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May 11, 2020
2020-1265

Employers risk FUTA credit reductions and higher state UI taxes as COVID-19 claims continue to climb

The US Treasury Department announced that as of May 7, 2020, nine states (California, Connecticut, Hawaii, Illinois, Massachusetts, New York, Ohio, Texas, and West Virginia) applied and were approved for federal unemployment insurance (UI) Title XII advances (UI loans). As of May 7, 2020, only California has taken receipt of an advance and currently has an outstanding federal loan balance of $1,428,000,000. Other states are sure to follow suit as the historic number of UI claims filed by individuals affected by COVID-19 continues to rise and state UI trust fund balances continue to fall.

Federal UI law requires states to continue to pay regular UI benefits, even when their UI trust funds are depleted. States with depleted trust fund balances apply for federal loans to bolster their trust fund balances so that the payment of UI benefits are not interrupted.

Federal advances taken in 2020 are interest-free if repaid by the end of 2020. Interest begins to accrue in 2021, and if a federal UI loan balance is still outstanding after two years (in 2022), employers are required to make payments toward the outstanding federal loan balance in the form of a federal unemployment insurance (FUTA) credit reduction that increases the FUTA taxes employers pay.

The last time the nation saw a substantial increase in UI benefit payouts was during the great recession of 2007 and 2008. During that period, the majority of states received federal loans to shore up their trust fund reserves, and at its peak in 2011, employers in 21 states fell subject to the FUTA credit reduction. Once triggered, it can take years for the FUTA credit reduction to go away. California, for instance, began borrowing in 2009, and its loan balance was not repaid until 2018, subjecting California employers to the FUTA credit reduction for seven years (2011 to 2017). The Virgin Islands has yet to repay its loan balance from this period, and a FUTA credit reduction in 2020 is again likely for Virgin Islands' employers. (See Figure 1 below.)

Figure 1: FUTA credit reduction due to the 20072008 recession

First year of long-term loan

Year FUTA credit reduction first applied

Number of jurisdictions subject to FUTA credit reduction on Form 940

 2007

2009

1

2008

2010

3

2009

2011

21

 

2012

19

 

2013

14

No new long-term loans

  

2014

8

2015

4

2016

2

 

2017

2

 

2018

1

 

2019

1

Interest surcharges can further increase state unemployment insurance tax cost

Under federal law, the interest on a federal UI loan, or any other debt instrument (e.g., a state bond) used to fund UI benefits, cannot be paid from the states' UI trust funds, forcing many states to recover the cost from employers in the form of interest surcharges. These surcharges are paid in addition to the normal UI tax employers pay, and they cannot be counted as UI contributions for purposes of computing the allowable credit on the Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return.

US rate of unemployment continues to rise due to COVID-19

The US Bureau of Labor Statistics (BLS) reports that due to the recent COVID-19 business shutdowns, for April 2020, total nonfarm payroll fell by 20.5 million and the rate of unemployment rose to 14.7%, up by 10.3% over March 2020. Employment fell sharply in all major industries sectors, with particularly heavy job loss in the leisure and hospitality sectors. (USDL-20-0815, The employment situation for April 2020, released May 8, 2020.)

According to the BLS, this is the highest rate and the largest over-the-month increase since the agency started measuring the monthly statistics in January 1948. In April 2020, 23.1 million individuals were unemployed; 18.1 million of these individuals reported that they were temporarily laid off and 2 million reported that their layoff was permanent.

FUTA credit reduction: the added burden of long-term debt

When a FUTA credit reduction applies, the maximum FUTA credit falls below 5.4%. To lose a portion of the maximum 5.4% FUTA credit means that the net FUTA tax rate rises above the normal 0.6%. For instance, if the maximum 5.4% FUTA credit is reduced by 0.3%, the net FUTA rate increases from 0.6% to 0.9% [6.0% - (5.4% - 0.3%) = 0.9%].

States are given the option of accepting a federal UI loan to augment their UI trust funds. If states do not repay these federal loans within a certain time frame, employers in those states are required to assist in repaying these loan balances through funds obtained from the FUTA credit reduction.

Specifically, if a state has an outstanding federal UI loan balance on January 1 of two consecutive years and fails to repay the entire balance by November 10 of the second year, employers in that state are subject to a reduction in the maximum 5.4% FUTA credit. With certain exceptions, the credit reduction increases in 0.3% increments each subsequent year the loan balance remains unpaid. The additional FUTA tax per employee that is the result of this FUTA credit reduction can be substantial, particularly if federal UI loan balances linger over several years. (See Figure 2.)

Figure 2: FUTA credit reduction effect before add-on

Number of years with outstanding federal UI loan

Adjusted net FUTA rate (net FUTA rate of 0.6% + FUTA credit reduction)

Increase over $42 per employee (assuming

$7,000 × 0.6%)

2

0.9%

$21

3

1.2%

$42

4

1.5%

$63

5

1.8%

$84

Federal law discourages states from carrying their federal unemployment insurance loan balances over several years by further reducing the FUTA credit beginning in the fifth year of the loan. This add-on to the FUTA credit reduction is referred to as the Benefit Cost Rate (BCR).

The BCR penalty may be waived if the jurisdiction's governor submits an application to the US Secretary of Labor no later than July 1 of the penalty year; and the jurisdiction takes no action (legislative, judicial, or administrative) during the 12-month period ending September 30 that would reduce unemployment insurance trust fund solvency during that same time period.

Should the BCR add-on be waived, as is normally the case if the conditions are met, another penalty, referred to as the 2.7 add-on, can apply if the jurisdiction's average unemployment insurance tax rate is inadequate. The 2.7 add-on penalty rate cannot be avoided or waived once activated.

Ernst & Young LLP insights

In addition to the possible increases in future FUTA taxes, employers should also anticipate future increases in state UI taxes to replenish state trust funds. Calendar year 2021 SUI tax rates will most likely be impacted by falling state UI trust funds, even though most states have agreed that employer SUI accounts will not be directly charged for UI benefits paid in connection with COVID-19.

Note, however, that the additional $600 Pandemic Unemployment Assistance (PUA) payments are fully funded by the federal government and will not affect state UI trust fund balances.

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Contact Information
For additional information concerning this Alert, please contact:
 
Workforce Tax Services - Employment Tax Advisory Services
   • Kenneth Hausser (kenneth.hausser@ey.com)
   • Debera Salam (debera.salam@ey.com)
   • Kristie Lowery (kristie.lowery@ey.com)
   • Peter Berard (peter.berard@ey.com)

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