Employee vs Contractor, Exempt vs Non-Exempt: Are You Correctly Categorizing Your Staff?
Misclassifying people is one of those issues that looks harmless—right up until the back wages, overtime, penalties, and attorney letters start showing up.
This article breaks the problem into two clear buckets:
Employee vs Contractor – are you putting people in the right tax and legal bucket?
Exempt vs Non-Exempt – once they’re employees, are you handling overtime correctly?
Note: This post is based on U.S. federal rules as of 2025. State law can be stricter, and this is general information, not legal advice.
Employee vs Contractor
Why This Matters
If someone looks and behaves like part of your team but you’re treating them as a 1099 contractor to “save on payroll taxes,” you’re carrying real risk.
Two main agencies care about how you classify people:
IRS – cares about payroll taxes and withholding.
U.S. Department of Labor (DOL) – cares about minimum wage, overtime, and worker protections under the Fair Labor Standards Act (FLSA).
Both focus on what the relationship actually looks like in practice, not just what the contract says.
IRS View: Who’s Really in Control?
The IRS looks at three broad categories when deciding if someone is an employee or an independent contractor:
Behavioral control
Do you decide when, where, and how the work is done?
Do you provide detailed instructions, training, and policies the worker must follow?
Financial control
Can the worker profit or lose based on how they run their own business?
Do they have meaningful investment in tools/equipment?
Are they free to work for other clients and set their own rates?
Type of relationship
Is the relationship ongoing and open-ended, or project-based and temporary?
Do you provide benefits like PTO, health insurance, or retirement?
Is the work central to your core business?
The IRS looks at the totality of the facts, not any single factor. If you’re truly unsure, you can request a formal determination by filing Form SS-8 with the IRS.
DOL View: The “Economic Realities” Test
Under the FLSA, the DOL applies an “economic realities” test. The core question is: is the worker in business for themselves, or economically dependent on you?
Factors include:
Opportunity for profit or loss based on their own business decisions
Investment in equipment, tools, or staff
Permanence of the working relationship
Degree of control you exercise over how work is performed
Whether the work is integral to your business
Level of skill and independent initiative
Labels like “freelancer” or “1099” don’t carry much weight if the reality is that the person works like a full-time staff member.
Red Flags That a “Contractor” Is Really an Employee
You should reassess classification if:
You set their weekly schedule and daily hours
They work only for you, long-term
They use your systems, equipment, and email address
They appear on the org chart or attend regular staff meetings
You restrict them from working with others
The work is clearly part of your main service or program delivery
If that sounds like half your 1099s, you already know there’s a problem.
Don’t Ignore State Law
Some states use stricter tests (like the ABC test) that make it much harder to call someone a contractor if they’re doing work in the ordinary course of your business.
Result: a worker can be treated as a contractor under one rule set and an employee under another. You need to understand both federal and state requirements in the places you operate.
Practical Steps: Cleaning Up Employee vs Contractor
Here’s a simple, action-oriented cleanup plan:
List all 1099 workers from the last 2–3 years.
Group them by role (e.g., instructors, admin support, marketing, field staff).Evaluate control and independence.
For each role, ask:Who controls how and when the work is done?
Do they have their own business, tools, and multiple clients?
Is their work central to what you deliver?
Flag the obvious misclassifications.
Anyone who functions like a long-term internal staff member should be seriously considered for W-2 status going forward.Consult legal/tax advisors on edge cases.
Grey areas and multi-state operations deserve professional guidance.Fix the structure going forward.
True contractors: written services agreement, clear scope, non-exclusive relationship, their own business operations.
Employees: proper onboarding, payroll setup, benefits policies, and inclusion in your HR framework.
Communicate the change.
Reclassification can be emotional. Be clear that you’re tightening compliance and protecting both the organization and the worker.
Exempt vs Non-Exempt – Who Gets Overtime?
Once someone is an employee, the next question is: are they exempt or non-exempt under the FLSA?
