Issue 3-2016

THE NEW FEDERAL OVERTIME REGULATIONS AND THEIR IMPACT ON CALIFORNIA EMPLOYERS

 

A. INTRODUCTION

On May 18, 2016, the Department of Labor (DoL) has issued the final version (“Final Rules”) of the Fair Labor Standards Act (FLSA) regulations regarding the salary threshold for exempt employees. FLSA provides an exemption from the overtime pay requirement for the workers employed as executive, administrative, and professional employees (“exempt white collar employees”). The FLSA also exempts from overtime highly compensated employees (“HCE’s”).

The state of California has its own set rules for overtime. Thus, in order to apply the exemption from payment of overtime, California employers have to comply both with federal and state regulations. In case of conflict or rules, the one more favorable to the employee will apply.

The new federal regulations will be effective as from December 1, 2016, and is foreseen they will significantly affect the position of thousand of employees in America. Employers may take the decision of updating the current employment agreements in order to comply with the regulations, with all the consequences that will be explained in this article.

Therefore, this article provides some insight into how to understand, and eventually apply, the new federal regulations, and how to be in compliance with California law.

 

B. OVERVIEW OF THE SALARY SYSTEM IN THE US

In the U.S. employees are usually classified as non-exempt employees and exempt employees.

The main difference is that nonexempt employees are paid the overtime, while exempt employees do not receive any overtime compensation regardless the hours worked.

Exempt employees’ salary is calculated on a hourly basis. Federal law establishes a minimum wage that cannot be reduced. As well, each single state can establish its own minimum wage than can be equal to or higher than the federal minimum wage. Naturally, employers can decide to correspond a base salary higher (but never below to) than the minimum wage established by the law. Currently, federal minimum wage is $7.25 per hour, while in California is now set at $10 per hour)1.

Likewise, federal law regulates the compensation of overtime, as well as is regulated in each single state. According to federal law, overtime is calculated as one and half time the base salary (not the minimum wage) per each hour worked over the ordinary eight hours per day (forty hours per week). Almost all the states follow the federal rule. Conversely, California has adopted a different system whereas overtime is calculated based on one and half time the base salary per each hour worked over the ordinary eight hours up to a maximum of twelve hours. Over the twelve hours of work, overtime is calculated doubling the base salary.

 

C. CLASSIFICATION OF EXEMPT EMPLOYEES UNDER FEDERAL AND CA LAW

To be considered exempt under federal law, the employee must meet two criteria2.

  1. The salary test. The employee has to be paid on a predetermined “salary basis” - i.e. the salary cannot be reduced because of variations in the quality or quantity of work performed. The current minimum salary threshold is $455 per week or $23,660 per year.
  2. The duties test. The employee needs also to perform certain white-collar job duties. There are three typical categories of exempt job duties, called (a) “executive”, (b) “professional”, and (c) “administrative”.

a) Job duties are exempt executive job duties if the employee (i) regularly supervises two or more other employees, (ii) has management as the primary duty of the position, and (iii) has some genuine input into the job status of other employees (such as hiring, firing, promotions, or assignments).

Determining whether an employee has management as the primary duty of the position requires case-by-case evaluation. A "rule of thumb" is to determine if the employee is "in charge" of a department or subdivision of the enterprise (such as a shift).

b) The job duties of the traditional "learned professions" are exempt. These include lawyers, doctors, dentists, teachers, architects, etc. Also included are accountants (but not bookkeepers), engineers (who have engineering degrees or the equivalent and perform work of the sort usually performed by licensed professional engineers), actuaries, scientists (but not technicians), and other employees who perform work requiring "advanced knowledge" similar to that historically associated with the traditional learned professions.

Professionally exempt work means work that is predominantly intellectual, requires specialized education, and involves the exercise of discretion and judgment. Professionally exempt workers must have education beyond high school, and usually beyond college, in fields that are distinguished from (more "academic" than) the mechanical arts or skilled trades. Advanced degrees are the most common measure of this, but are not absolutely necessary if an employee has attained a similar level of advanced education through other means (and perform essentially the same kind of work as similar employees who do have advanced degrees).

c) The Regulatory definition provides that exempt administrative job duties are (i) office or non-manual work, which is (ii) directly related to management or general business operations of the employer or the employer's customers, and (iii) a primary component of which involves the exercise of independent judgment and discretion about (iv) matters of significance.

