What Exactly is an “Exempt Employee”?

An “exempt” employee under California law may be paid on a salary basis, without overtime wages, without meal and rest periods, without certain record-keeping rights and without some of the other legal protections provided to workers who are nonexempt.  Deciding whether an employee is exempt or nonexempt is one of the most important decisions an employer must make before offering employment to an individual.  Unfortunately, California employers frequently struggle with this issue and sometimes make the wrong choice.  An employee who is misclassified as exempt can bring suit against their employer for unpaid wages and a variety of valuable statutory penalties.  The cost of defending or settling a misclassification lawsuit can be substantial.

The California Industrial Welfare Commission Wage Orders

In 1916 the California Industrial Welfare Commission (“IWC”) promulgated its first Wage Order establishing the minimum wage of 16 cents per hour.  Today the number of Wage Orders has grown to seventeen.  Each Wage Orders applies to different occupational categories, including, for example, the “Manufacturing Industry” (Wage Order 1). Wage Orders set forth a wide range of employment laws, including laws governing minimum and overtime wages, hours and days of work, alternative workweeks, and meal and rest periods.  The Wage Orders also set out the five conditions under which an employee may be classified as exempt

The Five Exemptions

All of the Wage Orders contain provisions that govern the designation of an employee as exempt or non-exempt.  Only five kinds of exemption in California are recognized in the Wage Orders. The five primary exemptions are:

  1. The Executive Exemption;
  2. The Administrative Exemption;
  3. The Professional Exemption;
  4. The Inside Salesperson Exemption; and
  5. The Outside Salesperson Exemption.

The Executive Exemption

California’s Executive Exemption is relatively straightforward.  It requires the employee to have duties relating to the management of the company, regularly supervise two or more employees, have a voice in employment-related decisions like hiring and firing, and to “customarily and regularly exercises discretion and independent judgment.”  The employee must spend more than 50% of their time engaged in duties that meet the test of the exemption.  And, the employee must be paid a monthly salary that is no less than two times the state minimum wage.

In essence, the Executive Exemption requires the employer to carefully assess the work the employee actually performs on a daily basis and to avoid relying on mere titles to support the classification.   As with all of the exemptions, an employee’s exemption status can change.  For example, if an employee is classified exempt under the Executive Exemption and her team of two subordinates is cut down to one on a long-term basis, then she may no longer qualify for the exemption, which requires the supervision of two or more workers.

The Administrative Exemption

The Administrative Exemption exempts employees who are engaged in fairly high-level work that is specifically related to management policies or general business operations of the employer or its customers.  If the employee spends more than half of their time engaged in low level production activities with a few administrative duties thrown in, like an administrative assistant to a low-level manager, they are not likely to be exempt.  The administrative assistant to the CEO, however, may spend most of their time engaged in higher level exempt activities and fall inside the Administrative Exemption.

Courts and governmental agencies have grappled with this exemption for decades.  What we know for certain is that the outcome of any dispute over the application of the Administrative Exemption is fact intensive.  It requires an analysis of the reasonable expectations of the employer (what did the employer expect the employee to do?) and the actual work performed by the employee.

At their core, the Wage Orders’ exemptions are both qualitative and quantitative.  What is the nature or quality of the alleged exempt work and how much time is the worker engaged in it?  Because proper classification is treated as an affirmative defense in a wage and hour lawsuit, the employer shoulders the burden at trial of proving that it made the correct decision with respect to the employee’s exemption status.

The Professional Exemption

The Professional Exemption sets out eight specific professions (law, medicine, dentistry, optometry, architecture, engineering, teaching, and accounting) that are exempt from the first 12 sections of the Wage Orders.  It also addresses certain other professions, including nurses, pharmacists and software coders.

Too lengthy to quote in full here, it can be found at section 3 of Wage Order 4-2001.  The core of the exemption is the requirement that the employee be engaged in “an occupation commonly recognized as a learned or artistic profession.”

To satisfy the “learned profession” requirement, the employee needs to have advanced knowledge in the subject matter of their job.  This is the kind of knowledge “customarily acquired by a prolonged course of specialized intellectual instruction and study, as distinguished from a general academic education and from an apprenticeship, and from training in the performance of routine mental, manual, or physical processes, or work that is an essential part of or necessarily incident to any of the above work.”

To satisfy the alternative, “artistic profession” the work must be “original and creative” and must be the result of “the invention, imagination, or talent of the employee or work that is an essential part of or necessarily incident to any of the above work.”

Under either category, the work must be “predominately intellectual and varied in character.”  The employ must regularly exercise “discretion and independent judgment,” and earn no less than two times the state minimum wage for a full-time employee.

Except for the professions called out directly in the Wage Orders, proving the Professional Exemption requires an evaluation of the work being performed, what the employer reasonably expected the employee to do, and the amount of time spent engaged in exempt activities.

