IRS Form 940 and Unemployment Update

IRS Form 940 is the Employer's Annual Federal Unemployment (FUTA) Tax Return, used to report and pay Federal Unemployment Tax Act (FUTA) tax. FUTA funds unemployment insurance benefits for workers who lose their jobs and supports the federal-state unemployment system. Most employers who paid wages of $1,500 or more in any calendar quarter, or who employed at least one worker for any part of a day in 20 or more different weeks, must file Form 940 annually. The FUTA tax rate is 6.0% on the first $7,000 of each employee's wages. Employers who pay state unemployment taxes on time generally receive a credit of up to 5.4%, reducing the effective federal rate to 0.6%. Form 940 is due January 31 following the end of the calendar year, with a February 10 extension if all FUTA deposits were timely made. Employers must deposit FUTA tax quarterly whenever the cumulative liability exceeds $500, making payroll calendar management essential to avoid late deposit penalties.

The FUTA credit reduction applies to employers in states that borrowed from the federal unemployment trust fund to pay benefits and have not repaid those loans within the required timeframe. Under normal circumstances, employers claim a 5.4% credit against the 6.0% FUTA rate, resulting in an effective rate of 0.6%. However, if a state has had outstanding federal loans as of January 1 for two consecutive years, the credit is reduced by 0.3% for each additional year the loan remains unpaid. The reduction is applied on Schedule A of Form 940 and can significantly increase an employer's FUTA liability. For example, a 0.3% credit reduction adds $21 per employee per year at the $7,000 wage base. States with ongoing FUTA credit reductions are published annually by the IRS, typically in November. Employers with employees in credit reduction states must monitor these lists closely to accurately calculate FUTA taxes and make timely deposits, as underestimating FUTA liability due to unanticipated credit reductions is a common and costly error.

Form 940 errors can result in IRS notices, penalties, and underpayment interest, making accurate preparation essential. Among the most common mistakes is incorrectly calculating the FUTA taxable wage base: only the first $7,000 paid to each employee is subject to FUTA, and payroll systems may not properly cap wages for employees who changed jobs mid-year or whose records were imported with errors. Forgetting to apply the FUTA credit reduction for affected states leads to underpayment. Misclassifying workers as independent contractors—excluding them from FUTA calculations—is a significant compliance risk. Failing to deposit FUTA tax quarterly when liability exceeds $500, then paying the full balance with the annual return, results in late deposit penalties. Finally, errors in reporting exempt payments—such as employer-paid health insurance, qualified retirement plan contributions, or dependent care assistance—either overstate or understate taxable wages and warrant careful review before filing. Keeping payroll systems current and reconciling FUTA wages to state SUI reports each quarter prevents most of these errors.

Not all employee compensation is subject to FUTA tax, and correctly identifying exempt payments is essential to accurate Form 940 reporting. Employer contributions to qualified retirement plans, employer-paid health insurance premiums, employer-provided dependent care assistance up to the exclusion limit, and employer-provided educational assistance up to $5,250 are generally FUTA-exempt. Third-party sick pay paid after the sixth month of disability absence is excluded, as are wages paid to certain agricultural workers below applicable thresholds, wages paid to household employees below the annual household employment threshold, and compensation paid to corporate officers in S corporations under certain conditions. Wages paid to immediate family members employed by a sole proprietor or partnership also have special FUTA treatment. Accurately identifying and separately tracking these exempt payments in payroll systems ensures they are properly excluded from FUTA taxable wages, preventing both overpayment and underpayment errors on Form 940 and its accompanying Schedule A.

Unemployment tax law changes at both the federal and state levels periodically affect employer FUTA and state unemployment insurance (SUI) obligations and Form 940 reporting. At the federal level, the most impactful annual changes involve the IRS's determination of which states have FUTA credit reductions due to outstanding federal loans, directly increasing employer tax liability in affected states. State unemployment tax rate changes also indirectly affect Form 940 because the full 5.4% FUTA credit requires employers to pay state unemployment taxes in full and on time—underpaying SUI taxes can cause partial loss of the FUTA credit. Post-pandemic, many states reassessed their trust fund balances and significantly adjusted SUI tax rates, affecting the overall unemployment tax burden on employers. Staying current with IRS announcements on credit reduction states, state SUI rate notices, and any Congressional action affecting FUTA wage bases or rates is critical for payroll and HR professionals responsible for accurate and timely unemployment tax compliance.