FLSA Status: How-to Classify Employee Exemption and Contractors

According to the Fair Labor Standards Act (FLSA), there are three different categories workers; non-exempt employees, exempt employees, and independent contractors. Employers need to know which category each person working for them is. A misclassification of a worker may lead to monetary consequences in the form of fines or penalties.

Employee Classification

The FLSA is enforced by the Wage and Hour Division of the Department of Labor (DOL), whose duty is to recover back wages and assess penalties. These penalties can be up to $1,000 per violation.

In fact, in the 2021 fiscal year, the DOL recovered over $230 million in total back wages due to the misclassification of workers. Even still, it continues to be one of the most common payroll mistakes employers tend to make.  

How To Classify Exempt vs. Non-Exempt Employees

The following sections will help employers determine the exemption status of employees, meaning which employees are exempt from minimum wage and overtime pay under the FLSA rules and regulations.

Exempt Employees

Any employee who is classified as exempt is not subject to FLSA overtime and minimum wage requirements. 

While there are several categories of exempt workers, one thing the majority of them have in common is they must pass the Salary Level Test as part of their exemption requirements.

Salary Level Test

In order to pass the Salary Level Test, an employee must be paid on a salary basis of no less than the standard salary level:

Employers may use nondiscretionary bonuses and incentive payments (such as commissions) paid on an annual or frequent basis, to satisfy up to 10% of the salary requirement. 

Any employee who passes this test is one step closer to being classified as exempt. After passing the Salary Level Test, an employee must also meet the requirements of one of the next six categories.

Executive Exemption

In order to qualify for an executive exemption, an employee must pass the Salary Level Test as well as:

• Have a primary duty of either:
  • Managing a business/company
  • Managing a customarily recognized department or subdivision of a business/company
• Customarily and regularly direct the work of at least two or more other full-time employees
• Have the authority to hire and/or fire other employees, or their thoughts on similar decisions are given particular weight and consideration

If an employee meets the previous three requirements as well as the Salary Level Test, then they are considered an Executive Exempt Employee and are not subject to FLSA minimum wage and overtime law.

Administrative Exemption

In order to qualify for an administrative exemption, an employee must pass the Salary Level Test as well as:

• Have a primary duty of office or non-manual work that is directly related to the management, or general business operations of either the employer or the employer’s customers 
• Have a primary duty that includes the exercise of discretion and independent judgment in regard to important matters

If an employee meets the previous two requirements as well as the Salary Level Test, then they are considered an Administrative Exempt Employee and are not subject to FLSA minimum wage and overtime law. 

Professional Exemption

There are two categories of professional exempt employees according to the FLSA, each with its own requirements.

Learned Professional Exempt Employees

In order to qualify for a learned professional exemption, an employee must pass the Salary Level Test as well as:

• Have a primary duty of work requiring advanced knowledge
  • Defined as work that is predominantly intellectual and requires the consistent exercise of discretion and judgment
  • The advanced knowledge must be in a field of science or learning and must be obtained by a prolonged course of specialized intellectual instruction (such as college) 

If an employee meets the previous requirement as well as the Salary Level Test, then they are considered a Learned Professional Exempt Employee and are not subject to FLSA minimum wage and overtime law.

Creative Professional Exempt Employees

In order to qualify for a creative professional exemption, an employee must pass the Salary Level Test as well as:

• Have a primary duty of work requiring invention, imagination, originality, or talent in a recognized field of artistic or creative endeavor (Musicians, Composers, Engineers, etc.)

If an employee meets the previous requirement as well as the Salary Level Test, then they are considered a Creative Professional Exempt Employee and are not subject to FLSA minimum wage and overtime law.

Computer Employee Exemption

In order to qualify for a computer employee exemption an employee must first either pass the Salary Level Test or be compensated at $27.63 per hour on an hourly basis, as well as:

• Be employed as a computer systems analyst, computer programmer, software engineer, or another similarly skilled worker in the computer field performing one or more of the following duties:
  • The application of systems analysis techniques and procedures, including consulting with users, to determine hardware, software, or system functional specifications
  • The design, development, documentation, analysis, creation, testing, or modification of computer systems or programs, including prototypes, based on and related to user or system design specifications
  • The design, documentation, testing, creation, or modification of computer programs related to machine operating systems
  • A combination of the aforementioned duties, the performance of which requires the same level of skills

If an employee meets the previous requirement as well as the Salary Level Test or specific wage requirement, then they are considered a Computer Exempt Employee and are not subject to FLSA minimum wage and overtime law.

