Companies need to understand and recognize the differences between (1) “independent contractors” and “employees” and (2) “exempt” and “non-exempt” employees. Classifying workers correctly in each of these respects is extremely important under both federal and state laws. (See http://ow.ly/1yRib for a summary of the ten largest private settlements of wage-and-hour cases in 2009, totaling almost $364 million.)

“Employees” vs. “Independent Contractors”

When an employer hires a worker, it must determine whether to classify the worker as an employee or an independent contractor (IC). As a general rule, a worker is considered an employee if the employer can control what the worker will be doing and how it will be done. Likewise, a worker is usually considered an IC if the employer has the right to control or direct the result of the work but not the means or methods that the worker uses to accomplish the result.

While this can be a very subtle distinction in many situations, it is an important one in several respects:

* Workers who are classified as “employees” have legal rights under federal and state employment laws – e.g., regarding wages and hours, family and medical leave, and protection from workplace discrimination and harassment – that do not apply to ICs. As employees, workers are eligible for federal Social Security and Medicare benefits, and they may be in line to receive additional “employee” benefits from their employer.

* The employer must ensure that it is paying all applicable payroll taxes, proper wages and overtime, and complying with other wage-and-hour requirements. Penalties for failing to comply with these laws can be substantial.

* Federal and statement governments lose considerable tax revenue if workers who are actually employees are misclassified as ICs. A recent report estimated that misclassification could cost the U.S. Treasury Department more than $7 billion in lost payroll-tax revenue over the next decade.

“Exempt” vs. “Non-Exempt” Employees

Once an employer has classified a worker as an “employee,” it must determine if the employee should be classified as “exempt” or “non-exempt” under federal (Fair Labor Standards Act) and state wage-and-hour laws. Most employees are covered by these laws – that is, they are non-exempt – and thus must be paid at least minimum wage and must receive time-and-a-half for all hours worked beyond 40 hours in a workweek.

Certain types of employees – typically executive, professional, administrative and outside-sales employees – are considered exempt from wage-and-hour-laws and are not entitled to overtime pay. Proper classification depends on the employee’s duties and responsibilities – not simply his/her title. For example, not all “managers” are exempt employees.

Problems arise when an employer improperly classifies non-exempt employees as “exempt” or assigns non-exempt tasks to exempt employees. Misclassification can lead to substantial fines, penalties, awards of back-pay to affected employees, and even class-action lawsuits.