A "credit reduction state" is a state that has not repaid the money it borrowed from the federal government in order to pay its unemployment benefits. The Department of Labor determines annually if such states exist. If an employer pays wages that are subject to the unemployment tax laws of a credit reduction state, that employer must pay additional federal unemployment taxes when filing its Form 940. For 2010, Indiana, Michigan and South Carolina are credit reduction states, which means that employers in these three states will pay extra taxes in 2011 (2010 taxes are payable in 2011).
Instead of receiving the full 5.4% credit, employers in Indiana and South Carolina will receive 5.1% (5.4% minus 0.3% disallowed to a first-year credit reduction state) so they will pay 1.1% in federal taxes and not 0.8% next year. Michigan was a credit reduction state in 2009 so its employers will lose 0.6% of the 5.4% credit as a second-year credit reduction state and will pay 1.4% in taxes. Note that Michigan employers may apply for a state tax credit to offset some of this expense (2010 Instructions for Form 940).