Outside Sales Exemption

In order to qualify for an outside sales exemption an employee must:

• Have a primary duty of either:
  • Making sales as defined by the FLSA
  • Obtaining orders or contracts for services or for the use of facilities for which a consideration will be paid by the client or customer
• Be customarily and regularly engaged away from the employer’s place or places of business 

If an employee meets the previous two requirements then they are considered an Outside Sales Exempt Employee and are not subject to FLSA minimum wage and overtime law.

Highly Compensated Employee Exemption

In order to qualify for a highly compensated employee exemption an employee must:

• Pass the Salary Level Test
• Perform office or annual work
• Customarily and regularly perform at least one of the duties of an exempt executive, administrative, or professional employee
  or
• Earn an annual compensation of the following or more:

If an employee meets the previous four requirements, then they are considered a Highly Compensated Exempt Employee and are not subject to FLSA minimum wage and overtime law.

Non-Exempt Employees

If an employee fails to qualify for any of the above exemptions, then they are considered to be a non-exempt employee. Non-exempt employees are workers that are paid an hourly rate and are subject to the minimum wage and overtime requirements set by the FLSA. 

There are also some specific professions that exemptions may not apply for, these include:

• Blue-Collar Workers
• Police
• Firefighters
• Paramedics
• Other First Responders

How to Classify an Independent Contractor

In addition to having to determine whether an employee is exempt or non-exempt, employers also need to understand the distinction between an employee and an independent contractor. 

Generally, employers must withhold and pay income taxes, social security taxes, medicare taxes, and unemployment tax on wages paid to an employee. Typically, none of the previously mentioned taxes are withheld or paid on payments to independent contractors. 

In short, understanding this type of classification can make a big financial difference for employers and employees alike. 

Determining whether or not a worker is an independent contractor or not mainly revolves around the relationship between the employer and the worker. The IRS has a list of rules that pertain to determining that relationship.

IRS Final Rule for Classifying Independent Contractors

Rescinding the Independent Contractor Status Under the Fair Labor Standards Act rule (2021 IC Rule), the U.S. Department of Labor has published a final rule for classifying workers as independent contractors or employees.

To determine whether workers are employees or independent contractors under the FLSA, the final rule indicates employers must take into account six factors equally to determine if a worker is in business for themselves as a matter of economic reality.

The following six factors to be considered are:

1. Opportunity for profit or loss depending on managerial skill
2. Investments by the worker and the potential employer
3. The degree of permanence of the work relationship
4. The nature of and degree of control
5. The extent to which the work performed is an integral part of the employer’s business
6. Skill and initiative of the worker

Each of these factors are summarized below.

1. Opportunity for Profit or For Loss Depending on Managerial Skill

In order to further understand this factor, the Department of Labor has developed a list that may be relevant when considering this factor. However, circumstances are not limited to this list: 

• Whether the worker determines or can meaningfully negotiate the charge or pay for the work provided
• Whether the worker accepts or declines jobs or chooses the order and/ or time in which the jobs are performed
• Whether the worker engages in marketing, advertising, or other efforts to expand their business or secure more work
• Whether the worker makes decisions to hire others, purchase materials and equipment, and/ or rent space

Under this factor, the Department of Labor emphasizes that when a worker lacks the opportunity for a profit or loss, it indicates that the worker is an employee. 

In addition, decisions made by a worker that affect their pay typically do not demonstrate managerial skill that indicates independent contractor status under the given criteria. These decisions that affect pay can be things such as working longer hours or taking additional jobs.

2. Investments by the Worker and the Potential Employer

To further identify employee classification status, the Department of Labor proposed this factor to consider “whether any investments by a worker is capital or entrepreneurial in nature.”

The second factor clarifies that expenses incurred by a worker for job-related tasks, such as tools, equipment, and labor, do not signify capital or entrepreneurial investment and thus imply employee status. 

Further stated by the Department of Labor, independent contractor status is defined by investments that are capital and entrepreneurial in nature, these are investments made that “generally support an independent business and serve a business-like function”. 