The administrative exemption is designed for relatively high-level employees whose main job is to "keep the business running." A useful rule of thumb is to distinguish administrative employees from "operational" or "production" employees. Employees who make what the business sells are not administrative employees. Administrative employees provide "support" to the operational or production employees. They are "staff" rather than "line" employees. Examples of administrative functions include labor relations and personnel (human resources employees), payroll and finance (including budgeting and benefits management), records maintenance, accounting and tax, marketing and advertising (as differentiated from direct sales), quality control, public relations (including shareholder or investment relations, and government relations), legal and regulatory compliance, and some computer-related jobs (such as network, internet and database administration).

Finally, HCE’s are usually white-collars workers3 receiving a minimum salary threshold of $100,000 per year.

Conversely, California has its own salary basis test for white-collar exempt employees, which is currently set at forty hours times twice the state’s minimum wage.

In addition California provides its own categories of exempt employees, which are in some way similar to the ones established at federal level. The most commons are the “executive/managerial exemption”, the “administrative exemption”, the “computer professional exemption”, the “commissioned inside sales exemption”, and the “outside salesperson exemption”. The substantial difference is that under California law the employee has to to be "primarily engaged in" the duty performed, while the federal test simply requires that the "primary duty" of the employee falls within the exempt duties. Therefore, to qualify for the California exemption, the employee must spend more than 50% of their work time on exempt duties.

 

D. THE FINAL RULES

The Final Rules modify only the salary basis test. while the duties test remains untouched.

The new regulations increase the white-collar employee salary threshold from $455 per week ($23,660 per year) to $913 per week ($47,476 per year). Also the annual compensation for HCE’s is increased from $100,000 per year to $134,004 per year4.

Finally, the new regulations allow employers to use non-discretionary bonuses and incentive payments (including commissions) to satisfy up to 10% of the new salary threshold for exempt white-collar employees.

Therefore, beginning December 1, 2016, to be considered exempt from overtime the employee must (i) perform certain white-collar duties, (ii) receive a predetermined salary that cannot be adjusted according to the quality or the quantity of the work performed, and (iii) be paid a minimum salary of $47,474 or $134,000 per year (if considered a HCE’s).

 

E. PRACTICAL CONSEQUENCES

As anticipated above, California employers have to comply both with federal and state law.

The new federal regulations will require employers to increase the salary threshold for those exempt employees currently earning less than $47,476 or $134,004 to $913 per week or $47,476 per year.

In addition, California employers must take in account that they are subject to a different salary threshold that will rise over time. This means that employers will have to pay careful attention to how the thresholds change over time to ensure they are classifying their employees properly. Currently, the minimum wage is $10 per hour; therefore the minimum salary threshold is $800 per week (40 hours x 2 x $10), or $41,600 per year – about $6,000 below the new federal overtime rule’s $47,476 salary threshold. However, the California minimum wage will rise over time until it reaches $15 per hour by 2022, and then it will continue to rise based on a statutory-required formula5. The Final Rules establishes that the salary threshold may also rise every three years (the next time will be in 2020). For example, beginning January 1, 2019, when California’s minimum wage reaches $12 per hour, the threshold for California employers will be $49,920 – higher than the federal threshold, which may necessitate another classification change unless the employer raises the employee’s salary.

Further, regardless of the salary threshold, California requires employees to be “primarily engaged” in exempt duties to qualify as exempt (meaning that more than 50% of an employee’s time must be spent engaging in the activities that earn the exemption, according to the specific exempt category). Thus, even if a California employer pays someone enough under the federal and state standard, it may still not qualify them as exempt under California law.

Then, California does not have an exemption same or similar to the federal exemption for HCE. Therefore an employee meeting the new rule’s requirements may not be exempt under California law.

Finally, California does not permit employers to include non-discretionary and commissions in satisfying the salary basis test (see paragraph D) above.

Given this scenario, California employers have some potential options in order to be in compliance at federal and state level. The first option would be increasing the exempt employee’s salary to meet both exemptions. The second option would be reclassifying the exempt employee as a non-exempt employee. The third option would be maintaining the employee’s exempt status under California law and treating the employee as non-exempt under federal law.

However, all the options can potentially bear some significant consequences.

The first option (increase the salary) could not be business-wise ideal because of the impact that this would have on other higher-paid employees, who may demand salary increases when lower-paid employees receive raises.

