This article goes over FUTA (the Federal Unemployment Tax Act), and explains how this started our federal unemployment insurance system. Do you need to pay for this? It depends!
The Covid pandemic has had devastating effects on the United States’ labor market. In April 2020, a month after the pandemic started ripping through the US, the national unemployment rate reached 14.8%. This isn’t as bad as the Great Depression when the rate was reportedly 25%, But this was the highest rate since World War II. The good news is that millions of people were able to receive substantial unemployment benefits to help pay their bills. A lot of this was paid for by the CARES act, which provided $260 billion in increased unemployment benefits.
If you lost your job or had your hours reduced like so many others, you hopefully got to take advantage of these increased benefits. You might not have realized that even in normal times there’s a lot of money floating around to pay for unemployment. Don’t be too happy, though — you’re paying for it!
This deep dive into unemployment taxes is a bit more in the weeds than my usual posts, but as an owner of a growing real estate business, I’ve considered employment taxes as I consider expanding my empire (and perhaps taking on employees). In normal conversation, I’d be embarrassed to admit that I read about stuff like this for educational purposes. But if you’re here, maybe you like to read this stuff too?
(I find taxation really interesting, but I understand completely if it’s not your cup of tea. Go and read about my real estate portfolio instead!)
What does FUTA stand for?
Unemployment taxes were established by FUTA, which stands for the Federal Unemployment Tax Act. Passed in 1939, this federal law can also be thought of as federal-state program that basically established a national unemployment insurance program.
If you’re employed, you might not be aware that you’re paying these, because your employer is paying for it on your behalf.
When you look at your paycheck, you may or may not see “FUTA” being deducted. Even if you don’t see it explicitly listed, the FUTA tax liability affects your pay, whether you like it or not.
What is the FUTA tax rate?
For a small business owner, this tax can represent a significant business expense. It’s a form of payroll taxes, and the base FUTA rate is 6% of the first $7000 of any employee’s wages. When you do the math, it’s $420 (as of 2021). Across many workers, these employer contributions can really add up!
But federal and state unemployment taxes are just another one of a myriad of costs of having employees.
The cost of having an employee
Here’s a short list of some of the payroll taxes you have to pay if you have an employee (Tax rates as of 2021):
- Employer share of FICA taxes (social security tax): 7.65-9.1%
- Employer share of Medicare taxes: 1.45%
- FUTA taxes (combined state and federal): 6%
Altogether, this is about 15% additional cost to having an employee, not to mention other benefits like insurance and retirement fund matching.
If a business actually has employees, they have to take on these extra expenses. Inevitably, these will get passed along either to the workers or to the customers.
No wonder a lot of companies prefer using temporary workers!
Who has to pay FUTA taxes?
There are two ways to know if you have to pay the FUTA tax. It depends how much you’re paying in employee wages during a given calendar year. Here’s the exact wording from the IRS website:
- You paid wages of $1,500 or more to employees in any calendar quarter during 2019 or 2020, or
- You had one or more employees for at least some part of a day in any 20 or more different weeks in 2019 or 20 or more different weeks in 2020. Count all full-time, part-time, and temporary employees.
What is the definition of “employee?”
You can see that the definition of “employee” becomes really important to employers, as a lot of money rides on this semantic difference. If your business uses only independent contractors, you can potentially save a ton of money that you’d otherwise have to pay in taxes and benefits.
Here is the general test to define an independent contractor from the IRS: “The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”
This seems incredibly vague to me, and to others as well. It’s led to some massive fights because so much money is at stake. In 2020, California passed a law and sued gig worker companies like Uber and Lyft. The lawsuit tried to force them to classify their workers as employees, rather than as independent contractors. These companies poured $200 million into a ballot measure to defeat this law — and they won. Proposition 22 passed with 59% of the vote in late 2020 and exempted app-based companies from classifying their workers as employees.
The following year, various organizations promptly sued. The fate of the legislation has been locked in court battles ever since.
Agricultural employers have been targeted in similar lawsuits, and payroll tax related issues even reach the level of household employees.
What about SUTA?
At the state level, there’s a parallel unemployment tax system that was established alongside the FUTA in 1939. The SUTA (state unemployment tax act) established mandatory payroll taxes to cover unemployment payments as well. The exact SUTA tax rate varies by state and are deductible against the FUTA. Depending on the state, employers can claim up to the maximum credit of 5.4% of their FUTA taxes with their SUTA taxes.
State governments are not exempt
Even state governments are not exempt from having to pay unemployment taxes on behalf of their employees. They will also have to pay the minimum 6% on the first $7000 of employees’ wages. But not all state governments have that kind of cash lying around. This has come up as an issue so often that there’s actually a system to bail out poorer states. Basically, the federal government will loan state governments money to pay for these FUTA taxes. If the state doesn’t pay the loans back by the due date, the federal government starts to wrest the money back.
In this scenario, the federal government reduces the FUTA tax credit that the state can claim when they file their federal taxes. This tax credit is the same credit that an employer can claim so they’re not paying the unemployment tax twice.
If this happens in your state, you live in a “credit reduction state.”
As of February 2021, there were 19 credit reduction states that owed the internal revenue service loans for unpaid FUTA taxes. Interestingly, the Virgin Islands are on this list, which is strange to me.
The whole program is run by the Department of Labor, and in early 2021 the unpaid loan balance was a whopping $48,694,365,541. And you thought you had debt problems?
Conclusion
I hope you enjoyed this deep dive into FUTA, the Federal Unemployment Tax Act. It’s fascinating how it basically established a federal system of unemployment insurance. My big takeaway is that it’s costly to have employees. Most small business owners will be smart to just use independent contractors as long as possible.
When it comes to my growing real estate business, it’ll probably be a two person show for the near future. As far as I know, I don’t have to pay a FUTA payroll tax for my wife. That is, unless we count things like date night and baking implements. These two things add up to more than any unemployment tax would anyway!
— TDD
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