FUTA Credit Reductions: Why Your State’s Debt is Your Problem

Most business owners across the country enjoy a standard Federal Unemployment Tax (FUTA) rate of just 0.6%. This is thanks to a generous 5.4% credit given by the IRS for paying your state unemployment taxes on time.

However, if your business is located in a "Credit Reduction State," that 0.6% rate is a thing of the past. For 2026, the cost of doing business in certain states has effectively doubled, or even tripled, overnight.

What is a Credit Reduction State?

When states run out of money to pay unemployment benefits (as many did during the pandemic), they borrow from the federal government. If a state fails to repay that loan within two years, the federal government "claws back" the money by reducing the FUTA tax credit available to employers in that state.

Instead of a 5.4% credit, your credit is reduced by 0.3% for every year the debt remains unpaid.

The 2026 Landscape: Who is Affected?

As we move through 2026, the list of affected jurisdictions has shifted.

• California: California continues to struggle with a massive federal loan balance (over $20 billion). In 2026, California remains a high-impact credit-reduction state. Employers should budget for a 1.2% to 1.5% reduction, bringing the effective FUTA rate as high as 2.1% per employee.
  
  
• U.S. Virgin Islands: The USVI has had an outstanding balance for over a decade. Their credit reduction is significantly higher, often exceeding 4.5%, meaning employers there pay nearly the full 6.0% FUTA rate.
  
  
• New York & Connecticut: There is good news here! Both states made significant moves in late 2025 to repay their federal loans. For the 2026 tax year, employers in NY and CT have returned to the standard 0.6% rate, providing much-needed relief.

How to Calculate Your 2026 FUTA Bill

The FUTA tax applies only to the first $7,000 of each employee's wages.

Why this matters for your cash flow: You might think you only owe $42 per person, but when you file Form 940 in January, you could be hit with a "Catch-Up" payment of an extra $84 or more per employee. If you have 50 employees in California, that is a $4,200 surprise you didn't plan for.

Pro-Tip: The "Catch-Up" Deposit

If you are in California or the Virgin Islands, don't wait until January to find the money. We recommend "over-funding" your quarterly FUTA deposits or setting aside a reserve in your payroll account specifically for the Schedule A (Form 940) adjustment.

Is Your Payroll Software Calculating This Correctly?

Many "off-the-shelf" payroll platforms fail to update credit reduction rates until the very last minute. If your quarterly reports look too low, you might be walking into a trap.

At Wolf Tax, we help multi-state employers audit their FUTA liabilities and ensure their Year-End filings are accurate. Don't let a state government's debt bring your business down.