A credit reduction state is a state or U.S. territory that borrowed from the federal government to pay unemployment benefits and didn’t repay the loan on time. Employers there lose part of the credit that normally offsets most of their federal unemployment tax, so they owe more FUTA tax per employee at year-end. For the 2025 tax year, only two jurisdictions are affected: California, with a 1.2% credit reduction, and the U.S. Virgin Islands, with a 4.5% credit reduction.1Federal Register. Notice of the Federal Unemployment Tax Act (FUTA) Credit Reductions Applicable for 2025
What the Reduction Costs You Per Employee
FUTA is a 6.0% tax on the first $7,000 of each employee’s wages each year, paid entirely by the employer.2Employment & Training Administration. Unemployment Insurance Tax Topic3Internal Revenue Service. Federal Unemployment Tax Employers who pay their state unemployment taxes on time normally get a 5.4% credit against that rate, bringing the effective FUTA rate down to 0.6%, or $42 per employee.4Internal Revenue Service. FUTA Credit Reduction
In a credit reduction state, that 5.4% credit shrinks and your effective rate climbs by the same amount. For 2025:
- California employers: effective FUTA rate of 1.8%, or $126 per employee. That’s $84 more than the standard $42.
- U.S. Virgin Islands employers: effective FUTA rate of 5.1%, or $357 per employee. That’s $315 more than the standard amount.
Both jurisdictions received waivers of the additional Benefit Cost Rate add-on for 2025, and no other add-on amount was assessed, so the figures above are the full increase.1Federal Register. Notice of the Federal Unemployment Tax Act (FUTA) Credit Reductions Applicable for 2025
Why a State Ends Up on the List
When a state’s unemployment trust fund runs low, it can borrow from the U.S. Treasury through Title XII advances to keep paying benefits. If the state still has an outstanding balance on January 1 of two consecutive years and hasn’t paid it off by November 10 of that second year, the credit reduction kicks in.5Employment & Training Administration. FUTA Credit Reductions The reduction starts at 0.3% in the first year and climbs another 0.3% for every consecutive year the loan stays unpaid.4Internal Revenue Service. FUTA Credit Reduction
The Department of Labor announces the final list each November, which is why employers often don’t know their full FUTA liability until the fourth quarter. A state exits the list by repaying its balance before the November 10 cutoff. Connecticut and New York both carried outstanding advances heading into 2025 and paid them off before the deadline, so their employers owe no credit reduction for the year.1Federal Register. Notice of the Federal Unemployment Tax Act (FUTA) Credit Reductions Applicable for 2025 The list can change every year.
Which of Your Wages Are Affected
The credit reduction applies only to wages subject to unemployment tax in the credit reduction jurisdiction, not to your entire payroll.6Internal Revenue Service. 2025 Schedule A (Form 940) If you have 50 employees in California and 50 in Texas, you calculate the extra 1.2% only on the California wages.
For employees who work across state lines, the Department of Labor uses a sequence of tests to decide which state’s unemployment law covers them: where their work is localized first, then their base of operations, then where their work is directed from, and finally where they live.7U.S. Department of Labor. Unemployment Insurance Program Letter No. 20-04 Attachment I – Localization of Work Provisions Whichever state the employee lands in through that sequence determines whether their wages carry the credit reduction.
How and When You Pay the Extra Amount
You report FUTA on Form 940 once a year, but you deposit it quarterly whenever your cumulative liability exceeds $500.8Internal Revenue Service. Depositing and Reporting Employment Taxes The additional tax from a credit reduction is treated as if it were incurred entirely in the fourth quarter, no matter when you actually paid the underlying wages.4Internal Revenue Service. FUTA Credit Reduction So you don’t need to build it into your first three quarterly deposits; it comes due with your fourth-quarter deposit or your Form 940 filing.
If you paid wages in a credit reduction state, you have to complete Schedule A (Form 940) and attach it to your return.9Internal Revenue Service. Form 940 – Employers Annual Federal Unemployment (FUTA) Tax Return Schedule A is also required if you paid wages in more than one state during the year, even if none of them appear on the credit reduction list.10Internal Revenue Service. Topic No. 759, Form 940 – Filing and Deposit Requirements
Form 940 for the 2025 tax year is due February 2, 2026. If you deposited all your FUTA tax on time throughout the year, the deadline extends to February 10, 2026.11Internal Revenue Service. Instructions for Form 940 (2025)
Watch for State-Level Increases Too
The federal credit reduction is often not the only cost increase employers in these jurisdictions face. States that borrow from the federal government frequently raise their own unemployment tax rates or add solvency surcharges to rebuild their trust funds. Those state-level increases are separate from the federal reduction and stack on top of it. If your state is on the credit reduction list for 2025, check whether your state unemployment tax rate has moved as well before estimating your total year-end bill.