Reclassifying exempt employees as nonexempt employees (second option), may present other challenges for the employers, who now should ensure compliance with the various minimum labor standards applying to non exempt employees (overtime, meal and rest periods, paid leaves, etc.). Besides that, experience shows that employees who are reclassified often perceive such change as a demotion is status.

Employers seeking to take the third option and treat an employee as exempt for purposes of California law but non-exempt for purposes of federal law will likely encounter significant obstacles to ensuring compliance. While such employees would not be entitled to daily overtime, meal and rest periods, or other minimum labor standards required under California law, such employees would still be entitled to overtime for all hours worked over 40 hours per week and the employer would have additional recordkeeping obligations under federal law.

Most importantly, as seen above, employers may then face some doubts regarding whether it would be more convenient increasing the salary threshold or reclassifying the worker from exempt to nonexempt employee. Below, we have drafted an example to illustrate the point.

Let’s assume that the exempt employee is paid a fixed salary of $10.00 per hour - $800 per week (currently, the minimum threshold in California)6, and usually works ten hours per day. As things currently stand, such employee is not entitled to overtime (10 hours of weekly overtime - 2 hours x five days). However, if the exempt employee should keep receiving the same salary after December 1, 2016, he or she would be considered as non exempt employee and would be entitled for overtime. By applying the overtime calculation rule (one and half the base salary for each hour worked over the ordinary eight hours up to a maximum of twelve hours), the total compensation for ordinary work and overtime would be:

$800/weekly + [(1.5 x $10) x 10] = 800 + 150 = $950/weekly7.

The total compensation is already higher than the new salary threshold of $913/weekly for exempt employees. The same result will occur if the employer would decide to eventually treat the employee as exempt under California law but as non-exempt under federal law. Therefore, in this scenario, reclassifying the employee in order to avoid labor costs could be detrimental to the employer.

 

F. CONCLUSIONS

The new regulations issued by the DoL significantly affect the labor market in the U.S., specifically for exempt employees (white-collars and HCE’s).

Employers have time until December 1, 2016, to revise and adjust their employment agreements and make sure that they comply with both federal and California law.

Below, we have outlined some suggestions we recommend employers to evaluate in order to be in compliance when the deadline is passed.

  1. Identify all the exempt employees and, for each of them, review the basis of the exemption;
  2. Once the review is done, determine which changes are to be made for each affected exempt employee;
  3. Establish, if necessary, a time-keeping system that, by December 1, 2016, will allow tracking the hours worked by all employees earning less than the minimum salary threshold;
  4. Increasing the salary of any affected employees to meet the FLSA threshold and maintain exempt status, assuming those employees meet the duties test (that is, the duties are truly those of an executive, administrative or professional employee). This option works well for employees who have salaries near the new salary level and regularly work overtime;
  5. Maintaining the salary of exempt employees at $800 per week (subject to yearly adjustments) to preserve the California exemption and pay FLSA overtime at one-and-a-half times the employees’ regular rate of pay for hours worked over 40 in a week. The employee would be exempt under California law but non-exempt under the FLSA. This means that such employees would continue to be exempt from California’s meal and rest period requirements. This option works well for employees who work 40 hours or fewer in a typical workweek, with only occasional overtime; and/or
  6. Reclassifying the affected employees to non-exempt, hourly status and avoid having employees work overtime, or reduce base salary to budget for overtime, or consider an alternative work week schedule.

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NOTES

1 Minimum salary threshold under California will increase during the next several years in connection with the scheduled annual increases to California’s minimum wage, which will reach $15 per hour by 2022.

2 Like for the minimum wage, each state can establish different more favorable rules for the determination of the category of exempt employees.

3 Usually HCE’s are those workers that customarily and not occasionally perform certain white-collar duties such as executives, etc.

4 The Final Rules also provide that such thresholds are automatically adjusted every three years.

5 For employers with 26 or more employees, the increase of the minimum wage will begin as from January 1, 2017, while for employers with 25 or fewer employees, the increase process is delayed to January 1, 2018.

6 Keep in mind that the minimum wage will increase to $10.50 per hour for employers with more than 26 employers in 2017, while will remain at $10.00 per hour until 2018 for employers with fewer than 25 employees.

7 This value could be even higher if the employee should work over twelve hours a day because in such case California law requires to double the base salary in calculating the overtime.