A Wage and Hour Primer for Small Business Owners:

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1 WHITE PAPER A Wage and Hour Primer for Small Business Owners: Avoid Common Pitfalls of Employee Classification

2 What makes someone an employee and not an independent contractor? Well-intentioned small business owners doing their best to comply with the complex web of employment laws often stumble over the question of employee classification. When is an employee exempt from the overtime laws? And, for that matter, what makes someone an employee and not just an independent contractor? The answers to these straightforward questions are unfortunately less than simple. Yet, your failure to get it right could result in significant liability and expense. A New Sheriff in Town : The Department of Labor Gets Serious Small business owners should be aware that the Wage and Hour Division (WHD) of the U.S. Department of Labor (DOL), the agency responsible for enforcing federal wage and hour laws (the Fair Labor Standards Act, the FLSA ), is pursuing an aggressive campaign to identify and address violations. The WHD investigates allegations that employers failed to pay minimum wages or overtime, as well as alleged misclassification of employees as exempt or independent contractors. DOL investigations can be triggered by complaints from employees, competitors, unions or routine audits. Proclaiming herself the new sheriff in town, U.S. Secretary of Labor Hilda Solis unveiled a plan in December 2009 to dramatically increase FLSA enforcement. The DOL has since added 250 new wage and hour investigators to the WHD roster to help police and enforce wage and hour laws, with plans to hire 100 more by the end of Meanwhile, the WHD has also launched a public awareness campaign, educating workers how to file complaints and pursue claims against employers. The hallmark of the WHD s 2011 budget is the Employee Misclassification Initiative, a $25 million joint Treasury-Labor initiative designed to detect and deter the inappropriate misclassification of employees as independent contractors, and to strengthen and coordinate federal and state efforts to enforce labor violations arising from such misclassifications. If you have any doubt about the seriousness of these initiatives, then consider the ultimate goal: increased tax revenue. By forcing employers to examine the classification of employees more closely, the federal government hopes to get more people on to company payrolls, thus resulting in an increase in revenue from payroll taxes. 2 trinet.com

3 Employee misclassification is a common mistake made by business owners large and small. I. Liability for Misclassifying Employees as Independent Contractors A common mistake made by business owners large and small stems from a misunderstanding of when an independent contractor is actually an employee in the eyes of the law. Companies that misclassify its workers as independent contractors when they should be employees may be subject to significant penalties under both the FLSA and the Internal Revenue Code (IRC), including: Unpaid overtime where the misclassification was intentional, 1.5 percent of each worker s federal income tax liability; Up to 20 percent of the employee s missing FICA contribution; Interest on amounts that should have been withheld; Tax penalties for failing to comply with COBRA; ERISA liability; and Unemployment insurance reimbursed to the state unemployment compensation system, for amounts the employer should have contributed, plus interest for each month they are in default. State laws also impose additional penalties, although this white paper focuses on federal and not state laws. Before classifying a worker as an independent contractor, it is critical to have a basic understanding of the tests applied in making the distinction between employee and independent contractor. The IRS has a vested interest in the proper classification of employees. Under the Internal Revenue Code, an employer is required to pay taxes to the IRS through payroll deductions and contributions. Independent contractors, who are responsible for directly paying their taxes to the IRS, often underreport their income, and this represents a potential major loss of revenue to the federal government. The IRS, therefore, is very much interested in ensuring that employees are properly classified and seeking enforcement against employers who fail to comply. trinet.com 3

4 Employees who are exempt under the FLSA are not required to be paid overtime or minimum wages. The IRS uses Training Guidelines for its agents to use in determining worker classifications for federal tax purposes. The Training Guidelines are broken down into three broad categories: 1. Behavioral control evaluating whether the entity or the worker controls the manner in which services are performed 2. Financial control evaluating whether the entity or the worker controls the financial aspects of a worker s activities. Factors include: a. Whether the worker has made a significant investment in his or her business; b. Whether the worker is responsible for expenses incurred in the performance of services; c. Whether the worker makes his/her services available to the relevant market; d. The method of payment for the worker s fees; and e. Whether the worker has the opportunity for a profit or loss. 3. The relationship of the parties how the parties perceive their relationship. Factors include: a. The expressed intent of the parties (e.g., by written contract); b. Whether the worker is provided with employee benefits; c. Whether the worker can be discharged, or the contract terminated, without notice; and d. Whether the services performed for the business are a key aspect of the regular business activity of the company. The Training Guidelines can be found at article/0,,id=98941,00.html 4 trinet.com

