Can W-2 Employees Be Commission Only?

It is legally possible for a W-2 employee to be paid entirely on a commission basis. This arrangement, however, is subject to strict federal and state labor laws designed to protect employee wages. The feasibility of this pay structure depends on the employee’s role and whether they qualify for specific legal exemptions. For most commission-only employees, employers must guarantee that their pay meets wage standards for every hour worked.

Minimum Wage and Overtime Compliance

The Fair Labor Standards Act (FLSA) establishes compensation rules for non-exempt, commission-only W-2 employees. The primary requirement is that an employee’s total earnings for a workweek must average out to at least the federal minimum wage for all hours worked. If an employee’s commissions fall short of this threshold, the employer is legally obligated to pay the difference, which requires tracking all hours worked.

To manage this requirement, employers often use a “draw against commission.” A draw is an advance payment, similar to a loan, paid to the employee to ensure their compensation will cover the minimum wage. This draw is then recovered by the employer from the commissions the employee earns. If an employee earns more in commission than the draw amount, they receive the excess, while a deficit is typically carried over to be repaid from future commissions.

Calculating overtime for non-exempt, commission-only employees also requires attention. Overtime, paid at 1.5 times the employee’s regular rate, is due for hours worked beyond 40 in a workweek. To determine the “regular rate” for a commission-only employee, the employer must divide the total commissions earned in a workweek by the total hours worked that week. Because commission earnings can fluctuate, this regular rate must be recalculated for each workweek in which overtime is worked.

The Outside Sales Employee Exemption

An exception to wage and hour rules is the “outside sales” employee exemption. If an employee meets the criteria for this classification under the FLSA, the employer is relieved of the obligation to pay both minimum wage and overtime. The classification is not determined by job title but by the specific duties the employee performs.

To qualify for the outside sales exemption, an employee must satisfy two primary tests. First, the employee’s primary duty must be making sales or obtaining orders and contracts for services. This duty must be the main reason for the employee’s position.

The second requirement is that the employee must be “customarily and regularly engaged” in performing these sales duties away from the employer’s place of business. This means the employee makes sales at a customer’s home or business rather than from the employer’s office. Any fixed site, including a home office used for calls or emails, is considered the employer’s place of business, and work from such a location does not qualify as “outside” sales activity.

The Inside Sales Employee Exemption

Another exception is the “inside sales” exemption, known as the Section 7(i) exemption under the FLSA. This exemption applies to employees of a “retail or service establishment” and, if its conditions are met, it relieves the employer from the overtime pay requirement, but not the minimum wage requirement. An employee’s total compensation must still equal at least the federal minimum wage for all hours worked.

For the exemption to apply, two tests must be satisfied. The first is that the employee’s regular rate of pay for any workweek with overtime must be more than 1.5 times the federal minimum wage. The second test requires that more than half of the employee’s total earnings in a designated “representative period” must consist of commissions. This period must be at least one month but no longer than one year and be chosen by the employer to accurately reflect the employee’s typical earnings.

A business qualifies as a “retail or service establishment” if at least 75% of its annual sales volume is not for resale and is recognized as retail sales or services within its industry. This often includes businesses that sell directly to consumers, like car dealerships or certain stores.

Employer Payroll and Withholding Obligations

Regardless of how a W-2 employee is paid, whether by commission, salary, or an hourly wage, the employer’s payroll and tax obligations remain the same. The “W-2” designation signifies an employment relationship that carries defined responsibilities for tax withholding and contributions.

For every W-2 employee, the employer must withhold federal, state, and local income taxes from their paychecks based on the employee’s Form W-4. The employer is also required to withhold the employee’s share of Federal Insurance Contributions Act (FICA) taxes, which consist of a 6.2% Social Security tax on wages up to an annual limit and a 1.45% Medicare tax on all wages.

In addition to withholding from the employee’s pay, the employer must pay its own share of taxes. This includes matching the employee’s FICA contributions. Employers are also responsible for paying federal unemployment taxes under the Federal Unemployment Tax Act (FUTA) and state unemployment taxes (SUTA). The FUTA tax is 6.0% on the first $7,000 of an employee’s wages, though employers can often receive a credit that lowers this rate.