To fund unemployment compensation benefits programs, employers are subject to federal and state unemployment taxes based on various factors. These factors include the amounts employers pay their employees, the type and age of the business, and the unemployment claims filed against the business.
All states use an experience rating system to assign tax rates to employers based on their history of unemployment insurance claims. Generally, an employer with a large number of unemployment claims will have a high experience rating and a correspondingly high tax rate. That is why some employers take part in a tax evasion scheme called SUTA dumping. This involves the manipulation of an employer’s unemployment insurance tax rate to achieve a lower rate and thereby pay fewer UI taxes. However, employers who engage in SUTA dumping or any other tax manipulation schemes may face serious consequences.
State Unemployment Tax Avoidance
SUTA dumping refers to different tax planning strategies used by employers to minimize the tax burden of federally mandated state unemployment taxes. These strategies are based on the differences in methods states use to determine unemployment tax rates among established employers compared to the method by which states determine the tax rate of new companies and companies that have either created new subsidiaries or have absorbed other companies.
SUTA dumping and companies avoiding their appropriate state unemployment taxes lead to tax inequities. As a result, companies that follow state unemployment tax law are burdened with additional taxes due to the tax avoidance by the firms that engage in SUTA dumping.
Types of SUTA Dumping
There are several schemes businesses use to inappropriately lower their UI tax rate. Employers should be aware that these practices constitute SUTA dumping and that there are serious consequences for disguising the true unemployment experience of a business for the purpose of lowering unemployment taxes. Examples of SUTA dumping schemes include:
- Purchased Shell Transaction by Existing Business
A business with a large payroll and a high UI rate purchases a corporate shell and a small payroll is reported each year until a low or minimum UI rate is achieved. Once the low rate is achieved, the business transfers its employees or payroll to the purchased entity.
- Purchased Shell Transaction by a Person Who Is Not an Employing Unit
A person who is not an employer purchases a corporate shell with a low UI rate instead of forming a new business solely or primarily for the purpose of obtaining a lower UI rate.
- Affiliated Shell Transaction
A new corporation is registered, and a small payroll is reported each year until a low or minimum UI rate is achieved. Once the low rate is achieved, large payroll amounts from another related corporation are transferred into this account.
- New Employer Rate
An existing sole proprietor or other employers with a high UI rate registers a new company with a new employer rate that is lower, then transfers its payroll to the new company.
- High Plus High Equals Low
A high UI rate account with a large payroll is transferred to another high UI rate account with a small payroll at the beginning of the year. Since the calculation of the average base payroll is on a calendar year basis, only the small payroll is considered. However, the taxes from the large payroll are added to the reserve account balance as of June 30, resulting in a very low UI rate being established for the next year.Use this comprehensive guide to achieve a better understanding of UI management, prevent UI costs, and maintain effective compliance.
SUTA Dumping Prevention Act
Although only a small number of employers are involved in SUTA dumping, all employers are impacted. SUTA dumping damages the experience-rated UI tax system creates an unfair competitive cost advantage for employers that use SUTA dumping schemes and causes disadvantages for those employers who try to manage their work and maintain steady employment for their employees. In addition to this, SUTA dumping reduces money in state unemployment compensation funds, causes overall increases in employers’ taxes, and the loss of discounts to employers triggered when state fund balances reach certain levels. Finally, SUTA dumping reduces the funds available to pay unemployment benefits to unemployed workers.
As a result, Public Law No. 108-295, the SUTA Dumping Prevention Act of 2004 was signed on August 9, 2004. Therefore, states are obliged to adopt legislation to prevent SUTA dumping to qualify for federal unemployment insurance system administration grants. This law establishes a nationwide minimum standard to curb SUTA dumping and requires all states to change their unemployment laws to end SUTA dumping tax evasion schemes.
Protecting SUTA Rates and Avoiding SUTA Dumping
There are a number of methods employers can lower SUTA costs, such as contesting questionable unemployment claims, improving hiring processes, carefully documenting termination processes, or auditing SUTA statements and reports. At the same time, there are steps employers should avoid at any cost, and this includes SUTA dumping. Any employer who knowingly violates the law can be subject to the highest tax rate for the current and following 3 years. If the employer is already at the highest tax rate or if the amount of the rate increase is less than 2%, a penalty equal to contributions of 2% of taxable wages will be imposed for the current and following 3 years. Also, any person who is not an employer and knowingly violates or provides SUTA dumping advice may be subject to a civil penalty of up to $5,000.
While it may be challenging to manage tax obligations and keep unemployment tax rates low, employers should avoid any illegal form of rate manipulation that can potentially incur significant fines. At the same time, employers can outsource the unemployment claims process to reduce administrative burden and costs, detect erroneous overpayments on time, and improve the entire process with systems designed specifically for unemployment claims administration. Finally, complying with different state laws can be burdensome and time-consuming, but outsourcing unemployment insurance administration allows employers to focus on core business functions instead of monitoring the changes to the unemployment legal landscape.