FUTA Credit Reduction States Explained: What Employers Owe

Page of a historic handwritten payroll ledger

A historic worker's payroll book. Photo: Dmitry Makeev, public domain, via Wikimedia Commons.

You can pay every dollar of state unemployment tax on time, file clean, and still owe extra federal unemployment tax in January. The reason is a loan your state took out from the federal government to keep paying jobless benefits, and it is the employers in that state who end up covering it. If you have staff in California or the U.S. Virgin Islands, this is the line on Schedule A that deserves your attention.

A FUTA credit reduction state is a state that has not repaid federal loans it borrowed to pay unemployment benefits. According to the IRS, employers in that state lose part of the 5.4% credit they normally get against the 6.0% federal unemployment (FUTA) tax, so they owe more. The reduction starts at 0.3 percentage points and grows by 0.3 for each additional year the loan stays unpaid. The extra tax is reported on Schedule A of Form 940 and is treated as incurred in the fourth quarter.

By the Decision Makers Hub editorial team. Last updated November 2026. This article is general information, not tax or legal advice. It draws on IRS and U.S. Department of Labor pages. Final 2026 rates are set after the November 10 determination, so confirm current figures with the IRS and the Department of Labor before you file.

Key takeaways

  • FUTA is 6.0% on the first $7,000 of each employee's wages. Most employers get a credit of up to 5.4%, which leaves a net 0.6%.
  • A credit reduction state shrinks that 5.4% credit, so the effective FUTA rate goes up for wages paid there.
  • For 2025, the IRS lists California (1.2%) and the U.S. Virgin Islands (4.5%) on Schedule A.
  • The IRS draft 2026 Schedule A assumes the same two jurisdictions, but the rates are placeholders until the Department of Labor finalizes them.
  • Single state employers can be affected too. Schedule A is required if you paid wages in any credit reduction state.

How does the FUTA credit reduction work?

The IRS explains the baseline this way: FUTA tax is 6.0% of the first $7,000 you pay each employee, and employers generally receive a credit of up to 5.4% for state unemployment taxes paid on time. That leaves a net federal rate of 0.6%. In practice, that is a maximum of $42 per employee per year at the base rate. Our guide to employer only payroll taxes, FUTA and SUTA covers the basics if you want the full picture first.

When a state cannot cover its unemployment benefits from its own trust fund, it borrows from the federal government. If the state still owes on January 1 for two consecutive years and does not repay the full amount by November 10 of the second year, the IRS says it becomes a credit reduction state. The credit employers in that state can claim then drops by 0.3 percentage points for the first year, another 0.3 for the second, and an additional 0.3 for each later year the loan stays outstanding. The IRS page also notes that offset reductions can apply starting in the third and fifth taxable years.

The IRS gives a simple example: with a 0.3% reduction, the credit falls from 5.4% to 5.1%, so the effective FUTA rate rises from 0.6% to 0.9%.

StepRateWhat it means
Gross FUTA rate6.0%Applies to the first $7,000 of each employee's wages
Normal creditUp to 5.4%For state unemployment tax paid on time
Net FUTA rate0.6%What most employers pay, or $42 per employee at the wage base
Credit reduction0.3 points or moreSubtracted from the credit, so the net rate rises
Effective rate with a 0.3% reduction0.9%The IRS example: credit becomes 5.1%

Which states are credit reduction states?

The Department of Labor says the final credit reduction for any year is not determined until November 10 of that year, and the IRS says DOL announces the states after that deadline. That timing creates a gap every November: employers know which states are at risk, but the final rates are not set until after the date has passed.

Jurisdiction2025 credit reduction (final)2026 status
California1.2% (0.012) on IRS Schedule A for 2025Named in the IRS draft 2026 Schedule A; rate shown only as a placeholder
U.S. Virgin Islands4.5% (0.045) on IRS Schedule A for 2025Named in the IRS draft 2026 Schedule A; rate shown only as a placeholder

The IRS draft form carries a warning worth repeating: the states are assumed "for purposes of this draft," and the final form may show fewer states subject to credit reduction. We are not listing 2026 rates here because the final figures were not confirmed in the sources we could read when this was published. Check the Department of Labor's FUTA credit reductions page and the final 2026 Schedule A for the numbers you will actually file with.

