Classification Complications

How to navigate the maze of California’s new rules on overtime and independent contractors

Back Longreads Aug 21, 2018 By Steven Yoder

Jane Bei, chief financial officer at California Electronic Asset Recovery, thought she had a deal.

Last April, the company’s former sales director asked whether she could get back the position she had left in August. By then, CEAR, an electronics recycling company in Mather, had hired a replacement and couldn’t afford two salaried people in that role. So the former employee made the company an offer: She’d work as a contract salesperson on commission only, earning 10 percent of each sale. She’d work off-site and set her own schedule. Bei says both sides thought it was a good plan.

But when CEAR ran the arrangement by their human resources expert, the answer was no. Under federal and California state labor law, the former employee would need to have her own company and do similar work for other clients to be a legal independent contractor. “It’s frustrating because we both lost,” Bei says.

But what the parties want doesn’t matter when it comes to the key state rules on employee classification — who qualifies as an independent contractor, and which employees must be paid hourly as nonexempt vs. salaried as exempt. There’s a reason, say proponents of the current framework: Without those mandates, employers could force workers into arrangements that look consensual but aren’t.

Recent court cases have tightened up the classification requirements even more. Given the penalties associated with mistakes, it’s more important than ever that companies stick to sound personnel management procedures to stay in compliance, say employment lawyers and human resource experts.

California Rules Just Got Tougher

The California Division of Labor Standards Enforcement launches hundreds of investigations on employee classification each year and sends a report to the state Legislature on how many companies it has fined for breaking wage and hour laws. In 2016, the department issued about 300 citations involving overtime and misclassification, with penalties totaling about a million dollars statewide. One company was hit with a fine of $221,000.

The rules often are so complex that assessing whether a business is in compliance can be a job for specialists. Take the regulations on the “exempt-nonexempt” division — who must be paid hourly and who can be salaried. Those in executive, administrative or professional roles generally can be salaried. Most others must be paid hourly, receive overtime and be provided meal and rest breaks.

Those categories may seem straightforward, but there are trip wires. For example, to meet the executive exemption, a worker must spend at least 51 percent of their time on managerial tasks, including regularly exercising “discretion and independent judgment.” But that phrase has a specific meaning: “An employee who merely applies his or her memory in following prescribed procedures or determining which required procedure out of the company manual to follow” isn’t exercising discretion and independent judgment, according to the California Department of Industrial Relations’ website.

And to get the administrative exemption, the employee must, among other requirements, do “office or non-manual work directly related to management policies or general business operations of his or her employer or his or her employer’s customers.” But the rule carefully distinguishes between “administrative” functions and the “production” aspects of the business: Someone who spends too much time helping create a product the business sells doesn’t qualify.

Meeting the professional exemption is more straightforward. The employee has to work in a job that requires a license or certification or one that’s “commonly recognized as a learned or artistic profession,” among a few other rules.

Employers often wrongly think that job titles matter in assessing classification. “Many people say, ‘We’re going to hire this person, and their job title is going to be X,’ and that should be good enough,” says Amelya Stevenson, president of human resource consulting firm e-VentExe in Granite Bay. “I tell them, ‘Throw the title out the window.’ What the administrative law judge will look at is … their actual duties every day.” She points to Starbucks, which has been sued by store managers alleging the company wrongly labeled them exempt. Those cases turn in part on whether, titles aside, managers spend the majority of their time making coffee.

In July 2017, judges in the federal Ninth Circuit reversed a lower-court decision, which had ruled that a California bank’s underwriters were exempt from overtime and so were not owed back wages. The Ninth Circuit majority disagreed. It ruled that underwriters’ work is “not so distinct” from creating a product that the company sells — in this case mortgages — and so they must be paid hourly. That decision could open the door to other classes of workers challenging their exempt status: mid-level, white-collar, nonsupervisory workers who don’t need a professional license to do their jobs, says Gary Goyette, an attorney at Goyette & Associates in Gold River, which represents both employees and employers.

The seas also just got choppier for companies that use independent contractors. Until recently, labyrinthine but flexible rules governed who could be hired as a contractor. While the DIR listed at least 11 factors for determining if an independent contractor is legitimate, the primary factor was control: whether the company chose not just what work got done, but “the manner and means” by which that happened. Lesser considerations included how long the arrangement had lasted, and whether the work done was “part of the regular business” of the employer.

