A merit rating is a score that each state assigns to employers based on their employment stability and employee turnover. The state then uses the merit rating to levy state unemployment taxes on each employer. Companies with lower ratings will have to pay lower unemployment tax percentages.
Most state unemployment systems work by levying a payroll tax on the employers in their state. Unlike FICA taxes, the unemployment taxes are only levied on the employers. Only a few states have a portion contributed from the employees. Every state has their own rates and rules, but most states have a base tax of 5.4% on the first $7,000 of wages paid to each employee. Any wages paid to employees in excess of $7,000 a year are not subject to state unemployment taxes.
These taxes are collected by the state and put into a fund for unemployed people. When employees are fired or laid off, they can file with the state to collect from this fund. The amount of unemployment they receive depends on their prior salary, time employed, and numerous other considerations.
Most states recognize that it is unfair to tax employers with low employee turnover the same rates as employers with high turnover. That is why most states have instituted a merit rating system. By assigning merit ratings, they can reward employers for having a higher employee retention rates. If employers can be encouraged to keep their employees longer, the states will have less unemployment claims and less payouts.
For example, a company with 5 employees that hasnít laid off an employee for 10 years is rewarded with a merit rating of 1%. This means the total unemployment taxes each year will only be $350 ($7,000 x 1% x 5 employees). Compare that with a company of the same size with the base tax rate of 5.4%. Their taxes would be $1,890 ($7,000 x 5.4% x 5 employees).
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