Non-exempt employees must receive at least minimum wage and overtime at 1.5x their regular rate for hours over 40 in a workweek.
Exempt employees are not entitled to overtime, but only if they meet specific criteria on how they’re paid and what they actually do.
Paying someone a salary does not automatically make them exempt.
The Three-Part Test for Most White-Collar Exemptions
For the common “white-collar” exemptions (executive, administrative, professional), you generally need all three:
Salary Basis
The employee is paid a fixed salary that doesn’t go up and down based on hours worked or day-to-day performance (with limited exceptions).
Salary Level (Federal)
As of now, under the 2019 rule, the federal minimum salary level for most white-collar exemptions is $684 per week (about $35,568 per year).
There’s a higher threshold for “highly compensated employees” (HCE).
Several states (e.g., California, New York, Colorado) set higher salary thresholds, and those higher state levels must be followed when applicable.
Duties Test
The employee’s primary duties must fall into one of the recognized exempt categories, such as:Executive – manages a department or subdivision, regularly directs 2+ full-time employees, and has input on hiring/firing decisions.
Administrative – office or non-manual work related to management or general business operations, involving discretion and independent judgment on important matters.
Professional – work requiring advanced knowledge in a field of science or learning (e.g., law, accounting, engineering, certain specialized roles).
If the salary basis, salary level, or duties requirement isn’t met, the role is non-exempt, meaning overtime rules apply.
Common Misclassification Patterns
Watch out for these patterns:
Calling someone a “manager” but they don’t supervise anyone and have no real decision-making authority.
Treating coordinators, assistants, or bookkeepers as “exempt admin” when their work is largely transactional.
Paying someone a salary below the required threshold and assuming that alone makes them exempt.
Assuming nonprofits, small organizations, or churches aren’t covered by FLSA — many are.
Practical Steps: Cleaning Up Exempt vs Non-Exempt
You can tackle this in a structured pass:
List all salaried employees.
For each, capture salary, typical weekly hours, and a short description of actual day-to-day responsibilities.Check the salary level.
Anyone below the applicable federal or state threshold is almost certainly non-exempt.
For multi-state operations, make sure you’re checking state-specific thresholds.
Evaluate the actual duties.
Compare each role to the DOL’s duties tests:Are they managing people and making real decisions?
Or are they executing the process someone else designed?
Reclassify where needed.
Options:Adjust salary and responsibilities so they genuinely fit the exemption; or
Reclassify the role as non-exempt and start tracking hours and paying overtime.
Implement timekeeping for non-exempt staff.
Even salaried non-exempt employees must have hours tracked.
Make it clear: all hours worked must be reported, and off-the-clock work is not allowed.
Train managers.
Managers need to understand:Who is non-exempt
When overtime is allowed
That they cannot “strongly suggest” off-the-clock work to hit deadlines.
Review annually or when roles change.
Promotions, restructures, and new laws can change classification status quickly.
Bringing It All Together
Getting both classification questions right:
Employee vs contractor
Exempt vs non-exempt
…protects you from back pay claims, penalties, legal costs, and nasty surprises during audits, grant reviews, or due diligence.
It also:
Builds trust with staff who know they’re being treated fairly
Gives leadership accurate visibility into true labor costs
Reduces noise so you can focus on strategy and growth instead of rework
How Lumiere Strategies Can Help
This is exactly the type of messy, cross-functional problem that benefits from a structured, outside partner.
Lumiere can:
Audit your current classifications (employees vs contractors, exempt vs non-exempt)
Coordinate with your HR and legal teams to validate any grey areas
Update payroll structures and timekeeping workflows
Help refresh your handbook, policies, and documentation
Build an ongoing review cadence so you stay compliant as laws and roles change
If you’re not completely confident your people are classified correctly, now is the time to fix it—quietly and proactively—before an auditor, grantor, agency, or ex-employee forces the issue.
Schedule a consultation with Lumiere Strategies today. You focus on mission. We’ll handle the financial backbone that makes impact possible.