Federal law requires that all states provide most types of employees with unemployment compensation insurance. Employers are required to contribute to a state unemployment insurance fund. Employees make no contributions, except in Alaska, New Jersey, Pennsylvania and Rhode Island where small employee contributions are withheld from employees’ paychecks by their employers.
Unemployment compensation (UC) is only for employees; ICs cannot collect it. Firms that hire ICs don’t have to pay unemployment compensation taxes for them. This is one of the significant benefits of classifying workers as ICs, since unemployment compensation taxes typically amount to hundreds of dollars per year for each employee.
The Cost of Unemployment Compensation Insurance
The unemployment tax rate varies from state to state and depends partly on the age of the hiring firm, the type of industry and how many claims have been filed by a firm’s employees. Employers who maintain a stable payroll and file and pay their unemployment taxes on time will generally have a lower unemployment tax rate than employers with high turnovers or large fluctuations in their payroll and those who do not file or pay their taxes on time.
As a general rule, however, the unemployment tax rate is usually somewhere between 2% to 5% of wages—up to the maximum amount of wages that are taxable under the state’s unemployment compensation law. The taxable limit in a majority of states ranges from $7,000 to $10,000, but in some states is much higher.
1. Unemployment Compensation Audits
You’re more likely to be audited by a state UC auditor than by any other type of government auditor, including the IRS. There are two main reasons for this. First, most states have become very aggressive in auditing hiring firms for UC purposes. The more workers that are classified as ICs for UC purposes, the less money there is for the state’s UC fund—and states are increasingly more aggressive about guarding these funds. In addition, state unemployment auditors are often the first to become aware of a firm’s worker classification practices because ICs often apply for unemployment compensation when their work for a hiring firm ends.
When a worker classified as an IC files an unemployment compensation application, state unemployment auditors will investigate the hiring firm to determine if the worker was in fact an employee under the state’s unemployment compensation law. If the state auditors determine the worker should have been classified as an employee, they will require the hiring firm to pay all the unemployment taxes it should have paid for the worker going back several years—three years is common—plus interest.
In addition, auditors will usually impose penalties for the misclassification. Penalties vary from state to state. A 10% penalty is common, but penalties are much higher in some states. For example, if a California employer willfully misclassifies a worker as an IC—that is, classifies the worker as an IC even though the firm knows he or she is an employee—a penalty equal to about 50% of the total compensation paid the worker for the prior three years may be imposed.
Unfortunately for hiring firms, unemployment compensation agencies in a great many states share information with other state agencies and the IRS. For example, they inform other agencies that a worker was misclassified for UC purposes. The IRS and other agencies will likely assume that the worker has been misclassified for their purposes as well and conduct an audit. An unemployment compensation audit may only be the first of many audits: workers’ compensation, state income tax and IRS audits may well follow. Clearly, deciding how to classify a worker for unemployment compensation purposes is a very important decision for any hiring firm.
2. Threshold Requirements for UC Taxes
Before going to the time and trouble of trying to decide whether workers are employees or ICs under your state UC law, first see whether you’re required to pay for UC coverage for your employees. In most states, if your payroll is very small, you won’t have to pay UC taxes. It will make no difference to you whether a worker is an IC or employee; either way, no UC taxes will be due.
In most states, you must pay state UC taxes for employees if you’re paying federal UC taxes, also called FUTA taxes. This means you must pay state UC taxes if:
- you pay $1,500 or more to employees during any calendar quarter—that is, any three-month period, or
- you have at least one employee during any day of a week during 20 weeks in a calendar year (the 20 weeks need not be consecutive).
But a large number of states have more strict requirements.
Nine states provide the broadest possible UC coverage by requiring employers to pay UC taxes for any employee whose earnings or hours worked surpass a threshold level. These states are Alaska, Colorado, Hawaii, Maryland, Minnesota, Pennsylvania, Rhode Island, Washington and Wyoming.
Ten states have payroll or service requirements that are less than the FUTA requirements. For example, a California employer must pay UC taxes if it pays one or more employees $100 or more per quarter. Other states in this category include Massachusetts, Montana, Nevada, New Jersey, New Mexico, New York, Oregon, Utah and Wyoming.
Contact your state unemployment agency for the exact service and payroll amounts.