In light of the tight labor market, many employers are offering employees the opportunity to increase their income with commission-based pay. There is no fixed formula on commission pay. It can be based upon a percentage of a sale, a dollar amount for each sale or a commission based upon quarterly or annual performance. While commission-based pay plans can help recruiting efforts, implementing these plans requires a systematic approach. California laws govern every aspect of these plans – from the initial agreement to final termination pay. For those just venturing out on this alternative pay structure, a review of the legal landscape will assist with compliance. To start that review, consider the following:
The term Commission refers to sales-driven pay.
The Department of Industrial Relations (“DIR”) defines commissions as “[c]ompensation paid to any person for services rendered in the sale of the employer’s property or services and based upon the amount or value thereof. If the employee’s compensation is based upon a sale, then the compensation plan is a commission.” Commissions are by nature non-discretionary, meaning employers are contractually obligated to pay them once all conditions have been met for them to be earned.
1. Commissions Plans Must Be in Writing
Commission plans must be memorialized in commission agreements, which are often drafted in a manner similar to employment agreements. (Labor Code section 2751(a).).
The California Labor Code requires commission agreements to detail “the method by which the commissions shall be computed and paid.” (Labor Code section 2751(a).) This means commissions agreements should be drafted such that employees can readily understand: (1) how commissions are earned (i.e., which types of sales are entitled to commissions); (2) when commissions are considered “earned” (i.e., what conditions must be met before the employee receives payment); and (3) how commissions are calculated. Commission agreements should be sufficiently clear that employees are fully informed of their earned wages. Phrased differently, employees should not be surprised by the amount of their pay. Commission agreements should also state that the employer reserves the right to modify the commission plan on a going forward basis, at any time, and for any reason, with reasonable notice.
2. Be Very Careful When Defining When Commissions Are Earned
The definition of when commissions are earned can be a double-edged sword. On one hand, the ability to define “earned” offers considerable flexibility in structuring the commission plan. On the other hand, a vague and or overbroad definition can lead to inadvertently promising to pay commissions before a sale is final, leading to unintended consequences.
Take, for example, a commission agreement which states the following:
“Commissions will be considered earned upon completion of each sale.”
At first blush, this definition is clear. However, at some point down the road an issue may arise with regard to when a sale is “complete;” likely in the event that an invoice goes unpaid, or a product is returned. The employee may insist that the sale was “complete” when the client or customer agreed to pay for the service or product. The employer, on the other hand, may take the position that the sale was never “complete” because the client or customer never paid.
These situations are avoidable with careful drafting. Specifically, the commission agreement should state when commissions are “earned” with precision. If the sale is subject to a return option, and the commission is not earned until after the customer’s right to return has expired, the agreement must state that. It is always recommended to illustrate a complex situation with examples as well.
Again, keep in mind that once these conditions are satisfied the employer is contractually obligated to pay the agreed upon commissions, as set forth in the commission agreement. This means that, if an employer prepares a commission agreement such that commissions are earned upon a client signing a purchase agreement, but before remitting payment, the employer must pay commissions for the sale even if the customer never pays.
3. Employees Are Typically Owed Reasonably Calculable Commissions Upon Employment Separation
How an employer defines when commissions are “earned” will also impact how commissions are paid in the event of an employee’s separation. As discussed above, an employee has the contractual right to a commission once the employee has satisfied all conditions for earning it. This means earned wages must also be paid in the event of an employee’s separation, whether voluntary or involuntary.
California law is very protective of employees’ final wages, and commissions are no exception. This is particularly true when an employer discharges an employee before a commission is paid, as employees may argue they were discharged specifically to avoid payment of earned commissions. Guidance from the Department of Labor Standards Enforcement suggests employees are owed all wages that can be “reasonably calculated” at the time of the employee’s separation. Nonetheless, courts are split on how restrictive commission agreements can be on this issue, and assess commission agreements on a case-by-case basis with an eye toward avoiding excessive unfairness (or “unconscionability”). For example, in American Software, Inc. v. Ali, the court enforced a provision stating the employee was not entitled to commissions on payments received more than 30 days after the employee’s separation. Ellis v. McKinnon Broadcasting Co., on the other hand, found a provision stating that the employee was not entitled to commissions on any payments received after the employee’s separation was unconscionable. As is typically the case in contract drafting, employers should avoid ambiguity in commission agreements by addressing what commissions employees will receive upon their separation. Given the fact-specific nature of this issue, however, employers should consult an employment attorney to determine how best to tailor their commission agreements.
