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How Unemployment Insurance Works, for Small Businesses

A young woman in a pony tail and wearing an orange T-shirt is sitting at a table, looking down at a laptop in front of her. Both her hands are cradling her face and she looks sad. She's just got the news that she's lost her job. Now, she'll probably need that unemployment insurance her former employer had been paying into, as a part of something every employer is required to do by law.

When you start a business, you hope the business grows. But, sometimes, it grows and then it shrinks. You have to let employees go even though they didn’t do anything wrong. This is where unemployment insurance comes in. The employees can get a payout from the state government to tide them over for a bit. But unemployment insurance doesn’t come out of just anywhere. It’s paid by your business to both the federal government and the state government where you have employees. This article is a part of our How to Hire Your First Employees series. Below, we’ll go over how unemployment insurance works for businesses. We’ll also show you how you can minimize how much you have to pay.

As a reminder, this article is on US unemployment insurance rules. If you’re reading this from another country, be sure to use your country’s rules instead.

Businesses Pay Unemployment Insurance to the State and the Federal Government

As a business with employees, you have to pay unemployment insurance for each employee. You pay it to both the federal government and the state government. For state payments, you pay to each state where you have an employee.

You don’t have to pay unemployment insurance for contractors. But there are fines if you misclassify an employee as a contractor. If you’re not sure if a worker is an employee or contractor, check out the linked article to see how to decide between the two.

The Federal Unemployment Insurance Tax

The federal unemployment insurance is called the Federal Unemployment Tax Act (FUTA) tax. Businesses pay FUTA to the IRS, which collects the money for the Department of Labor. There’s a minimum threshold where you have to pay the tax, but the threshold is pretty low.

You must pay FUTA if you’ve had one employee (full time, part time, or temporary) for:

  • 20 weeks out of the year OR
  • If you paid $1,500 in wages total

FUTA is 6% of the first $7,000 you pay to an employee for the year. Once you hit the $7,000 threshold for a particular employee, you can stop paying FUTA for that employee for the year.

There are special FUTA rules for farm employees and household employees. Be sure to review those rules if you run a farm or if you employee nannies, housekeepers, and similar.

You pay FUTA every quarter, when you reach $500 in the FUTA you have to pay. This means if you have employees but the FUTA tax is below $500 in a quarter, you can hold on to it and file it in the quarter when you do reach the $500 threshold. At the end of the year, you have to file a Form 940 with the IRS where you total up and report the amount you’ve filed.

Sometimes, depending on how your state unemployment tax works with the federal tax, you might get a federal credit of up to 5.4% of the 6% of the FUTA tax. In other words, what you pay to your state can reduce your federal tax. This credit is calculated every year for every state, so you always have to check to see if it’s available in your state. Here’s the Department of Labor’s webpage with information on which state qualifies.

State Unemployment Insurance

For the unemployment insurance you have to pay to your state, it’s a steadier payment than FUTA. When you hire your first employee, you have to notify your state. You usually have to do this within a few days of hiring the employee, so don’t put this off for too long.

Once you notified your state, they will give you a tax filing number. You’ll use this number to file the unemployment insurance tax. They’ll also tell you your tax rate. There’s usually a standard rate for new employers. This rate can fluctuate in the future, depending on how many and how often your former workers claim unemployment insurance.

Every state calls their agency responsible for handling unemployment insurance something a little different. In Texas, the agency is called the Texas Workforce Commission. In California, the agency is the Employment Development Department of the Labor and Workforce Development Agency. In New York, it’s the Division of Labor Standards under the Department of Labor. To find your state’s agency, we suggest you simply do an internet search with the name of your state and the keywords “unemployment insurance registration.” The correct agency should pop up. Then, go register with them as an employer.

Under What Circumstances Can an Ex-Employee Collect Unemployment Insurance?

We mentioned earlier that your state unemployment insurance rates can fluctuate based on how often your former employees claim unemployment. The rate also depends on your line of business and if you’ve had to stop employing workers from time to time.

Not every former employee who files for unemployment benefits will get it. They’ll have to have worked for you for some period of time—usually a year but it’s different in every state. If they have worked for you for however long the state requires, they can still be denied unemployment if they:

  • Quit (there are some exceptions depending on your state laws).
  • Are fired for misconduct related to work (misconduct includes acting a certain way or failing to act in a certain way).
  • Were not able to work or available for work (except under circumstances protected by law such as the FMLA). The employee must be able, ready, and willing to accept suitable work.
  • Refuse an offer of suitable work.
  • Make false statements to obtain benefit payments.
  • Are denied based on other reasons specifically set out by your state.

Some former employees will claim unemployment without telling the state why they no longer work for you. If you don’t correct the record with one of the reasons above, the employee will be awarded unemployment.

Employers Usually Have to Decide to Fight the Claim or Pay

In the US, every state except Montana has some sort of at-will employment. This means that you can let go of an employee for any reason or no reason (and an employee can leave for any reason or no reason). On the flip side of this, you can’t let employees go for discriminatory reasons such as age, sex, nationality, and similar.

So, the typical advice from employment lawyers and HR professionals is that, when you let an employee go, don’t tell them why. You simply tell them you don’t need their services anymore. This is to prevent you from accidentally saying anything that can be taken as discriminatory.

But, not saying anything also means that, if these former employees file for unemployment insurance, you have to keep silent. You let the state pay the unemployment, knowing that your rate will go up higher.

Of course, you don’t have to do this. You can fight. You might open yourself to accusations of discrimination, but you can keep your unemployment insurance rate in check. And, sometimes, you are truly in the right to fire the person.

If you prefer to fight, then always document the times when the employee misbehaves or refuses to work. Keep the evidence in their personnel file. This way, you’ll have evidence to show to your state’s unemployment agency so they can deny unemployment insurance.

There is no right answer to this one. We’ve seen employers do both.

Unemployment Insurance is a Cost of Doing Business

The only way to avoid paying unemployment insurance is if you hire just contractors. Of course, there are disadvantages to this. A contractor might not always be available when you need them because they’re working with other clients. Or another business might decide to hire them away for a full time job. And, of course, you’ll be penalized if you misclassify an employee as a contractor.

We think the better approach is to treat unemployment insurance as a cost of doing business. Some part of this—the FUTA tax—are basically fixed and predictable. And you do have at least a little bit of control over your state unemployment insurance rate.

So, budget this insurance as a part of the cost of hiring employees, along with your other costs. This way, you won’t be surprised.

Interested in starting and running a small business? Here’s the beginning of our step-by-step guide: What to do right after getting that great business idea.

DISCLAIMER: This article does not constitute legal or accounting advice. Instead, it contains general information. The information gives you the background you’ll need to hit the ground running when you do go get advice from a lawyer or accountant. Only lawyers and accountants properly licensed in your state/country are qualified to give you legal or accounting advice.

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