What Is FUTA Tax? Rate, Who Pays, and Form 940

Almost every explanation of this tax gives you the same four numbers and stops: six percent, a credit of five point four percent, a net rate of six tenths of one percent, and a maximum of forty two dollars per employee. Those numbers are correct. They are also the reason small employers get surprised by their own federal unemployment bill, because forty two dollars is a ceiling per person rather than a rate on payroll.

Here is what that distinction actually costs. Take two businesses that each paid out $700,000 in wages last year. The first has ten long tenured employees earning around $70,000 each, and owes roughly $420 in federal unemployment tax for the whole year. The second spread the same $700,000 across forty five people who came and went, and owes closer to $1,890. Identical payroll. Four and a half times the tax.

Nobody writes that down, because the rate is genuinely small and the acronym is genuinely boring. But the mechanism matters: this is one of the few taxes in the US system that charges you for churn rather than for compensation, and the businesses it hits hardest are restaurants, retail, agriculture, home care, and anyone else running a revolving door. This guide covers what the acronym means, the three tests that decide whether you owe anything, how to calculate the number correctly, what a credit reduction state does to your January, and how the return and deposit rules work. I build payroll and employee record tooling for businesses without a payroll department at FirstHR.

What FUTA Is

FUTA is a federal tax that employers pay on a slice of each employee's wages to fund the unemployment insurance system. It is not withheld from anyone's paycheck, it is not matched by employees, and the money does not go to your own former employees directly.

The split between federal and state is the part that confuses people. Your former employee's weekly unemployment check comes from your state's fund, which is financed by your state unemployment tax. The federal tax pays for the machinery: the state agencies that process claims, the federal half of extended benefits during downturns, and the loan account states draw on when claims outrun contributions. Two taxes, two destinations, one event.

That structure explains something otherwise puzzling. The federal tax barely moves, since the wage base has sat at $7,000 since 1983 and the net rate has been 0.6 percent since mid 2011. Your state rate, by contrast, moves every year based on your own layoff history. When employers talk about unemployment tax getting expensive after a round of layoffs, they are almost always talking about the state side. The federal side only becomes expensive under one specific condition, covered below.

What FUTA Stands For

FUTA stands for the Federal Unemployment Tax Act. In payroll, tax, and accounting contexts the acronym always refers to this law, and it is pronounced as a word rather than spelled out.

The law came out of the Social Security Amendments of 1939, which consolidated and restructured provisions originally enacted in the Social Security Act of 1935. It is codified in the Internal Revenue Code at sections 3301 through 3311. The constitutional question about whether Congress could tax employers to push states into building unemployment systems was settled by the Supreme Court in 1937, in a case brought by an Alabama company against the federal collector.

The design is deliberately coercive and worth understanding, because it explains the credit that dominates the arithmetic. Congress set a high federal tax and then offered employers a large credit for contributions to a state unemployment fund that meets federal standards. States that did not build a conforming system would see their employers pay the full federal rate with nothing coming back to the state. Every state built one. What remains today is a headline rate almost nobody pays and a discount almost everybody gets.

Who Pays FUTA Tax

Employers pay FUTA, and only employers. Employees pay nothing toward it, and it is unlawful to deduct it from wages. Whether your business owes it at all depends on one of three tests, and you only need to meet one.

The IRS guidance on Form 940 filing requirements spells out the general test with a detail that trips people up: the lookback covers the current year and the prior year. A business that hit $1,500 in a single quarter last year is liable this year even if this year is quiet. Liability is sticky in a way that quarterly payroll taxes are not.

A few situations that come up constantly at small businesses:

The contractor row carries the most risk. FUTA is one of several taxes that reappear when a classification is overturned, alongside the employer share of Social Security and Medicare, income tax withholding exposure, and state unemployment contributions. If you rely heavily on 1099 workers, the question of employee versus contractor status is worth settling before an audit settles it for you, and the cost of getting classification wrong compounds across every year the arrangement ran.

If you use a staffing agency or a professional employer organization, the answer depends on the arrangement. Workers supplied by a staffing agency are usually that agency’s employees and appear on its return rather than yours. Under a co-employment arrangement the paperwork can go either way, and certified organizations are permitted to file on behalf of their client employers. It is worth confirming in writing which entity files and which one carries the liability, because the client business does not automatically stop being an employer for tax purposes just because someone else runs the payroll.

The Rate and Wage Base

The statutory FUTA rate is 6.0 percent on the first $7,000 of each employee's wages for the calendar year, and the credit for state unemployment tax brings most employers down to an effective 0.6 percent. That is a maximum of $42 per employee per year.

Two properties of the wage base matter more than the rate itself.

First, the base is per employee, per employer, per calendar year. If someone earns $200,000 from you, only $7,000 of it is subject to FUTA. If someone earns $5,000, all $5,000 is subject. The base resets every January regardless of tenure, so a ten year employee generates the same $42 as a brand new hire.