4. Employees Must Acknowledge and Receive a Copy of the Commission Agreement
These requirements are very easy to overlook. The Labor Code requires not only that the commissioned employee receive a signed copy of the agreement, but also that the employer obtain a “signed receipt” from the employee. (Labor Code section 2751(a).) This means employers should ensure that the agreement includes both a signature page and an acknowledgement of receipt page. Both the employee and an employer representative should sign the agreement, and the employer should retain signed copies of the agreement and acknowledgement.
5. Tread Carefully When Advancing Commissions or Implementing Chargebacks
As previously noted, earned commissions are considered wages. Labor Code section 221 makes it illegal for employers to collect wages from employees, subject to certain standard exceptions (such as tax withholdings, insurance premiums, pension plain contributions, etc.).
Employers often consider implementing a chargeback provision to protect themselves in situations where customers return a product or discontinue a service. Particularly for employees receiving both a base rate and commissions, it is often advisable to simply define when commissions are “earned” such that the employee has not earned the commission until a product’s return window has passed, or a client has fully paid the invoice for a service. Nonetheless, employers may advance commissions, or chargeback paid commissions, under certain circumstances.
Employers commonly offer advances or “draws” for purely commissioned employees. Under this arrangement, the employee receives an advance on commissions the employee expects to earn. If an employee does not meet this expectation, the employer deducts the difference between the amount drawn and the actual commissions earned from the employee’s next paycheck. Employers wishing to allow their commissioned employees to take a draw may do so, but confirm such an agreement in writing.
It is critical to again emphasize that it is unlawful to deduct an employee’s wages. Advances of this kind are lawful only because they are not considered wages, but instead as loans on wages yet to be earned. For this reason, employers should explicitly state in the commission agreement that the draw is treated as an advance or loan, and that the employee understands and agrees to have the balance of unearned commissions deducted from the following paycheck. An additional complexity arises if the plan does not separately provide for paid rest breaks, as those payments cannot be subject to a charge back. Employers adopting these plans should consult with counsel on how to ensure proper compensation for rest breaks.
Chargeback or clawback arrangements are different than draws, that is advances on future earnings. They are lawful arrangements, but again must be carefully implemented and documented. The employer must specify the terms in writing and must clearly state that any amounts paid before the commissions are earned are considered an advance or loan. Otherwise, regardless of the employer’s intent, the commissions will be treated as wages and cannot be clawed back.
Once more, California places great importance on employees’ wages being predictable. As a result, employers must be mindful that advances cannot be structured in a way that leads to unpredictable deductions or chargebacks beyond the employee’s control. (Sciborski v. Pacific Bell Directory (2012) 205 Cal.App.4th 1152, 1168.) For example, the court in Hudgins v. Neiman Marcus Group, Inc., found it unlawful to deduct unidentified returns (i.e., returns of products for which the employer is unsure which employee made the sale), as such deductions were unpredictable and beyond the employee’s control. Employers should consult an employment attorney before implementing advances or chargebacks to ensure they are compliant with California law.
6. Remember that Commissions Affect Regular Rate of Pay for Non-Exempt Employees
It is a common misconception that employees who receive commissions are automatically exempt, salaried employees. Employers must be mindful that employees receiving commissions must still meet an exemption to be considered exempt. Otherwise, the employee must be treated as non-exempt and receive meal breaks, rest breaks, and overtime pay.
For those employees who do not meet an exemption, remember that commissions are factored into employees’ regular rate of pay. This means employers must ensure they are adequately prepared before offering commissions to non-exempt employees, as commissioned employees’ regular rate of pay, and by extension overtime rates, meal and rest period premium rates, and paid sick leave rates may fluctuate each pay period. If an employers’ payroll department inadvertently omits commissions from regular rate of pay calculations, the employer could face claims for unpaid wages and associated derivative claims.
In conclusion, while commission agreements can benefit both employer and employee, in California they require careful planning and attention to detail. They also require an agreement in writing, signed and acknowledged by the commission-earning employee.