The Internal Revenue Service (IRS) has released draft instructions for the 2026 Form 940 (Employer's Annual Federal Unemployment Tax Return). These updates outline critical federal unemployment tax (FUTA) revisions that employers, payroll administrators, and tax professionals must account for in the upcoming tax year.
1. Credit Reduction States for 2026
When a state hasn't repaid money it borrowed from the federal government to pay unemployment benefits, it is called a credit reduction state. The U.S. Department of Labor determines these states.
For tax year 2026, there are credit reduction states. If an employer pays wages subject to the unemployment compensation laws of a credit reduction state, their credit against federal unemployment tax will be reduced based on the credit reduction rate for that state. Employers impacted by these reductions must use Schedule A (Form 940) to figure the credit reduction.
2. Higher FUTA Exclusion Limits for Dependent Care Assistance
Enacted under Public Law 119-21, commonly known as the One Big Beautiful Bill Act, the annual exclusion cap for employer-provided dependent care assistance payments has increased:
- Standard Limit: Increased to $7,500 (up from $5,000).
- Married Filing Separately: Increased to $3,750 (up from $2,500).
These limits apply to payments made for a qualifying person's care that allows employees to work and that would be excludable by the employee under section 129.
3. Moving Expense and Bicycle Commuting Reimbursements Now Fully Subject to FUTA
P.L. 119-21 permanently eliminates previous exclusions related to certain employer-provided fringe benefits:
- Qualified Moving Expenses: The income exclusion under section 132 and the deduction under section 217 have been permanently removed.
- Bicycle Commuting Reimbursements: The section 132 qualified exclusion has been permanently eliminated.
Consequently, moving expense and bicycle commuting reimbursements are no longer exempt from FUTA tax. Employers must treat these reimbursements as taxable wages and should not include moving expense or bicycle commuting reimbursements on Form 940, line 4.
4. Transition to Automatic Exemption from Penalty (AEP) Relief
Beginning in July 2026, the IRS implemented a new Automatic Exemption from Penalty (AEP) program for the 2025 tax year and future tax periods. The AEP is an administrative penalty relief program that replaces First Time Abate (FTA) relief.
Form 940 filers may qualify for AEP based on their filing and payment history. To qualify, an employer must have:
- Timely filed Form 940 for the prior 3 years.
- Timely paid any tax due for the prior 3 years.
For eligible employers, the IRS won't assess the following penalties when processing the return:
- Failure to file.
- Failure to pay.
- Failure to deposit, unless the penalty is for failing to make deposits by electronic funds transfer (EFT).
Employers who don't qualify for AEP may still request penalty relief based on reasonable cause. Note that information returns, such as Form W-2 and Forms 1099, and returns filed only for specific transactions or infrequent events generally aren't eligible.
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