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The Forgotten Overtime Exemption

May 29, 2008
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Related Topics: Compensation Design and Communication, Variable Pay, Wages and Hours, Featured Article, Legal
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In recent years, the federal Fair Labor Standards Act—or one of its state law equivalents—has become the weapon of choice for plaintiff-side employment attorneys. Taking advantage of cryptic regulations, inconsistent case law and innumerable traps for the unwary, the plaintiffs’ bar has vigorously pursued class and collective claims against employers for overtime violations. All too frequently, these suits have been successful, resulting in the imposition of sometimes crippling financial liability on employers.

    Most employers are quite familiar with the FLSA’s executive, administrative and professional exemptions. These exemptions relieve employers of the obligation to pay overtime if the employee in question meets the duties, salary-basis and salary-level tests required to qualify as exempt. Lawsuits over these exemptions tend to focus on the imprecise "duties" test for "administrative" employees or on a failure to pay a fixed salary without the possibility of improper deductions.

    Much less well known is the overtime exemption set forth in Section 7(i) of the Fair Labor Standards Act. Limited to retail or service establishments, this exemption focuses not on the duties of the employee, but on how the employee is paid. Qualifying establishments are relieved from paying overtime to employees who are paid the majority of their compensation in commissions on goods or services and who earn at least one-and-a-half times the minimum wage. Given that all of these conditions must be present before an employer may utilize the exemption, employers should be wary of the nuances associated with each requirement.

    Companies with employees who set their own schedules or work uncontrollable numbers of hours, or that need to align labor costs more closely with revenue, should consider whether this exemption for might work for them.

    Employees currently paid on an hourly or other basis can be converted to exempt 7(i) commissioned employees by basing their compensation on the amount of revenue that they or their work unit generate. Once properly implemented, the company can be more flexible about scheduling and need not worry about employees who may inadvertently cross the 40-hour threshold. Employees who generate more revenue for the company will see their compensation increase commensurately and the company can be assured that this higher compensation is fully funded by higher revenue.

    Although the FLSA no longer defines the term "retail or service establishment," the Department of Labor and the courts have borrowed the definition given to the phrase by the now-repealed Section 13(a)(2) of the act. Accordingly, a retail or service establishment is one that:

  • Engages in the making of sales of goods or services;
  • Seventy-five percent of its sales of goods or services, or of both, are recognized as retail in the particular industry;
  • Not more than twenty-five percent of its sales of goods or services, or of both, are sales for resale.

   Notably, the exemption may only apply to specific "establishments" within a company. For example, a manufacturer may operate a plant for production of its goods, a separate warehouse for storage and distribution and several retail stores from which its products are sold. While employees working in the manufacturing plant or the warehouse would not qualify for the exemption, the retail store employees could. With regard to each establishment, the FLSA does not impose a minimum or maximum threshold of employees or revenues necessary to qualify for the exemption.

    Typically, an establishment that will qualify as a retail or service establishment is one that sells goods or services to the general public, servicing the everyday needs of the community by selling products directly to end users and not taking part in the manufacturing process.

    By way of recent examples, courts and the U.S. Department of Labor have found that private health clubs, pest control companies, propane dealers, automobile dealerships and furniture stores constitute retail or service establishments. By contrast, the regulations accompanying the FLSA identify accounting firms, credit companies, finance companies, insurance brokerages, loan offices and tax services as lacking the requisite retail concept. These examples do not, however, foreclose an establishment from qualifying for the exemption simply because its retail concept is directed at commercial consumers rather than households.

    Satisfaction of the "retail or service establishment" prong of the inquiry permits potential exemption of all employees employed by such an establishment, provided that their compensation satisfies certain requirements. Specifically, the employee’s regular rate of pay must exceed one-and-a-half times the applicable minimum wage. Further, more than half of the employee’s total earnings during a representative period must represent "bona fide" commissions on goods or services.

    The former requirement is straightforward. With a current federal minimum wage of $5.85 per hour, the employee’s regular rate must be at least $8.78 per hour before the exemption is applicable. (The federal minimum wage rises to $6.55 per hour on July 24, 2008, and to $7.25 per hour on July 24, 2009.) The regular rate can include "all remuneration paid to, or on behalf of, the employee" except gifts, vacation pay, premium pay or other amounts specifically identified under Section 7(e) of the FLSA.

    The "bona fide commission" prong is more exacting. The regulations accompanying the FLSA make clear that where an employee always earns the same fixed amount for each workweek, or where the employee receives a regular payment representing a percentage of the sales that the establishment can always be expected to make, the employee does not earn a bona fide commission and will not qualify for the exemption.

    Instead, decisional law and the regulations make clear that a bona fide commission contemplates a compensation arrangement where the amount of sales an employee makes increases the employee’s pay. Where the commission plan does not affect the rate of pay, it likely fails to qualify as bona fide. Thus, an employee paid a flat amount without regard to the value of the services performed or goods sold would not qualify.

    The regulations direct employers to test whether the commission amounts represent a majority of the employees’ compensation by reviewing an employee’s compensation for a "representative period" of not less than one month.

    The representative period must typify the total characteristics of an employee’s earning pattern with respect to the seasonal or other fluctuations such that for the entire representative period, more than half of the employee’s total compensation is derived from commissions. Alert employers should maintain records of the basis for, and the results of, the determination of the "representative period" inquiry.

    Employers that clearly qualify as a retail or service establishment and whose employees meet the compensation requirements of Section 7(i) should still be vigilant to guard against potential pitfalls. For instance, while the FLSA does not require that an employer maintain certain records for exempt executive, professional or administrative employees, such as hours worked each workday, failure to maintain such records may prevent an employer from substantiating that the conditions under Section 7(i) have been met, if the employer is challenged. In particular, since employees must make at least 1.5 times the applicable minimum wage, the number of hours the employee worked must be known to ensure that this minimum is satisfied. Some employers pay employees a draw equivalent to 1.5 times the applicable minimum wage and have them earn commissions against that draw to fulfill this prong of the test.

    Further, employers ostensibly qualifying as retail or service establishments should be wary of using the exemption for an employee or group of employees who are employed by the enterprise’s central office and not by the retail or service establishment itself. Lastly, employers considering taking advantage of the exemption must consider whether state law impacts or even eliminates its availability.

    Despite these caveats, the potential utility of the Section 7(i) exemption is generally worth considering. Employers with retail or service establishments employing commissioned employees may be able to eliminate overtime liability and significantly curtail labor costs. The exemption may be particularly useful for employers with commissioned employees who set their own schedule and work hours that, as a practical matter, evade employer control. At the very least, the availability of this exemption is worth remembering.

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