FUTA (Federal Unemployment Tax Act)

FUTA, the Federal Unemployment Tax Act, is a federal tax that employers pay to help fund unemployment compensation for workers who lose their jobs. It is an employer-only tax. According to IRS Topic 759, “the FUTA tax rate is 6.0%” and “the tax applies to the first $7,000 you paid to each employee as wages during the year.” Most employers do not pay the full 6.0 percent, because a credit for state unemployment tax brings the effective rate down sharply. FUTA is reported annually on Form 940, the Employer’s Annual Federal Unemployment (FUTA) Tax Return.

How FUTA Works

FUTA is levied on the employer, not the worker. Unlike income tax or the employee share of Social Security and Medicare, FUTA is never withheld from a paycheck. The employer computes the tax on the wage base and pays it directly.

The mechanics, per IRS Topic 759, are straightforward:

1. The rate is 6.0 percent.
2. It applies only to the first $7,000 of wages paid to each employee during the calendar year. Wages above $7,000 for that employee are not subject to FUTA.
3. The tax is reported on Form 940 and deposited according to the IRS deposit rules.

The State Credit and the Net 0.6 Percent

The 6.0 percent rate is rarely the amount an employer actually pays. The IRS states on Topic 759 that employers who pay their state unemployment tax in full and on time receive “a credit of up to 5.4% of FUTA taxable wages.” That credit reduces the federal rate to a net 0.6 percent. The IRS confirms the arithmetic on its FUTA credit reduction page: “Generally, employers may receive a credit of 5.4% when they file their Form 940 … to result in a net FUTA tax rate of 0.6% (6.0% - 5.4% = 0.6%).”

In a state that is in good standing with the federal unemployment fund, this means an employer’s FUTA cost is generally 0.6 percent on the first $7,000 per employee, or about $42 per employee per year. Employers in a credit reduction state pay more, because the state has an outstanding federal loan and part of the credit is taken away.

FUTA Applies to Employees, Not Contractors

FUTA attaches to the employer-employee relationship. It applies to wages paid to employees and does not apply to amounts paid to independent contractors. The distinction tracks worker classification. A common-law employee generates FUTA liability for the employer, while a properly classified independent contractor does not.

This is one reason classification matters for tax cost. Worker misclassification, treating a true employee as a contractor, can leave a payer liable for back FUTA along with other unpaid employment taxes and penalties. FUTA sits alongside the other payroll tax obligations that ride with employment.

Common Pitfalls

• Withholding FUTA from pay. FUTA is an employer tax. It cannot be deducted from an employee’s wages.
• Applying the rate to all wages. FUTA only reaches the first $7,000 of each employee’s annual wages, not total payroll.
• Assuming the full 6.0 percent. Employers in good standing with their state generally pay a net 0.6 percent after the 5.4 percent credit.
• Paying FUTA on contractor payments. FUTA applies to employees. Amounts paid to a correctly classified independent contractor are outside FUTA.

Related Terms

• Payroll Tax: the broader set of employment taxes FUTA belongs to.
• Common-Law Employee: the worker status that triggers FUTA.
• Worker Misclassification: the classification error that can create back FUTA liability.

Omnivoo classifies each worker before payment, so US employers and payers know when a payment carries employment-tax obligations like FUTA and when it does not.