Take Care in Classifying Employees and Interns

By Maryann O’Connell

Maryann O'Connell
The federal government is stepping up efforts to uncover employers—including nonprofits—who misclassify employees as a means of trimming payroll costs, intentionally or otherwise, which can lead to substantial fines.

The U.S. Department of Labor and the Treasury Department reportedly will spend an extra $25 million in 2011 in hopes of producing billions of dollars in extra revenue from payroll taxes and penalties levied on enterprises that wrongly classify employees as exempt from overtime pay, hire “independent contractors” whom the government says actually function as employees, or bring aboard unpaid interns who do work that allegedly qualifies them as employees.

This is happening at the same time as the weak economy and concerns about a “double-dip” recession are prompting many employers—nonprofit and for-profit alike--to keep their ranks of permanent employees low and decrease payroll costs.

However, the catastrophic penalties can do so much financial damage to an organization, and the chances of being found in violation are rising so substantially, that it is more important than ever to avoid running afoul of labor laws.

Exemption from Overtime

Many nonprofits violate these rules because, for the most part, they do not understand them. For example, the Fair Labor Standards Act (FLSA) rules defining exempt and non-exempt status (“exempt” employees do not have to be paid overtime) are very complex. Employers often erroneously assume that any employee who is paid a salary (as opposed to an hourly wage) is automatically exempt.

Just as a salary alone doesn’t determine exemption status, neither does a person’s job title. To qualify as exempt from overtime pay requirements, not only under FLSA but many state laws as well, employees generally must meet certain tests regarding their duties and the way they are paid.

For example, there are tests to help employers determine a worker’s status under the most common overtime exemptions, sometimes referred to as the “white collar exemptions.” First, and easiest, is the salary level test. An employee paid less than $455 a week ($23,660 annually) is non-exempt, regardless of duties. Salaried employees earning more than $100,000 may be easier to qualify for exempt status as highly compensated employees. (Note, however, that hourly wage earners are not exempt, even if highly compensated.)

The next factor to consider is the salary basis test that is designed to make sure the employee’s compensation basis is not, in effect, an hourly wage disguised as a salary. Is the employee paid a sum that is guaranteed regardless of the quantity or quality of work performed, or can that sum be reduced if there is less than the “normal” amount of work available to be performed in a given period?

Most complex is the job duties test, which contains provisions that vary with the job classification. For example, in general terms, exempt executives must supervise at least two full-time or four part-time employees and must provide genuine input regarding the job status of other employees, such as delegation of assignments and promotion or dismissal decisions. They must also have management responsibilities as the primary duty and focus of the job.

Then there are rules that determine whether an employee is exempt as an administrative worker. Such an employee must perform office or non-manual work related to the management or business operations of the company or of the company’s customers. Therefore, the employee must be involved with the administration of the business rather than production-type work. Additionally, duties must include the exercise of discretion and independent judgment with regard to matters of significance. This can be very difficult to determine.

Misclassifying employees has become an increasingly costly mistake. Fines, penalties, and back pay for violations can add up to an enormous, sometimes crippling, sum. To bolster compliance, rules now dictate that back pay owed to employees who were misclassified can be doubled. The law also allows the Department of Labor to assess civil monetary penalties.

Keep in mind that employees bringing suit can recover attorney’s fees under the FLSA. In the long run, misclassification may be far more costly to an employer than the burden of paying overtime.

Employee or Contractor?

While exempt versus non-exempt tests are complex, at least they provide useful definitions with which to determine classification. In contrast, the matter of distinguishing an employee from an independent contractor is rife with ambiguity. The U.S. Supreme Court has ruled that no single test or rule provides an answer to whether a worker is an employee or independent contractor. Instead, the total activity or situation determines whether an employee relationship exists.

Factors such as the permanency of the relationship, the degree of control exercised by the company over how the work is performed (but not where it is performed), and the worker’s opportunity for profit and loss, among other issues, may be critical factors.

Unpaid Interns

If you are you thinking about bringing aboard an unpaid intern to supplement your staff, be very careful. Even though the internship takes place in an actual working environment, the training must be structured in ways similar to an academic environment. The intern’s presence may not displace an actual employee, and the internship must be for the benefit of the intern and provide no immediate advantage to the firm. And those are only some of the factors to take into account.

All circumstances in which an employer will avoid paying overtime or payroll taxes, or obtain free services by means of internships, should be carefully considered for appropriateness under the FLSA and other applicable laws. Seek professional help when you are unsure, because the penalties for violations can be steep, and the likelihood of detection is rising dramatically.

Maryann O’Connell is a team manager in the Boston office of Administaff, a human resource service that provides administrative relief and company benefits to small and medium-sized businesses. Call her at 800-465-3800.