Overtime pay: A ticking time bomb

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(FORTUNE Small Business) -- Rod Cotner, owner of Jericho Mortgage in Lancaster, Ohio, was shocked when the U.S. Department of Labor showed up at his door to investigate a wage-and-hour lawsuit filed on behalf of his 54 loan officers and sales managers.

His company was growing - sales exceeded $4 million that year - and his employees were profiting: "Some of the staffers named in the lawsuit were making over $150,000," he says. "After working in the industry for years, I'd never heard of this happening. Everyone pays their officers on a commission basis. How can someone who makes six figures a year demand back wages for his time?"

Cotner, 37, incorrectly assumed that his employees were exempt under the U.S. Fair Labor Standards Act, which mandates time-and-a-half wages for any hours worked beyond 40 a week. The FLSA exempts white-collar workers who make more than $100,000 a year but calculates those earnings on a weekly basis - many of Jericho's loan officers went unpaid during the weeks they didn't close loans.

Cotner, who's been battling the $220,000 lawsuit for two years, no longer has in-house loan officers; his company, which dwindled to fewer than 10 employees, now hires only what the law classifies as "outside sales employees," who work full-time for Jericho but don't have an on-site office.

The number of small businesses facing similar suits has exploded since 2004, when the U.S. Department of Labor revised the FLSA to clarify which workers are exempt from overtime laws. In doing so, it boosted the number of protected employees. In 2006 the department collected $172 million in back wages from employers - up 3.6 percent over its take in 2005.

Last year the department announced judgments and settlements in the millions against small businesses, which often have more exposure because they lack in-house legal teams or HR departments. A New Orleans security company was assessed $185,385. A small oil-and-gas outfit in Houston owes $1.1 million. A Las Vegas construction firm owes $1.2 million.

Originally the FLSA, which was passed in 1938, was designed to encourage Depression-era bosses to hire more employees. In today's service-oriented workplaces, however, the law's antiquated "white-collar exemptions"- the litmus tests that determine whether skilled workers earning between $23,660 and $99,999 are eligible for overtime - can be difficult to interpret. Because many managerial duties are now both autonomous and standardized, business owners must often wade through arcane scenarios to determine a worker's status. Does an "executive employee" have "the authority to fire other employees?" If not, says the FLSA, she may qualify for overtime.

And despite its overhaul, the FLSA's stringent regulations on hours don't keep pace with the realities of a world where East Coast businesses hire West Coast IT techs, and workers regularly telecommute for all or part of the workweek. Small businesses are the main source of job creation and innovation in this new global, flextime, cross-trained economy, but they are hindered by the law's Industrial Age concepts of employment. Some would rather avoid hiring remote employees than take the measures to micromanage their time.

"When entrepreneurs are constantly afraid of liabilities, they're not free to innovate - it isn't an environment that fosters creativity," says Jim Hawley, vice president of TechNet, a Washington D.C.-based association of executives that lobbies on behalf of the tech industry.

Some states enforce rules even more stringent than the FLSA's; in California and Nevada, employers pay overtime after an eight-hour workday even if the employee puts in fewer than 40 hours for the week.

Don Turner, 59, owns the Golden Bear Inn in Berkeley, where he likes to pay personal attention to his guests as well as his 25 employees. But California law prevents Turner from extending as much flexibility to his staff as he would like.

"I had an employee who wanted to watch his child's Little League game at four, but he was scheduled to get off at 4:30," he says. "He asked me if he could work through his lunch break instead, and I had to refuse him - the overtime law just wouldn't let me."

Turner is right to be wary of litigation. Searching "overtime" on the Web produces thousands of ads for plaintiffs attorneys who encourage workers to collect what they're due - whether they know they're due or not.

"Employees see the high-profile headlines for lawsuits against Wal-Mart (WMT, Fortune 500) and Microsoft (MSFT, Fortune 500) and think, 'I should be paid overtime,'" says Jill Weinberg, owner of Weinberg Law Firm in Plano, Tex., which typically represents businesses with fewer than 100 employees.

To the surprise of many business owners, discerning who is and is not exempt from overtime requires a lot more effort than just figuring out who is salaried. The employer must also weigh issues of education, responsibility, and the ability to make independent decisions. Classifying an employee incorrectly can be costly: Three Mile Canyon Farm in Boardman, Ore., assumed that its laborers were exempt under FLSA guidelines for agricultural workers; the U.S. Department of Labor ruled, however, that the workers were eligible because they bagged compost for sale, and the department assessed the farm $250,000 in overtime fees.

The lawsuits aren't hitting just farms and factories. White-collar workers such as store managers, computer programmers, and pharmaceutical sales reps are the next wave: They are skilled, highly compensated, multitasking - and often misclassified. Hawley of TechNet points to recent class-action settlements against companies such as Electronic Arts (ERTS) and IBM (IBM, Fortune 500).

"These days hiring a salaried software worker could be a liability," he says. Many tech companies are startups whose culture embraces long hours and total dedication, but "under the law, they can't work as hard as they want," he notes.

While Weinberg advocates determining exemptions by straight salary cutoffs for different industries, she says that because of union opposition, the FLSA is unlikely to change.

For now, the best that a small-business owner can do to avoid overtime lawsuits is keep painstaking payroll records for nonexempt employees and consult an employment lawyer to verify workers' status. And make sure to keep a sharp eye out for the kind of dedicated worker who might be tempted to skip lunch.

-Additional reporting by Todd Stauffer.