Second, the base does not reset when someone quits and comes back to the same employer in the same year. Wages you already counted stay counted. But if that person goes to work somewhere else, the new employer starts a fresh $7,000 base for them. Two employers, two wage bases, same worker, same year. That is a feature of the design rather than a loophole, and it is why the total federal unemployment tax collected on a mobile workforce is higher than the tax on a stable one.

How to Calculate It

The calculation is four steps, and the error almost everyone makes is applying the $7,000 cap to total payroll instead of to each person individually.

A worked example for a small operation with an owner on payroll, one full time employee, one part timer, and one seasonal hire:

At the standard 0.6 percent, that business owes $151.20 in federal unemployment tax for the year. Because the total stayed under $500, no quarterly deposit was required at any point and the whole amount is paid with the annual return. In a state with a 1.2 percent credit reduction the same payroll produces an effective 1.8 percent rate and a bill of $453.60, still under the deposit threshold but three times the cost.

Why Turnover Raises It

FUTA is charged per head rather than per payroll dollar, which means the same wage bill produces very different tax depending on how many people it passed through. This is the single most useful thing to understand about the tax and the thing incumbent explainers leave out.

The mechanism is simply the wage base. Once someone crosses $7,000, every additional dollar you pay them is free of federal unemployment tax. Concentrating payroll in fewer, longer tenured people minimizes the tax. Spreading it across many short stints maximizes it.

Those are illustrative rather than survey figures, and the exact taxable wage totals depend on how much each person earned before leaving. The direction is not in doubt, though: the churn heavy business pays several times the federal unemployment tax on the same money. Add the state side, where a claims history also drives your experience rate upward, and the combined unemployment cost of a revolving door is meaningfully larger than the headline rates suggest.

This is where a payroll line item turns into an operations question. The federal portion is small in absolute terms, but it is a clean, unarguable proxy for how many people entered and left your business, sitting right there on a tax return. If you already track what turnover costs you, the FUTA figure is a useful cross check, because unlike most turnover estimates it is not modeled. It is what you actually paid.

There is one important exception, and it matters to anyone buying a business. If you acquire a company and keep its employees, you are a successor employer, and you may count the wages the previous owner already paid those people toward their $7,000 base for the year. You check the successor employer box on the return and carry the wages forward rather than starting from zero. Missing this is a straightforward overpayment, and it is easy to miss because an acquisition usually means a new payroll system with no prior year to look at. If you are working through an acquisition, the wage base carryover belongs on the same list as the employee records handover.

How You Lose the Credit

There are three ways to end up paying more than 0.6 percent, and only one of them is outside your control. Paying state unemployment tax after the federal return is due costs you part of the credit. Paying wages that your state does not cover at all costs you the credit entirely on those wages. Operating in a credit reduction state costs you a slice of it regardless of what you do.

That last row is the one that reassures people and almost never gets said out loud. A new business or a business with no claims history often has a state unemployment rate well under 5.4 percent, sometimes closer to one percent. You do not lose federal credit for paying less state tax. An additional credit makes up the difference between what you actually paid and what 5.4 percent would have been, so a low state rate is a pure saving rather than a trade.

The second row is the expensive one. Late state payments are not forgiven and they are not fully penalized either: they earn ninety percent of the credit they would have earned on time, and the arithmetic runs through a worksheet in the form instructions rather than a single line. The third and fourth rows catch a narrower group. Some states exclude particular categories of worker, most commonly corporate officers or specific occupations, from state unemployment coverage. Those wages remain fully subject to federal unemployment tax with no state credit against them, so the effective rate on that portion is the full 6.0 percent.

Credit Reduction States

A credit reduction state is one that borrowed from the federal unemployment account and did not repay within the allowed window. Employers in that state lose part of the 5.4 percent credit, so their effective rate climbs above 0.6 percent.

The reduction starts at 0.3 percent in the second consecutive year a loan is outstanding and grows by another 0.3 percent each year the balance persists. An additional add on can apply after the fifth consecutive year, though states can and do apply for a waiver of it. The Department of Labor publishes both the potential list and the final determination, and the timing is the operationally important part: the final list is not settled until after November 10 of the tax year it applies to.

For the 2025 tax year, California and the U.S. Virgin Islands were the only jurisdictions affected. Connecticut and New York had both appeared on the potential list earlier in the year and repaid their outstanding balances before the November 10 deadline, so their employers stayed at the standard rate. California and the Virgin Islands each applied for and received a waiver of the additional fifth year add on, which kept their reductions lower than the preliminary figures had suggested.

Looking forward, the Department of Labor has again identified California and the U.S. Virgin Islands as potentially subject to a reduction for the current tax year, at a base rate of 1.5 percent and 4.8 percent respectively. California's figure could rise substantially if an add on applies without a waiver. None of this is final until after the November deadline, and any employer with wages in those jurisdictions should treat the higher end of the range as a planning number rather than assume the lower one.

Two details catch multi state employers. A credit reduction follows the state where the work was performed, not where your business is registered, so a company headquartered in a clean state with three remote employees in an affected one still owes the higher rate on those three. And any employer with wages in more than one state files Schedule A with the return, whether or not a reduction applies. If you are running payroll across state lines, this is the schedule that most often gets missed.