5 Violators may be subject to fines of up to $10,000. II. Liability for Misclassifying Employees as Exempt In addition to addressing the misclassification of employees as independent contractors, the WHD enforces federal minimum wage and overtime pay requirements of the FLSA. In contrast to non-exempt employees, employees who are exempt under the FLSA are not required to be paid overtime or minimum wages. Additionally, under the FLSA, exempt employees need not be provided rest or lunch breaks. The potential for employer liability for misclassifying employees as exempt is significant under both federal and state law. For example, in May 2010, Teleperformance USA, a call center based in Salt Lake City, paid nearly $2 million to almost 16,000 workers after a DOL investigation determined that the employees were misclassified as exempt and had not been compensated for overtime and meal breaks. (For more examples of DOL wage and hour settlements, visit the DOL Newsroom at: Employers who willfully (i.e., knowingly) violate the FLSA may be subject to criminal prosecution and face a fine of up to $10,000. A second conviction may result in imprisonment. Business owners, corporate officers and principal shareholders, as well as supervisors and managers can also be held personally liable. III. Determining Exempt vs. Non-Exempt Classifications Under the FLSA: A Primer The determination of whether an employee is classified as exempt or non-exempt can be very complex and is driven by the particular facts and circumstances in each case. The determination usually involves an analysis of how much the individual is paid and his/her primary job duties. Generally speaking, non-exempt employees are not paid on a salary basis and lack the authority to make decisions of significance to the business. Exempt employees must be paid on a salary basis and are typically but not always managers, executives, and other professionals who have a staff, make decisions regarding hiring and firing, and have an overall say in how a company is run. trinet.com 5

6 Overtime violations represent about 90 percent of all collected back wages under FLSA actions. The most common exempt positions fall into one of the following FLSA exemptions (Note: some state laws have different, often more stringent, requirements): Executive those who manage the enterprise or a department or subdivision, direct the work of at least two or more other full-time employees, and have authority to significantly influence hiring and firing decisions; Administrative those who perform office or non-manual work directly related to the management or general business operations of the employer or the employer s customers and who exercise discretion and independent judgment with respect to matters of significance; Professional those who perform work requiring advanced knowledge in a field of science or learning or a position that requires invention, imagination, originality or talent in a recognized field of artistic or creative endeavor; Certain computer professionals, as defined in the DOL regulations (see or Outside sales employees those who make sales or obtain orders or contracts for services or for the use of facilities and are regularly away from the employer s place of business. A. Case Study: Mortgage Loan Officers and the Administrative Exemption The March 2010 DOL Administrator s Interpretation (written public guidance from the DOL) finding mortgage loan officers non-exempt under the FLSA perfectly illustrates the complexity of the law and the potential for error and liability. In reaching its conclusion, the DOL noted that an employee s exempt status is determined by compensation and job duties, not job title. Thus, in addition to showing that an employee is compensated on a salary basis at the rate of at least $455 per week, an employer must also show that the employee fits within the parameters of the specific exemption sought. Thus, in seeking to apply the administrative exemption to mortgage loan officers, the employer was required to show that the employee performs office or non-manual work directly related to the management or general business operations of the employer or the employer s customers, and exercises discretion and independent judgment with respect to matters of significance. 6 trinet.com

