Employee Classification: How to Avoid Costly Mistakes

Getting employee classifications wrong isn’t just a paperwork issue; it’s a compliance landmine. With wage and hour lawsuits on the rise and the Department of Labor increasing enforcement, classification mistakes are not minor slip-ups. They’re lawsuits waiting to happen.

Whether you’re managing full-time staff, part-time help, or independent contractors, understanding the legal and functional differences between classification types is critical to remain compliant and out of court.

Exempt vs Non-Exempt: What’s the Difference?

One of the most common compliance pitfalls is misunderstanding the difference between exempt and non-exempt employees. This classification is based on both salary and job duties, not just how someone is paid.

Exempt Employees:

Exempt employees are typically salaried and ineligible for overtime pay. To legally qualify as exempt, employees must meet all three of the following federal tests:

Salary Level Test: Employees must earn at least $684 per week ($35,568 annually) under the Fair Labor Standards Act (FLSA). Note: Some states may have higher thresholds.
Salary Basis Test: Employees must receive a fixed salary not subject to reductions based on hours worked.
Duties Test: Employees must perform specific job functions that fall under one of the recognized exemption categories.

These categories include:

Executive: Manages part or all of the business, supervises two or more employees, and has authority over hiring, firing, or promotions.

Administrative: Performs non-manual office work related to management or operations, using independent judgment on significant matters.

Professional: Requires advanced knowledge, work in science or learning fields, or creative roles involving invention, imagination, or talent.

Computer Employee: Involves systems analysis, programming, software engineering, or other similar computer fields.

Outside Sales: Makes sales outside of the employer’s place of business as a primary duty.

Non-Exempt Employees:

Non-exempt employees can be paid hourly or salaried, but must be paid overtime (time and a half) for any hours worked over 40 in a week. There is no duties test for non-exempt status.

Key Risk: Just paying someone a salary doesn’t make them exempt. Misclassifying employees as exempt is one of the most frequent (and expensive) compliance errors.

Independent Contractors vs. Employees: The Control Test

Misclassifying workers as independent contractors when they function like employees can trigger penalties, back wages, and tax consequences.

If you hire freelancers or 1099 contractors, use the IRS’s Common Law Test, grouped into three categories:

Behavioral Control: Does the company control how the worker does their job?
Financial Control: Who determines how the worker is paid and reimbursed?
Type of Relationship: Is there an expectation of benefits, permanency, or integration into the business?

Pro Tip: Just calling someone a contractor doesn’t make them one. Courts and agencies look at how the relationship functions, not what it’s labeled.

Quick Classification Comparison

Classification	Exempt	Non-Exempt	Independent Contractor
Overtime Eligibility	No	Yes	No
Payment Method	Salary	Hourly or Salary	Per Project/Contract
Tests Required	Salary + Duties Test	None	IRS Common Law Test
Risk if Misclassified	High – unpaid overtime, fines	High – unpaid overtime	High – taxes, benefits, penalties

Pay Attention to State-Level Rules

Federal rules are just the beginning. Some states have stricter tests, like California’s ABC test for contractors, which makes it harder to classify workers as independent. Always review both state and federal guidelines.

Why Classifications Matter

If employees are misclassified, companies can face legal risks, eroded employee rights, and damaged company reputation.

Legal Risk: Misclassification can lead to back pay, unpaid overtime, benefits liability, and IRS penalties.

Employee Rights: Workers may be denied their entitled protections, like minimum wage or healthcare, if classified incorrectly.

Company Reputation: Public lawsuits hurt more than your finances. They destroy trust.

Don’t Guess, Audit Your Classifications

If it’s been a while since you reviewed employee classifications, or you’re unsure about how your classifications hold up, now’s the time to audit. Ask:

Do your exempt employees meet all federal tests?
Are contractors truly independent in practice?
Are your remote and hybrid workers clearly defined in terms of control, duties, and time?

If the answer is “I’m not sure”, that’s your red flag.

Ready for Peace of Mind?

HR Service, Inc. offers compliance audits, classification reviews, and ongoing HR support tailored for your business. One audit could save you tens of thousands and a compliance nightmare.

Schedule a free HR compliance consultation.

Want to go deeper on exempt vs. non-exempt? Catch the replay of our recent live session “Employee Classifications: Exempt vs. Non-Exempt,” where we offer expert guidance to help you stay compliant.