IRS Form 940: Reporting Federal Unemployment (FUTA) Tax

Form 940 is the annual return for reporting Federal Unemployment Tax Act (FUTA) taxes. While most employees never think about it, every employer in America is paying federal unemployment tax on their behalf. The FUTA system funds state unemployment agencies and provides a safety net for workers who lose their jobs through no fault of their own. The form itself is straightforward, but the underlying system; with its frozen wage base and credit mechanisms; is one of the most outdated corners of the tax code.

History and Origin

The Federal Unemployment Tax Act was enacted in 1939 as part of the Social Security Act amendments, building on the original unemployment insurance framework established in 1935 during the Great Depression. The idea was straightforward: create a federal-state partnership where employers pay taxes to fund unemployment benefits for workers who are laid off.

The system works through a credit mechanism. The federal FUTA tax rate is 6.0% on the first $7,000 of each employee's wages. However, employers who pay state unemployment taxes (SUTA) on time receive a credit of up to 5.4%, reducing the effective federal rate to just 0.6%. This credit mechanism encourages states to maintain their own unemployment insurance programs, if a state program fails to meet federal standards, the credit can be reduced.

The $7,000 wage base has been frozen since 1983, making it perhaps the most outdated threshold in the entire tax code. When set, $7,000 represented a real portion of annual wages. Today, it's a fraction of the average worker's earnings. By contrast, state unemployment tax wage bases vary widely; from $7,000 in states that match the federal minimum to over $60,000 in Washington state.

Who Files It and When

An employer must file Form 940 if they meet either of two tests:

• Paid wages of $1,500 or more in any calendar quarter during the current or preceding year
• Had one or more employees for at least some part of a day in any 20 or more different weeks in the current or preceding year

Special rules apply to agricultural employers (who must pay $20,000 or more in wages or employ 10 or more workers in 20 weeks) and household employers (who must pay $1,000 or more in a quarter).

The filing deadline is January 31 of the year following the tax year. However, if all FUTA tax was deposited on time throughout the year, the deadline extends to February 10. FUTA tax deposits are generally required quarterly if the accumulated tax exceeds $500.

The maximum FUTA tax per employee at the effective 0.6% rate is just $42 per year($7,000 x 0.6%). For an employer with 50 employees, that's $2,100 annually; a modest cost that funds the federal share of the unemployment system.

Key Sections Explained

• Part 1; Basic Information: Identifies whether the employer was required to pay state unemployment tax in only one state or multiple states, and whether they paid all state unemployment taxes by the due date. These answers determine whether the employer qualifies for the full 5.4% credit.
• Part 2; Tax Calculation: The core computation. Start with total payments to all employees, subtract exempt payments (fringe benefits, group-term life insurance, employer contributions to retirement plans, etc.), and subtract payments over $7,000 per employee. The result is taxable FUTA wages, which are multiplied by 0.006 (the net rate after the 5.4% credit).
• Part 3 — Adjustments:Adjustments for employers who owe FUTA tax at the full 6.0% rate because they didn't pay state taxes on time, or because their state has an outstanding federal loan (a "credit reduction state").
• Part 4 — Quarterly Liability: Breaks down the FUTA tax liability by quarter. This determines when deposits were due and whether the employer met deposit requirements.
• Part 5 — Balance Due or Overpayment: Reconciles total tax with deposits made, showing whether the employer owes additional tax or has an overpayment.

Common Mistakes

Missing the credit reduction adjustmentis a significant error. When a state borrows from the federal government to pay unemployment benefits and doesn't repay the loan within two years, employers in that state face a FUTA credit reduction. This means the 5.4% credit is reduced, and employers must pay more than the usual 0.6% effective rate. After the COVID-19 pandemic, several states carried outstanding federal loans, and employers in those states needed to account for the credit reduction on their Form 940.

Incorrectly calculating the $7,000 wage base per employee is another common issue. The $7,000 limit applies per employee, per calendar year. If an employee leaves and is rehired, the wages from both periods count toward the $7,000 cap. If an employee transfers between related companies, special rules may apply.

Late deposits trigger penalty and interest charges. FUTA tax must be deposited by the last day of the month following the quarter if the accumulated tax exceeds $500. Employers who only file annually sometimes forget to make quarterly deposits.

Misclassifying workers as independent contractors affects FUTA as well as other employment taxes. If the IRS determines that workers classified as contractors are actually employees, the employer can be liable for back FUTA taxes, penalties, and interest.

Recent Changes

The COVID-19 pandemic tested the unemployment system like never before. Unemployment claims surged to historic levels in 2020, and many states exhausted their unemployment trust funds. The federal government provided emergency supplements through programs like Pandemic Unemployment Assistance (PUA) and Federal Pandemic Unemployment Compensation (FPUC), which were funded separately from FUTA.

As states borrowed from the federal government to cover benefits, several became credit reduction states. This meant employers in those states paid higher effective FUTA rates — an additional cost passed to businesses at a time when many were already struggling. The number of credit reduction states has fluctuated as states repay their loans.

There have been periodic proposals to raise the FUTA wage base from $7,000 to a higher amount, reflecting four decades of wage growth. Proponents argue that the low wage base forces high tax rates on low-wage employment while exempting most of the payroll of higher-paid workers. However, business groups oppose increases, citing the additional cost burden.

The IRS continues to require electronic payment of FUTA taxes through the Electronic Federal Tax Payment System (EFTPS) for most employers. All businesses are required to deposit federal taxes electronically.

For more information, see the official IRS page: About Form 940.

This article is educational and does not constitute tax advice. Consult a qualified tax professional for guidance specific to your situation.