7 In its decision, the Administrator reasoned that if the mortgage loan officer s primary duty is to make sales, then it is unlikely that he or she is eligible for the administrative exemption because it is not work directly related to management or business operations. Instead, the officers work on the production side of the business, selling the employer s goods (i.e., mortgages) rather than performing administrative duties. The DOL found that, although mortgage loan officers do collect and analyze information, which does call for independent judgment, they are not analyzing the information to provide advice to the customer, which the customer could take and use elsewhere. Instead, they are performing a screening function for the benefit of the employer and, in any event, this function is only incidental to the primary duty of selling a product. (See DOL Administrator s Interpretation No March 24, 2010.) Therefore, the Administrator concluded that because a typical mortgage loan officer s primary duty is not related to the management or general business operations of the employer s customers, mortgage loan officers do not fall within the administrative exemption of FLSA, and must be paid overtime. B. Common FLSA Classification Pitfalls With so much complexity, it is easy for employers to run afoul of the wage and hour laws. In 2007, the DOL reported that overtime violations represented about 90 percent of all collected back wages under FLSA actions, and it now reports that 70 percent of employers are not in compliance with the FLSA, mostly regarding correctly classifying employees as exempt vs. non-exempt. In addition to DOL attention and penalties, employers should be aware that there are a plethora of private sector plaintiff class action lawsuits and resulting multi-million dollar verdicts all over the country stemming from this issue. Keep in mind that the requirements with respect to classifying employees as exempt or non-exempt do not stop at the federal level. In fact, many states and localities have enacted wage and hour laws affording employees even greater protections and a higher minimum wage. trinet.com 7

8 As you seek to bring your organization into compliance with the employee classification requirements of the FLSA, be especially mindful of the following common pitfalls: Failing to record overtime hours worked by non-exempt employees or failing to ensure accurate time reporting by employees. Providing PDAs and other mobile devices to non-exempt employees. There should be no reason for a non-exempt employee to have a device that allows for remote work. Mistaking salaried for exempt. Remember that a salaried employee might nevertheless be eligible for overtime and an hourly employee might not. The determination of whether someone is eligible for overtime depends upon the amount they are paid and their primary duties. Offering premium pay that factors in overtime. No matter how handsome the wage, you must pay a non-exempt employee for all hours actually worked. Giving comp time in lieu of overtime. Compensatory time is an area heavily regulated by law and compliance is difficult. Paying the overtime generally makes more sense. Disregarding state laws and municipal ordinances, which might provide more extensive rights and remedies than FLSA. IV. Avoiding Liability for Employee Misclassification: Best Practices Clearly, employers face significant liability in their decision regarding whether to classify a worker as an employee or an independent contractor, and whether to classify employees as exempt or non-exempt. But you can protect your business by faithfully following these best practices: Know the law. The rules regarding employee classification hold enormous potential for employer liability, mainly because business owners fail to take the time to fully understand them. You do not need to become a lawyer, but do become familiar enough with the law to be able to identify when you have a potential issue on your hands. 8 trinet.com

9 Check yourself. Do not wait for the DOL to conduct an audit of your employee classification practices. Take the initiative to review how you do business; catch mistakes now before they become systemic problems. Be honest (about what employees actually do). Because employees are classified as exempt or non-exempt based on what they actually do rather that what is in their job description, make sure that you periodically review and revise job descriptions to reflect actual duties. Train managers. A team of well-trained front-line managers can be your first line of defense against wage and hour liability. They can help you to remain in compliance with the law and identify issues swiftly. Get help. When in doubt about the classification of an employee or contractor, immediately seek guidance from legal counsel specialized in this area of law. trinet.com 9

10 About TriNet TriNet serves as a trusted HR partner to small businesses to help contain costs, minimize employer-related risks, relieve administrative burden, and keep focus on core business functions. From routine employee benefits service and payroll processing to high-level human capital consulting, TriNet s PEO expertise is integrated with every facet of a client s organization. Its solutions specialize in serving fast-moving companies in fields such as technology and professional services, who recognize that top-quality employees are the most critical competitive asset. For more information, visit Disclaimer The contents of this white paper have been prepared for educational and information purposes only. The content does not provide legal advice or legal opinions on any specific matters. Transmission of this information is not intended to create, and receipt does not constitute, a lawyer-client relationship between TriNet, the author(s), or the publishers and you. You should not act or refrain from acting on any legal matter based on the content without seeking professional counsel TriNet. All rights reserved. All trademarks, trade names, service marks and logos referenced herein belong to their respective companies. Dec Learn more at TriNet.com or call Ambitions Realized

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