What do you owe? A worked example

This example is illustrative and uses the 2025 California rate only to show the mechanics. It is not a forecast for 2026. Say you have 40 employees in California, each paid at least $7,000 in FUTA wages. Total FUTA wages are 40 times $7,000, or $280,000.

ItemMathAmount
Base FUTA after the normal credit$280,000 x 0.6%$1,680
Credit reduction at 1.2%$280,000 x 1.2%$3,360
Total FUTA for those employees$1,680 + $3,360$5,040

If only 10 of your 40 employees work in California and the other 30 work in a state with no reduction, the reduction applies only to the California wages: $70,000 x 1.2% = $840. Wages paid in other states are not touched. The IRS also says wages excluded from state unemployment tax are not subject to the credit reduction.

How do you report and pay it?

You report the credit reduction on Schedule A (Form 940). The IRS says you must file Schedule A if you paid FUTA taxable wages and state unemployment tax in more than one state, or if you paid wages in any credit reduction state, even if you operate in only one state. For each credit reduction state, you enter the FUTA taxable wages paid there, multiply by the reduction rate, add up the amounts, and carry the total to Form 940.

The IRS treats the extra tax as incurred in the fourth quarter, due January 31 of the following year. The Form 940 instructions put credit reduction liability with the fourth quarter deposit: if your fourth quarter FUTA liability is more than $500, you deposit it by the due date, and if it is $500 or less you can deposit it or pay it with the return. For tax year 2025, the instructions list February 2, 2026 as the filing date, or February 10, 2026 if you deposited all FUTA tax when due. January 31, 2027 falls on a Sunday, and the IRS weekend rule moves a due date to the next business day, so check the 2026 instructions for your exact date.

Because this is a quarter four item, it ties directly to your normal calendar. If you already file quarterly returns, our walkthrough of how to file Form 941 shows the rhythm, and if a filing needs correcting, see how to correct a quarterly payroll tax filing.

How can you plan for it?

  • Accrue the extra cost as you go. If you have California wages, set aside the estimated reduction each quarter instead of absorbing it in January.
  • Build the FUTA wage base by state. You need FUTA taxable wages for each credit reduction state, so your payroll reports should break them out.
  • Pay state unemployment tax on time. The normal 5.4% credit depends on timely state payments, and late payments can raise your FUTA tax.
  • Get worker classification right. Wages paid to employees count and contractor payments generally do not, which is why our piece on employee vs independent contractor matters here.
  • Add the item to your calendar. Our payroll compliance checklist is a good place to track it, and small teams can lean on our guide to running HR without an HR department.

More on this topic lives in our payroll and compliance guides.

Common mistakes to avoid

  • Assuming single state employers are exempt. The IRS requires Schedule A for any wages paid in a credit reduction state.
  • Applying the reduction to all wages. It applies to FUTA taxable wages paid in the credit reduction state, up to the $7,000 wage base.
  • Using last year's rate. The reduction can change every year, and a state can drop off the list if it repays its loan.
  • Treating a draft form as final. Wait for the final Schedule A before you finalize the numbers.
  • Forgetting that the liability lands in the fourth quarter, even though the reduction is tied to the whole year's wages.

Frequently asked questions

What is a FUTA credit reduction state?

It is a state that has not repaid federal loans it took to pay unemployment benefits. Employers there get a smaller FUTA credit, so they owe more federal unemployment tax.

Which states are credit reduction states?

For 2025, the IRS Schedule A lists California at 1.2% and the U.S. Virgin Islands at 4.5%. The IRS draft 2026 form assumes the same two, but the final list and rates come from the Department of Labor after November 10.

When is the credit reduction due?

The IRS says the tax is considered incurred in the fourth quarter and is due by January 31 of the following year, subject to the weekend rule. Check the Form 940 instructions for the exact filing date for your tax year.

Do I need Schedule A if I only have employees in one state?

Yes, if that state is a credit reduction state. The IRS requires Schedule A if you paid wages in any state with a credit reduction rate above zero.

Does the credit reduction apply to wages above $7,000?

No. It applies to FUTA taxable wages, which are the first $7,000 paid to each employee, in the credit reduction state.

The bottom line

If you pay wages in a credit reduction state, plan for a bigger January FUTA bill, break out wages by state, and wait for the final Schedule A before you lock the number. For everyone else, it is worth a quick check each November to confirm your states are not on the list.

Sources

This article is general information, not tax or legal advice. Consult a tax professional or your payroll provider before filing.

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