The Inside Sales Exemption

A person primarily engaged in the sale of their employer’s products or services in the company’s office (even a home office) can be exempt from overtime if two conditions are met.  First, the employee must be paid a salary of more than 1.5 times minimum wage.  Second, more than half of the wages earned by the employee must be in the form of sales commissions each work week.  If these two conditions are met, then the employee is exempt from daily and weekly overtime pay requirements.  If one or both conditions are not met during a work week, then the employee is entitled to overtime pay.

An inside salesperson can be exempt some weeks and non-exempt other weeks when they do not earn more than 50% of their total wages in commissions.  The second part of the test can catch employers unawares.  Especially in the Bay Area and Silicon Valley, some salespersons earn tens of thousands of dollars in commissions for sales that take months to move from proposal to contract.  Thus, an employee might work many overtime hours in an effort to complete a deal while earning no commissions at all.  If the commission agreement with the employee states that the salesperson only earns the commission wage when the money is paid by the customer, the employee might be entitled to overtime pay for all of the overtime hours worked on the deal.

Employers who choose to pay a sales associate a large annual salary, plus commissions, might be required to pay the employee overtime wages on all overtime hours worked during weeks when less than 50% of their wages are not comprised of sales commissions.

The Outside Sales Exemption

The California Wage Orders do not apply to outside salespersons.

“Outside salesperson” means any person, 18 years of age or over, who customarily and regularly works more than half the working time away from the employer’s place of business selling tangible or intangible items or obtaining orders or contracts for products, services or use of facilities.

This means that if certain requirements are met, outside salespersons are not guaranteed minimum wages, overtime wages, meal periods or rest periods.  The classification of an outside salesperson is not always clear, however. The classification determination is exceedingly fact-specific.  In Ramirez v. Yosemite Water Co., the California Supreme Court explained that it is important to evaluate both actual work performed by the employee and the reasonable expectations of the employer.

[T]he trial court should also consider whether the employee’s practice diverges from the employer’s realistic expectations, whether there was any concrete expression of employer displeasure over an employee’s substandard performance, and whether these expressions were themselves realistic given the actual overall requirements of the job.

Like each of the five exemptions, misclassifying an employee as an inside salesperson can have significant consequences for the employee and the employer.

Bad Classification Decisions Have Bad Consequences

A single plaintiff misclassification case can easily cost an employer over a hundred thousand dollars in attorneys’ fees and settlement costs.  A multiple plaintiff or class action case can expose an employer to multiples of that number.  A typical misclassification case might look like this:

A tech company maintains a 20-person sales team to pursue long term contracts with other businesses to use their online data management platform.  The company designates the entire team as exempt.  Every member of the team does the same kind of work researching and pitching their company’s product to other businesses.  All team members report to a director-level supervisor.  They are all paid $120,000 per year, plus sales commissions at different rates depending on productivity and seniority.

A team member quits or is fired.  They read about misclassification online and contacts an attorney.  A couple of weeks later, their attorney files a misclassification lawsuit against the company, alleging that the client was entitled to overtime wages because she was non-exempt.  Because she typically worked 60 hours per week, she was entitled to 20 hours of overtime each week for the 52 weeks she worked for the company.  The law provides that her annual $120,000 salary only covers her wages for 40 hours per week.  Her annual salary converts to $57.69 per hour.  Because she was only paid for 40 hours per week, all of the unpaid time is due at her overtime rate of $86.54.  At 20 hours per week for 52 weeks (1,040 hours), her unpaid overtime equals $90,001.60—for one year!

Unless her employer can prove that she was properly classified as exempt under one of the four exemptions, she will win, and the company will be ordered to pay her the unpaid overtime, interest at 10% per year, various statutory penalties and her attorneys’ fees and costs.  If the former salesperson is correct about the misclassification, her lawyers have just laid the groundwork for a six or even a seven-figure recovery.

The Takeaway:  Getting it Right and Keeping it Right

This example is fairly typical of misclassification cases filed in California.  Few of these kinds of misclassification cases reach a jury because of the nature of the risks that employers’ face.  Most are resolved through a confidential settlement.

The California Courts have instructed us that an employer must evaluate the specific work an employee is to perform to determine whether to classify them as exempt or non-exempt.  Properly classifying workers as exempt or non-exempt to overtime pay is not always an easy task.  The tests are complex and the case law is filled with decisions that define who is and who is not exempt.  In addition, an employee’s classification can change over time.    Periodic re-evaluations of employees’ exemption status can help.  Building the exemption evaluation into annual reviews is one way to ensure a company decision remains the right one over time.

If you have any questions about employee classification, please give Patrick Kitchin a call at 415-677-9058 for a free initial consultation.