Understanding How to Correctly Classify Exempt vs. Nonexempt Employees in Your Small Business

Published by Matt Brady | August 22, 2017

Small business owners have a lot of priorities to address every day in their business. One of those priorities is the management of their employees, and that’s why a proper understanding of employee classification under the law is an essential point of focus for small business owners. To help clarify some of these distinctions, we sat down for a chat with Tiffany Orford, a District Manager with ADP, for an interview on this essential topic:

Q. Can you briefly explain what the terms “non-exempt employee” and “exempt employee” mean?

Sure. A non-exempt employee must be paid at least the minimum wage appropriate to the applicable jurisdiction as well as overtime pay for any time worked beyond 40 hours in a given week. Overtime pay must be time-and-a-half for those additional overtime hours. Traditionally, we think of these as “hourly” positions in a business, since the standards applied by the Fair Labor Standards Act (FLSA) describe the compliance requirements in terms of hours worked and paid.

An exempt employee is an employee who is not covered by the protections of the FLSA and is therefore not entitled to overtime pay. In most cases, the law requires that in order to be classified as exempt, an individual must be paid at least $23,600 per year (or $455 per week); compensated on a salary basis; and must perform job duties that meet the standards for being exempt.

This brings up an essential point, which is that exemption is not just based on whether you pay a person by the hour or on a salary, nor is it solely based upon what kind of job a person has or what title they hold. The statute maintains very specific definitions for the three categories of job duties (executive, professional and administrative) that can be considered for exempt classification.

Employers should also note that there are various exceptions and special scenarios to be aware of as well. For example, some kinds of work are not governed by the FLSA at all (such as many kinds of agricultural jobs) and others are regulated by different laws other than the FLSA (such as truck drivers). In addition, special requirements within the FLSA may apply to certain specific professions such as physicians, schoolteachers, outside sales professionals and airline personnel.

In short — it’s not nearly as easy to classify correctly as most business owners tend to assume or want to believe.

Q. Many small business owners assume that the only difference between these designations is that one person is salaried and one person is hourly. However, that’s incorrect. Why do so many small businesses get this wrong?

They get it wrong for a number of reasons:

First, it’s because small business owners are focused on growing their business and may not know all of the compliance rules and regulations that apply to them.

Second, it’s because of a fundamental lack of education provided to business owners around issues such as employment classification and compliance.

And third, it’s likely also an issue of employees not knowing the law either. If a business owner makes incorrect classification decisions and his or her front-line managers make the same mistakes, it’s entirely possible that everyone involved — even the misclassified employee(s) themselves — may be operating in a noncompliant manner.

Since no one is saying there’s a problem, most small business owners assume that a lack of smoke means there is no fire.

Q. What are some of the factors that the Fair Labor Standards Act (FLSA) applies to determine if a person is, indeed, exempt?

Well, in addition to the core requirements (paid a set salary each week, compensation meets or exceeds the designated minimum), there is the job duties test. The job duties test is a critical (and often forgotten or ignored) component in the process of accurately classifying employees.

For example, in order to classify someone as exempt under the “executive” category, the person must “regularly perform” a series of tasks including actively supervising two or more other employees; operating in a role where her or his primary duties are generally recognized as managerial in nature; and the employer must be able to demonstrate that the employee has genuine input into other employee’s job status (in areas such as hiring, firing, assignments of duties, and so forth). Similar tests exists for professional and administrative positions as well.

This is critical to understand because it points out an area in which the U.S. Department of Labor has been pursuing compliance aggressively, which is in jobs that are called managerial but where the person in the position often performs many of the duties associated with a clerical or blue collar employee.

Q. The Obama administration applied a new salary basis requirement for employee classification that was to become effective this year, but it was later placed on hold by the Trump administration. What is the current standard and do you think it will change again in the near future?

The current standard for the compensation floor with regard to exempt employees in the administrative, professional and executive categories is $23,660 per year or $455 per week. This is a minimum salary requirement; otherwise employees are subject to overtime pay (regardless of what their title may be or their job duties may entail).

While no one can say for sure whether the change sought by the Obama administration will eventually happen under the current administration or after it, one thing is clear: employers need to recognize that accurate, legally defensible employee classification is a critical business issue and that it represents a high-profile policy priority for the government.

Q. Under what conditions might I be required to pay overtime to an employee who is salaried?

Well, first of all, if you have any employee being paid below the minimum threshold, they are eligible for overtime and you are obligated to pay it. This means that even if you pay someone below the threshold a salary, you had better be tracking and managing the time that they actually work because if they are eligible for overtime and you’re not tracking their hours worked, you are now facing a huge legal liability.

Second, you are obligated to pay overtime to any employee whose job does not meet all of the classification standards we’ve discussed this far. This means that in addition to how much they’re paid and how they’re paid, they also have to work in one of the categories that are recognized for exemption *and* meet all of the requirements of the exemption test within the applicable category. If you don’t meet of exceed all of these, you need to pay overtime.

Q. What kinds of businesses are particularly vulnerable to making errors in how they classify employees?

All industries are at risk for labor violations in this area — it’s such a common problem that there’s really no sector in which it is not a point of risk. That having been said, we see it happen a great deal in industries that have large and diverse workforces deployed in a variety of operational and supervisory roles together, such as construction contracting, landscaping, restaurants and hospitality and retail.

Q. What are the legal and/or financial penalties and other risks that small businesses may encounter if they misclassify employees?

As the business owner, you could be subject to fines and back wages/taxes for all of the years during which the employee was misclassified.

Q. How can a third-party payroll provider or a professional employer organization (PEO) help small business owners avoid these pitfalls and stay compliant?

As a professional payroll and human capital management provider, we can help business owners with classification audits, and we educate business owners and their key personnel on federal, state and local compliance updates daily. That brings up another important point, which is that in addition federal statutes, states and even some counties and cities all have their own layers of regulations, ordinances and requirements to consider. As a business owner, you need to know them all -— or you need to partner with someone who does.

In addition, the Professional Employer Organization (PEO) option can be attractive for many employers because in the PEO scenario, you’re outsourcing not only the management of payroll, benefits and administration for your employees, but on top of that you’re actually using the PEO as the employer of your personnel, which means that the PEO brings its professional expertise to the table and oversees the management of your human resources on your behalf.

Q. What are the top one or two takeaways that you’d like every small business owner to have in mind when they think about classifying employees correctly?

The first is to get to know the compliance rules for employee classification and then follow them to the letter.

The second is to avoid any fines or penalties by committing time and effort to learn and then do what is right by the Department of Labor and the FLSA.

And the third is to seriously consider partnering with a professional payroll, human resources or PEO provider (or, better yet, a company that can offer any of these options), so that you have expert advice and support as you manage your workforce.

About the Author:

Tiffany Orford is a District Manager with ADP, where she works closely with small business owners to meet their needs in the areas of human resource management, payroll and benefits administration and the delivery of other services such as Professional Employer Organization (PEO) solutions. Prior to joining ADP, she worked as the head of institutional marketing for Sidoti & Company, and as an executive team leader for Target Corporation. She received her bachelor’s degree in Business Administration and Marketing from the Fox School of Business at Temple University in Philadelphia, where she served as vice president of the American Marketing Association chapter and as an active member of student government. She may be reached at (732) 546-8584 or via email to tiffany.orford@adp.com.

Image Credit: NASA Goddard (Flickr @ Creative Commons)