An “exempt” employee under California law may be paid on a salary basis, without overtime. Deciding whether an employee is exempt or nonexempt is one of the most important decisions an employer must make before offering employment to anyone.

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, a variety of valuable penalties and attorneys’’ fees.  The cost of defending or settling a misclassification lawsuit can be substantial.

So, what steps can an employer take to make the right choice and avoid getting sued?  To answer this question, we need to understand the California Wage Orders.

The California Industrial Welfare Commission Wage Orders

In 1916 the California Industrial Welfare Commission (“IWC”) promulgated its first Wage Order establishing a minimum wage of 16 cents per hour.  Today the number of Wage Orders has grown to 17.  Each Wage Orders applies to different occupational categories, including, for example, Wage Order 1 that applies to the “Manufacturing Industry.”  IWC Wage Orders set forth a wide range of employment requirements, including laws governing minimum and overtime wages, hours and days of work, alternative workweeks, and meal and rest periods.  The Wage Orders provisions also are set out in the California Code of Regulations and they reference a range of California Labor Code provisions.

The Wage Orders set out the five conditions under which an employee may be classified as exempt from certain Wage Order requirements.

The Five Exemptions

All of the Wage Orders contain provisions that govern the designation of an employee as exempt or non-exempt.  Between the 17 Wage Orders, only five kinds of exemption in California are recognized.  The five exemptions are:

  1. The Executive Exemption;
  2. The Administrative Exemption;
  3. The Professional Exemption;
  4. The Inside Salesperson Exemption (set out in Wage Orders 4 and 7 only); and
  5. The Outside Salesperson Exemption.

All of the exemptions have both qualitative and quantitative measures.  What is the nature or quality of the alleged exempt work and how much time is the worker engaged in dong it?  Proper classification is treated as an affirmative defense in a wage and hour lawsuit.  This means that the employer carries the burden at trial of proving that it made the correct decision with respect to the employee’s exemption status.  It must show that the employee engaged in exempt activities more than 50% of their work time and was sufficiently paid.

          1.  The Executive Exemption

California’s Executive Exemption is relatively straightforward.  It requires the employee to have duties relating to the management of the company, to regularly supervise two or more employees, to have a voice in employment-related decisions like hiring and firing, and to “customarily and regularly exercise[] discretion and independent judgment.”  The employee must spend more than 50% of their time engaged in duties that meet the exemption.  And, the employee must be paid a monthly salary that is no less than two times the state minimum wage based on a 40-hour workweek.

Like all five exemptions, the Executive Exemption requires the employer to 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 they may no longer fit within the exemption.

          2.  The Administrative Exemption

The Administrative Exemption applies to 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 squarely inside the Administrative Exemption.  Like the Executive and Professional exemptions, the Administratively exempt employee must earn a salary equal to two times minimum wage.

Courts and governmental agencies have evaluated this exemption in numerous cases and situations over the decades.  The outcome of a dispute over the application of the Administrative Exemption is extremely 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.  An employee properly classified as exempt generally cannot become nonexempt by failing to do the job they were hire and expected to do.

Examples of the kinds of positions that often are correctly classified as exempt under the Administrative Exemption include, tax experts, insurance experts, sales research experts, wage rate analysts, foreign exchange consultants, and statisticians.

          3.  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 “artistic profession” requirement, 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.

          4.  The Inside Sales Exemption

The Inside Sales Exemption appears in only two of the Wage Orders, numbers 4 (professional, technical, clerical, mechanical, or similar occupations), and 7 (mercantile industry, i.e., retailers). 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 based on a 40-hour workweek.

Second, more than half of the wages earned by the employee must be in the form of sales commissions each pay period, and commissions earned during one pay period cannot be met by reassigning commissions earned during another.

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 pay period, then the employee is entitled to overtime pay.

Consequently, an inside salesperson can be exempt some pay periods and non-exempt other pay periods when they do not earn more than 50% of their total wages as 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 to payment.  Thus, an employee might work many overtime hours in an effort to complete a deal while earning no commissions at all.  The employee might be entitled to overtime pay for all of the overtime hours worked on the deal before the commissions were earned.

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 pay periods when less than 50% of their wages are not comprised of sales commissions.

The California Supreme Court addressed this issue in its 2014 decision Peabody v. Tim Warner Cable, Inc.  If the employer fails to maintain an accurate record of the hours worked by salespersons who are paid on a salary plus commission basis, an employee suing for overtime may be permitted to rely on their personal estimates of overtime hours worked.

          5.  The Outside Sales Exemption

Employees over the age of 18 who spend more than 50% of their work time in the “field,” away from their employers’ offices and who sell items, or obtains orders or contracts for products, services, or the use of facilities are exempt from all of the requirements set out in the Wage Orders.  This exemption is set out in all the Wage Orders.

A Hypothetical Case

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 customers and pitching their company’s product to other businesses.  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 contact an attorney.  A couple of weeks later, their attorney files a lawsuit against the company. The lawsuit alleges that the ex-employee is entitled to overtime wages because they were misclassified as exempt.  If the plaintiff employee worked 60 hours per week, they could be entitled to 20 hours of overtime pay each week they worked.  The law provides that the annual $120,000 salary only covers wages for 40 hours per week.  Their annual salary converts to $57.69 per hour.  Because they were only paid for 40 hours per week, all of the unpaid time is due at their overtime rate of $86.54.  At 20 hours per week for 52 weeks (1,040 hours), their unpaid overtime equals $90,001.60—for one year!

Unless the employer can prove that they properly classified the employee, the employer will lose.  The company will be ordered to pay the unpaid wages, interest at 10% per year, heavy monetary penalties and attorneys’ fees and costs.

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

The Takeaway

Bad classification decisions often have bad consequences. A single plaintiff misclassification case can easily cost an employer well 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.

The California courts have made it clear that an employer must evaluate the specific work an employee is to perform and to make the right decision as to whether to classify them as exempt or nonexempt.  Properly classifying workers 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 various industries.  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 unsure, consulting with an employment is recommended.