“The entire construct of independent contractor classification has changed. Every employer should be looking at every contractor they use and figuring out what to do.” Jennifer Randlett Madden, employment lawyer, Delfino Madden

But a May 1 ruling by the California Supreme Court now makes control just one element of a strict, three-part test for legally hiring a contractor. First, the worker has to perform a function that’s outside the usual course of the hiring company’s business. Second, the worker must have their own business — meaning, for example, they have other clients in addition to the contracting company, advertise their services, work by project rather than by time or have their own employees. Third, the worker must be free from substantial control by the employer over how and where they do the work. All three of those were part of the previous multifactor test. But now, instead of being assessed mostly on whether their contract workers have control, employers will also have to be cleared on the other two factors.  

Many companies will have to rethink how they get work done. “It’s a landmark decision,” says Jennifer Randlett Madden, an employment lawyer at Delfino Madden in Sacramento. “The entire construct of the independent contractor classification has changed. Every employer should be looking at every contractor they use and figuring out what to do.”

Misclassifying Puts Companies at Risk

Business owners struggling with classification isn’t new. “When I do trainings, I’m amazed — there are still so many smart people who don’t understand the rules,” Stevenson says.

Some owners flub out of honest ignorance. Janelle Arsich, an HR consultant with Sacramento-based HR to Go, has a client whose office manager works through lunch and on weekends when she needs to. Both the manager and the client think she deserves to be salaried since she’s “the kind of worker who wants to get the job done without tracking time,” Arsich explains. The office manager wants to be salaried — she thinks there’s prestige in being exempt. But none of that is relevant to what the law requires, says Arsich.

For others, it’s willful blindness. Some of those who contact Stevenson tell her they don’t care what the law says — they’re going to continue doing business as they have. Others say they can’t be profitable if they have to stay within the legal confines. “Until they feel the pinch, they’re going to continue to do what they’re doing,” Stevenson says.

Getting caught misclassifying someone as exempt instead of nonexempt can lead to more than a pinch. A state audit or lawsuit can put a company on the hook for back pay for overtime, meal breaks and rest breaks; compensation for legal fees the employee incurred; and penalties that accrue per pay period in which violations happened. To get a sense of how expensive that could get, consider that the penalty for each 30-minute meal break and 10-minute rest break that the employee missed is that the employer must pay for a full hour of work. The consequences of illegally classifying someone as a contractor are even worse: penalties of $5,000-$25,000 for each violation.

“If you’re not absolutely sure that they’re an independent contractor, you should treat them as an employee.”Gary Goyette, attorney, Goyette Associates

In either case, a civil action or class action that goes to trial can cost $300,000-$700,000 to defend against, Goyette says. And under Senate Bill 588, which took effect in 2016, company executives potentially can be held personally liable for wage-and-hour violations.

What Firms Should Do Now

Companies should assume that anyone who works should be an hourly employee unless there’s a clear case for exempt or an independent contractor status, say employment experts. In close-call decisions, err on the side of paying an employee hourly, Arsich says.  

As for employee-contractor decisions, “If you’re not absolutely sure that they’re an independent contractor, you should treat them as an employee,” Goyette says. Contractors who have been working on-site for many months or years — even if they’re working with a temp agency, are a red flag — says Jannene Litchfield of Litchfield Human Resources Management in Granite Bay.

The tougher rule on contractors could pose a challenge in today’s economy in which gig workers provide much of the fuel powering new companies. In the past, startups without much money used contractors to both ramp up production during their launch and to evaluate who would make a good fit as permanent hires, Stevenson says. A recent survey of 700 companies shows how important contractors have been: 45 percent of company executives said they expected their companies’ demand for independent contractors to grow in the following five years.

Given that reality, new companies should make full use of the flexibility they have in hiring employees. Arsich says firms can set long probationary periods that make it clear that an employee’s continuation will be re-evaluated based on demand for their services and their performance. There’s no legal restriction on the length of a probationary period.

Firms should also regularly do internal audits of their workers’ classifications, with the advice of an employment lawyer or human resources expert, says Randlett Madden. At the same time, they should do short- and long-term planning of the firm’s salary structure, says Litchfield. That’s because California’s minimum wage is scheduled to increase every year through 2023 and be indexed to inflation thereafter. Since under state rules, exempt employees’ minimum salary must be at least double the state minimum, as it increases, the minimum salaries for exempt employee must float up with it.

“Work closely with your human resource expert and legal counsel to ensure that as you’re building your business, you’re constructing a strong infrastructure just like you would when putting up a house,” Stevenson says. “You need a good foundation and structure inside your organization to play in California.”