These provisions include:

• Increasing the worker’s ability to do different job types
• Reducing costs
• Extending market reach

3. Degree of Permanence of the Work Relationship

The third factor is based on the degree of permanence of the work relationship. If the worker has an exclusive work relationship, or the work relationship is indefinite in duration / continuous, the Department of Labor weighs in favor of the worker being an employee. 

If a worker has a work relationship that is non-exclusive, definite in duration, project-based, or sporadic based on the worker being in business for themselves, the worker would be classified as an independent contractor.

Independent contractors may have regularly occurring fixed periods of work, but that by itself would not necessarily indicate independent contractor classification. 

The Department of Labor proposed that if the lack of work relationship permanence is due to operational characteristics that are unique to particular industries or businesses, and the worker operates under their own business initiative, this would indicate that the worker is classified as an employee.  

4. Nature and Degree of Control

The fourth factor to consider is based on the nature and degree of control that the potential employer holds in regard to key aspects and performance of the work, as well as the economic aspects of the working relationship. 

These key aspects of control include:

• Setting schedules
• Supervision and restrictions
• Control over price rates for goods or services
• Selecting projects
• Affecting the worker’s ability to work for others
• The use of technological means to monitor work performance
• Controlling workloads

If the potential employer establishes work schedules, oversees the work, and administers any necessary disciplinary actions, the factor suggests that the individuals subject to scheduling and supervision are classified as employees.

To further determine whether a worker is an independent contractor or an employee, the IRS has developed three common law rules to evaluate the relationship between the worker and the business. When determining the workers' classification, all relevant information indicating the level of control and the degree of independence must be taken into account. 

IRS Common Law Rules

The IRS has created three common law rules as part of its own test to help provide evidence of the degree of control and independence.

Behavioral Control

Behavioral control refers to if and when the business has the right to direct and control the work performed by the worker. If so, then they are typically not an independent contractor. Things to consider to help determine this are:

• Who controls how the work is done?
• Who controls when and where the work is done?
• Who controls what tools or equipment are used in doing the job?

Financial control refers to whether the business has a right to direct or control the financial and business aspects of the worker’s job. If so, then they are typically not an independent contractor. Things to consider to help determine this are:

• Does the employer reimburse for some or all of the worker’s business expenses?
• How is the worker paid?
• Who provides tools and equipment?

Relationship

The type of relationship is based on how the worker and business perceive their interaction with one another. Things that would typically mean a worker is an employee include benefits, permanency, and the services provided. 

Things to consider to help determine this are:

• Does the worker receive company benefits?
• Is there a written contract for employment?
• Is the position temporary or permanent?
• Are the services provided a key component of the business and the way it runs?

5. Extent to Which the Work Performed Is an Integral Part of the Potential Employer’s Business

The Department of Labor emphasizes the belief that if a worker is providing a service that is critical or necessary to the potential employer's business, the service is considered integral. 

Under this factor, a worker who performs work that is an integral part of the potential employer’s business is likely to be classified as an employee. 

If it is determined that the work provided is more peripheral and is not critical or necessary to the potential employer's business, the worker is more likely to be considered an independent contractor.

6. Skill and Initiative

The final factor to take into consideration is whether the worker performs specialized skills and whether those specialized skills contribute to business-like initiatives. 

It is indicated that a worker may be classified as an independent contractor if the worker brings specialized skills to the work relationship, and how the worker uses their specialized skills in connection with business-like initiatives.

In opposition, if a worker does not provide any specialized skills to the potential employer's business, and is reliant on training from the employer to perform the given work, this indicates the classification of employee status.

Final Thoughts on FLSA Status and Employee Classification

It is crucial that employers understand the distinction between different types of employees so that they can avoid any unnecessary payroll mistakes, fines, lawsuits, or damages.

Employers must look at the entire relationship and consider the extent to which they can control and direct the worker. Employers should also document all factors and common laws used to determine the relationship. 

Alternatively, any employer who can’t determine the relationship using these factors and laws can submit form SS-8 to the IRS, who will then review the factors and circumstances and make an official determination on the behalf of the employer or worker.

For any employers struggling with employee classification, an HR and payroll company may be of assistance as well. For more information, contact us or use our find a provider tool today.