Commissions and bonuses are forms of “wages” in California. The Labor Code imposes on employers a number of obligations regarding payment of wages. For example, wages must be paid within a specified time period after they are earned. Employees who quit or are terminated typically must be paid their final wages on their last day of employment or penalties may accrue. Wages must be included in the “regular rate” of pay, which is used to calculate overtime. They also must be detailed on the “wage statement” that is furnished employees with every paycheck.

Salaries and hourly pay are measured and paid in a straightforward way. Commissions and bonuses, on the other hand, may be based on more complex formulas. Over the years, employees have challenged a number of these arrangements as violating a variety of California’s wage and hour laws. But some recent appellate court decisions are enforcing commission and bonus agreements as written. Employers who understand the legal issues are more likely to avoid successful legal attacks on the compensation deals they make with their employees.

What Are Commissions?

Certain employees may be exempt from overtime and other wage and hour requirements if they are “commission” employees. Under the federal Fair Labor Standards Act, this is known as the 7(i) exemption, applicable only to “retail” salespeople. In California, the commission exemption primarily applies to the retail industry under Industrial and Welfare Commission Wage Order 7-2001. Under Wage Order 7 and Section 7(i) of the act, employees can qualify for the exemption if their total earnings exceed one-and-one-half times the minimum wage, more than one-half of which are commissions. (There is an identical provision in California’s Wage Order 4-2001, but the exemption might not be valid under federal law because of Section 7(i)’s retail requirement.)

A commission is a narrowly defined form of compensation under California law. Employees who receive commissions must be principally involved in selling, rather than producing, a product or service. In addition, the amount of their compensation must be a percent of the price of the product or service. Years ago, an auto dealership attempted to qualify its mechanics as exempt, claiming it paid them on a commission basis. But the court of appeal held that the mechanics performed the service and did not sell it. Similarly, if a commission is not calculated as a percentage of the selling price, the employer risks that a court will hold it is not a commission. If the compensation is not a commission, the exemption is not applicable, resulting in claims for unpaid overtime, meals and breaks and associated penalties.

What Is a Bonus?

Sales incentives that do not qualify as commissions under the above definition may be treated as bonuses. Unlike commissions, bonuses are not subject to precise definition under California law. Although there is no mention of “bonus” in the Labor Code, courts have long held they are another form of wages. Because they are wages, subject to narrow exceptions, bonuses must be included when calculating the applicable overtime rate for nonexempt employees.

Terms and Conditions

The courts and the state Division of Labor Standards Enforcement generally treat commission and bonus plans as contracts between the employer and the employee. However, because these contracts involve wage and hour law, a number of potential legal issues arise that are not generally applicable to other contracts.

Although employees doubtless welcome the additional pay, employers must not assume all incentive pay formulas are lawful. For example, Labor Code Section 221 prohibits employers from making deductions from wages, subject to listed exceptions. In Hudgins v. Neiman Marcus, 34 Cal.App.4th 1109 (1995), the employer’s commission plan included a provision allowing the retailer to deduct a pro-rata share of “unidentified returns.” These returns were goods that could not be attributable to a particular sales person. The court of appeal invalidated the commission plan, holding that the salespeople should not have their commissions reduced for the return of goods that they personally may not have sold. In Kerr’s Catering Service v. Department of Industrial Relations, 57 Cal.2d 319 (1962), the employer’s lunch-truck drivers received a 15 percent commission on their own sales exceeding $475 per week. However, the promised commission was subject to reduction for any cash shortage attributable to the driver for the month. The California Supreme Court held that the deduction was unlawful.

It also is illegal under Labor Code Section 3751 to make a deduction from employees’ wages to cover the cost of workers’ compensation insurance. However, the California Supreme Court recently held, in Prachasaisoradej v. Ralphs Grocery Co. Inc., 42 Cal. 4th 217 (2007), that Section 3751 does not prohibit employers from paying bonuses based on net profits, which necessarily includes in its formula the cost of insurance. There is a difference between making dollar-for-dollar offsets to wages and using a bonus formula that relies on a profit level that is net of overhead.

Forfeitures Versus Advances

Employers also must draft incentive plans so employees do not forfeit wages already earned. The courts are willing to enforce compensation arrangements that specify who is eligible for compensation and when compensation is deemed “earned.” On the other hand, once earned, such wages may not be forfeited. These issues frequently arise when employment is terminated before all commissions or bonuses are paid. However, it also arises when customers cancel or do not pay for orders.

Two 2005 cases involving commissions paid on subscriptions illustrate the difference between an illegal forfeiture and a valid compensation plan. In Steinhebel v. Los Angeles Times Communications LLC, 126 Cal.App.4th 696 (2005), the employer’s commission plan specified certain orders that were eligible for commissions. If a customer did not keep the subscription for more than 28 days, the order did not qualify. The plan also provided that commission payments would be advanced, but if a customer canceled an order before the 28-day limit, the commission advance would be offset against future commission payments. The court of appeal rejected employees’ arguments that the offset amounted to an unlawful deduction. The court found that because the commission agreement specifically defined an earned commission, the advanced amounts did not qualify as wages. Therefore, Section 221 did not apply, and the employer could credit the advanced amounts against future earned wages.

In an almost identical situation, the court of appeal in Harris v. Investor’s Business Daily Inc. , 138 Cal.App.4th 28 (2006), held that “chargebacks” of commissions on canceled subscriptions were illegal. Distinguishing Steinhebel, the court noted the employees did not specifically agree to the chargeback procedure, and that Investors did not characterize the paid commissions as an “advance.” As is the case with many wage and hour issues, the devil is in the details.

Termination of Employment

Many incentive compensation arrangements require performance over a period of time. “Stay” or “retention” bonuses expressly condition receipt of payment on employment until a certain date. Two recent decisions demonstrate courts will enforce their provisions in accordance with their terms, as long as they are clear.

In Schachter v. Citigroup, Inc., 159 Cal.App.4th 10 (2008), the employer allowed eligible employees the option of using a portion of their annual earnings to purchase shares in the company’s stock at a below-market price. However, the incentive plan provided that if the participating employee resigned or was terminated for cause within a two-year vesting period, the employee forfeited the stock, as well as the money used to purchase it. The court of appeal upheld the plan because the employee failed to satisfy the plan’s clear conditions and therefore did not earn the bonus. Similarly, in Neisendorf v. Levi Strauss & Co., 143 Cal.App.4th 509 (2006), the employer’s bonus plan was based on calendar year financial criteria. But the plan required participants to remain employed on the payout date. Again, the court upheld the express condition on eligibility for payment.

Notwithstanding these decisions, employers must be cautious when attempting to enforce such provisions against employees fired without sufficient cause. The Division of Labor Standards Enforcement, relying on dicta in older court decisions, takes the position that an employer must have a sufficient reason to discharge an employee without paying a bonus tied to length of service. Otherwise, the agency reasons, any employer could avoid payment just by firing the employee right before the payment was due. Additionally, employees fired without cause to avoid paying bonuses and other vested compensation potentially could assert a breach of the implied covenant or, if appropriate, promissory estoppel or fraud.

Recent decisions demonstrate that the courts are willing to enforce a clear incentive plan, even if there are specific conditions that, if unmet, will deprive employees of the potential benefits. However, employers must precisely draft such agreements to avoid claims of unconscionability or Labor Code violations.