How Employers are Impacted by Illinois’ FUTA Credit Reduction
Understanding FUTA Tax Credits and Reductions
What is a FUTA Tax?
In the US, unemployment insurance provides financial aid to eligible individuals while they seek new employment opportunities. Generally, unemployment insurance is managed by states, meaning different jurisdictions have different tax rates. The federal government, however, can also issue unemployment insurance during national emergencies – such as the COVID-19 pandemic.
Like most social welfare initiatives, unemployment insurance is primarily funded by tax contributions. As a result, every business owner is required to contribute to both state and Federal Unemployment Insurance (“UI”) funds through an “unemployment tax.”
The Employer’s Annual Federal Unemployment Tax, or FUTA, is the federal government's solution to funding unemployment insurance. As of 2022, the FUTA tax rate is 6.0%, applied to the first $7,000 paid toward each employee’s wages throughout the year.
Employers should file their FUTA contributions on an annual basis using Form 940. While filing, businesses can apply for credit reductions of up to 5.4%, reducing their individual tax rate to 0.6%.
What is a FUTA Credit Reduction State?
Just like how individual businesses can apply for FUTA credit reductions, state governments can also apply for reductions. These state-wide reductions lower the FUTA taxes that each employer must pay.
A state becomes a “credit reduction state” if it fails to repay federal government loans used to meet its unemployment benefit liabilities within the set time frame. Generally, FUTA credit reduction states are those with outstanding balances on January 1st for two consecutive years, and fail to clear their debt by November 10th of the second year.
For employers, a credit reduction against the full FUTA tax rate means increased tax rates on wages paid towards employees – meaning impacted employers will have to pay higher taxes in 2023.
According to the Department of Labor, the reduction schedule for credit reduction states is:
- A 0.3% reduction for the first year that a state is a credit reduction state;
- An additional 0.3% reduction each year until the state repays its loan;
- Potential additional credit reductions, applied at the beginning of the third and fifth taxable years if a loan balance is still outstanding.
For more information on FUTA Credit Reductions, visit the Internal Revenue Service.
How Illinois Became a FUTA Credit Reduction State
In response to the COVID-19 pandemic's direct impact on the American economy, twenty-one states and the Virgin Islands requested and received federal UI loans throughout 2020 and 2021.
Under federal law, UI loans must be partially or fully repaid within two years. If these debts are unpaid, then the FUTA taxes paid by state employers is increased to offset the principal balance. As of October 21st, 2022, around half of the twenty-two jurisdictions repaid their federal unemployment insurance loans.
The majority of borrowing states used either state funds, federal COVID-19 stimulus money, or a combination of both to offset their UI loan balances. Texas, for example, authorized a $7.2 billion deposit from the state’s unemployment insurance fund to repay its federal debt (SB 8).
On November 11th, 2022, the US Department of Labor announced that five jurisdictions failed to repay their federal loans by the November 10th deadline, effectively voiding their full FUTA credit for the year. Illinois was on this list, joined by California, Connecticut, New York, and the U.S. Virgin Islands.
By failing to pay its outstanding loans by the November 10th deadline, Illinois earned its classification as a “FUTA credit reduction state.” The impact of this classification is discussed in the section below.
How Employers are Impacted by Illinois’ FUTA Credit Reduction
For the most part, employers absorb the burden of the penalties the state receives for failing to repay their unemployment insurance loans. Specifically, employers are required to pay higher taxes on their Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return.
Currently, the Federal Unemployment (FUTA) Tax rate is 6%, applied to the first $7,000 paid to each employee. Generally, employers receive a maximum credit of 5.4%, lowering their tax rates to 0.6% – approximately $42 per employee per year. Because Illinois failed to meet their loan deadline, however, employers face an additional 0.3% credit reduction, resulting in a FUTA tax rate of 0.9% – approximately $63 per employee.
When it comes to payroll management, employers should be prepared to incur this FUTA tax liability during the fourth quarter of 2022. Employers must file their Form 940 and payment by January 31st, 2023.
As a result of Illinois’ status as a credit reduction state, employers should plan accordingly for higher FUTA tax rates.
To assist employers, the IRS includes resources for credit reduction states, applicable reduction rates, and examples in the instructions for Schedule A (Form 940), Multi-State Employer and Credit Reduct Information.
How to Report the Credit Reduction
To calculate their business’s credit reduction, employers should use Schedule A (Form 940).
On the form, employers should fill the checkbox for every state they paid state unemployment taxes for. If the state is currently a credit reduction state, then the employer should use the FUTA boxes to record their taxable wages.
Per the IRS, there are two types of employers who should use Schedule A (Form 940):
- Employers that paid FUTA taxable wages and UI tax in more than one state
- Employers that paid FUTA taxable wages and UI tax in any credit reduction state, even if the employer is a single-state employer. These employers report the FUTA taxable wages and multiply by the credit reduction rate (0.3%, 0.6%, 0.9%, etc.) to calculate the total credit reduction, which the employer carries forward to Form 940.
Notably, an employer who paid unemployment insurance taxes in more than one jurisdiction must fill in the Schedule A (Form 940) checkboxes for each state – even if they are not credit reduction states.
Easily Manage Every Policy Change with CAVU HCM
When it comes to running a business, policy changes are just one of many stressors that employers face on a daily basis. From managing staff, to operating an entire business, it can be easy to let impactful policies fall through the cracks – and face unintended penalties as a result.
Luckily, CAVU HCM’s comprehensive payroll service is available for businesses of all sizes.
Located in Peoria, Illinois, CAVU HCM uses a combination of concierge services and a premium software solution to provide support to employers as they manage their payroll, human resources, and more. Experts on the local, state, and federal level, CAVU’s Payroll Guides ensure their partners meet every form of compliance – including federal unemployment credit reductions.
To learn more about CAVU HCM’s extensive offerings, click here.