FUTA vs SUTA vs FICA

Three payroll taxes get confused with each other constantly because they appear on the same reports and sound alike. They differ on who pays, what the money does, and how the rate is set.

The relationship between the first two is the one worth internalizing. Your state unemployment tax is the one that responds to your layoff history and the one that gets genuinely expensive, with wage bases in some states many times the federal $7,000. The federal tax mostly sits still. But paying the state one correctly is what keeps the federal one at 0.6 percent, so they are linked in a way that Social Security and Medicare taxes are not linked to anything.

All three are employer obligations that show up on different forms with different cadences, which is the practical argument for keeping them on a single compliance calendar rather than reacting to each filing notice as it arrives.

Form 940 and Deposits

You report FUTA once a year on Form 940, due January 31 for the prior calendar year, but you may have to deposit the tax quarterly before you ever file. Those are two separate obligations with two separate deadlines, and conflating them is the most common filing error.

The deposit rule works on a running total rather than on each quarter in isolation. If your undeposited liability is $500 or less at the end of a quarter, you carry it forward. Once the cumulative figure passes $500, you deposit by the last day of the following month. If the annual total never passes $500, you simply pay it with the return. All federal deposits must go through electronic funds transfer.

When January 31 falls on a weekend or a legal holiday, the return deadline moves to the next business day. Employers who made every required deposit in full and on time earn an extended filing date ten days later, which is a small but real reward for keeping the deposit schedule clean.

On mechanics: you can file electronically through an authorized provider or on paper, and the mailing address depends on your state and on whether a payment is enclosed. If your total for the year came in at $500 or less you can send the payment with the return using the payment voucher rather than going through the deposit system at all. If you paid wages in more than one state, or in any state on the credit reduction list, the return needs the multi state schedule attached. Filing is required every year you meet one of the three tests, including years when the tax works out to zero.

The first sheet is the calculation itself, with separate columns for gross wages, exempt payments, and the capped amount, so the per person cap is applied where it belongs rather than at the bottom of a total. The second tracks the running liability against the $500 threshold quarter by quarter, including a row for the credit reduction true up that lands in Q4. The third is the pre filing checklist, which exists because the items that delay a Form 940 are almost always missing inputs rather than difficult math.

Keep the supporting records for at least four years after the tax was due or paid. That means payroll registers, the wage detail behind your taxable figure, deposit confirmations, and the filed return itself. The same retention logic applies to the rest of your payroll records, and keeping them in one place rather than scattered across a payroll provider, a bank, and a shoebox is what makes a notice a fifteen minute task instead of a week.

Penalties for Late Filing

Late FUTA filings and deposits carry the same penalty schedules as much larger employment taxes, which means the percentages look alarming even though the dollar amounts on a small federal unemployment bill rarely are. The real cost of being late is almost always the lost state credit rather than the penalty itself.

Put a real number on it. A twenty person business owing $840 in federal unemployment tax that files three months late faces a filing penalty in the low hundreds. The same business that paid its state unemployment tax after the federal return was due can lose enough credit to add thousands. The penalties are the visible cost and the smaller one.

Two practical notes. If you discover an error after filing, the correction goes on the amended version of the return rather than a fresh original, and it needs an explanation of what changed. And if you are closing the business or have stopped paying wages, mark the return final so the IRS stops expecting one, since a missing return generates notices long after there is anyone left to answer them. Both belong on the same offboarding list as your final paycheck obligations.

Wages That Are Exempt

Not every dollar you pay an employee is subject to FUTA. A handful of payment types come out before you apply the wage base, and getting this wrong in either direction is common.

The 401(k) row is the one that most often produces a wrong number. Elective deferrals are excluded from federal income tax withholding, which leads people to assume they are excluded from everything, but they remain subject to federal unemployment tax and to Social Security and Medicare. If your payroll deduction setup treats all pre tax deductions identically, this is worth checking before year end rather than after a notice.

On the employer side, section 501(c)(3) organizations and government entities are generally outside FUTA entirely. Nonprofits usually still participate in state unemployment insurance, often by reimbursing the state for benefits actually paid rather than by paying a contribution rate, which is a materially different arrangement and one that nonprofit employers should confirm with their state agency rather than assume.

Common Mistakes

The errors repeat across businesses of every size, and most of them are structural rather than arithmetic.

The last one deserves emphasis because it arrives with growth. A business that has always paid its federal unemployment tax with the return does not get a notification when it crosses into deposit territory. It simply becomes late, and the penalty is calculated on a deposit nobody knew was due. Reviewing the running total alongside your regular payroll reconciliation catches it, and reviewing it as part of a broader payroll audit catches the classification and exemption issues at the same time.

None of this is difficult once the wage base is understood correctly. What makes FUTA an outsized source of small business errors is that the number is small enough to ignore and structured differently from every other payroll tax on the same report. It rewards attention exactly once a year, and a clean set of payroll records makes that once a year attention take an hour instead of a weekend.

Frequently Asked Questions