Employee Commission Agreement: Employer Issues To Check Before You Hire

For US startups and small businesses, hiring employees on commission can drive sales and incentivize performance. However, commission pay arrangements bring legal risks and compliance obligations that many founders overlook. Common mistakes include misclassifying workers, failing to comply with wage laws, and using vague or incomplete agreements. These errors can lead to disputes, regulatory penalties, or unexpected costs. This guide explains what an employee commission agreement is, what to include, and the key legal issues to check before you hire. We cover federal rules, state law differences, practical examples, and common pitfalls so you can set up commission arrangements with confidence.

What Is an Employee Commission Agreement?

An employee commission agreement is a written contract between an employer and an employee that sets out how the employee will be paid commissions. Commissions are payments based on sales or other performance targets, commonly used for sales representatives, business development staff, recruiters, and other revenue-generating roles.

The agreement should clearly explain:

• How commissions are calculated (for example, a percentage of gross sales, net sales, or a fixed amount per sale)
• When commissions are considered earned (at sale closing, payment receipt, or product delivery)
• When commissions are paid out (monthly, quarterly, after client payment, etc.)
• What happens if a sale is canceled, refunded, or unpaid
• How commissions are handled if the employee leaves the company, whether by resignation or termination
• Any minimum or maximum commission amounts, thresholds, or accelerators
• How disputes about commissions will be resolved

For example, a SaaS startup might pay its sales team a 10% commission on all new annual contracts, with commissions considered earned when the client pays the invoice and paid out at the end of the following month. The agreement would specify that if a client cancels within 30 days, the commission is forfeited or clawed back from future payments.

Having a clear, written agreement helps prevent misunderstandings and disputes. It also helps you comply with federal and state wage laws, which often require employers to spell out commission arrangements in writing. If you are unsure how to draft an agreement, consider seeking guidance on employment law or contracts.

Federal Law: Wage and Hour Rules for Commission Pay

The Fair Labor Standards Act (FLSA) sets the federal baseline for wage and hour rules in the United States. The FLSA applies to most US employers and employees, including those paid by commission. Here are key points to consider:

• Minimum wage: Employees paid by commission must still receive at least the federal minimum wage ($7.25 per hour as of 2024) for each hour worked, unless a specific exemption applies.
• Overtime: Most commission-paid employees are entitled to overtime pay (time and a half) for hours worked over 40 in a workweek, unless they qualify for an exemption, such as the outside sales exemption or certain retail commission exemptions.
• Recordkeeping: Employers must keep accurate records of hours worked and wages paid, including commissions, even for employees who are primarily paid on commission.

For example, if a sales employee works 45 hours in a week and earns $400 in commissions, but this does not bring their average hourly pay above the federal minimum wage, the employer must make up the difference. Similarly, overtime pay must include commissions in the calculation, not just base pay. If the employee is non-exempt, their regular rate for overtime is calculated by dividing total earnings (including commissions) by total hours worked, then multiplying the overtime hours by 1.5 times that rate.

Some employees may be exempt from overtime if they meet the criteria for the outside sales exemption (primarily working away from the employer's place of business and making sales) or the retail commission exemption (for certain retail or service employees who earn more than half their pay from commissions and whose regular rate exceeds 1.5 times the minimum wage). These exemptions have strict requirements, so it is important to review the DOL's guidance or consult with a qualified attorney if you are unsure.

Employers must also be aware that the FLSA does not require commissions to be paid immediately upon earning; however, state laws may impose stricter timing requirements.

State Law: Key Differences and Additional Requirements

Many states have their own wage and hour laws that go beyond the federal baseline. State rules can affect commission agreements in several ways:

• Written agreement requirements: Some states, such as California, New York, and Illinois, require employers to provide a written commission agreement to employees. These agreements must include specific details about how commissions are calculated and paid, and a signed copy must be provided to the employee.
• Final pay rules: States may have rules about when final commissions must be paid if an employee leaves or is terminated. For example, in California, all earned commissions must be paid at termination, and failure to do so can trigger waiting time penalties.
• Minimum wage and overtime: State minimum wage rates and overtime rules may be higher or stricter than federal law. For example, as of 2024, California's minimum wage is $16 per hour, and New York's is $15 per hour (higher in New York City and some counties). Employers must follow the rule that provides the greatest benefit to the employee.
• Restrictions on deductions: Some states limit when employers can deduct chargebacks or other amounts from commissions, especially after termination. For instance, in Massachusetts, deductions from earned wages (including commissions) are generally prohibited unless required by law or authorized in writing for the employee's benefit.
• Industry-specific rules: Certain industries, such as real estate, insurance, or securities, may have additional state licensing or commission payment requirements.

It is important to check the rules in every state where your employees work. For example, a commission agreement that is valid in Texas may not meet the requirements in California or New York. State labor agencies often publish guidance and sample language for commission agreements. When in doubt, seek advice from a qualified legal professional familiar with state-specific rules.

Practical Example: A startup based in Texas hires a remote sales employee who lives and works in California. Even though the business is based in Texas, California law will apply to the employment relationship. The employer must provide a written commission agreement that complies with California Labor Code section 2751, pay at least California minimum wage for all hours worked, and pay all earned commissions immediately upon termination.

Checklist for State Law Compliance:

• Identify the state(s) where employees perform work
• Check written commission agreement requirements
• Review state minimum wage and overtime rules
• Understand final pay and timing rules for commissions
• Check restrictions on deductions and chargebacks
• Look for industry-specific regulations

Employee or Contractor? Classification Risks with Commission Pay

One of the most common mistakes startups make is misclassifying workers who are paid by commission. Just because someone is paid on commission does not mean they are automatically an independent contractor. The IRS and DOL use multiple factors to determine worker classification, including:

• The degree of control the business has over how work is performed
• Whether the worker can set their own hours and work for other clients
• How the worker is paid (commission, hourly, salary, etc.)
• Whether the worker provides their own tools and equipment
• The permanency of the relationship

If you treat a commission-based worker like an employee (for example, by setting their schedule, providing tools, or requiring them to follow company policies), they are likely to be classified as an employee under federal and state law. Misclassification can lead to serious legal and tax consequences, including back pay, penalties, and liability for unpaid taxes.

IRS Guidance: The IRS uses the common law test, focusing on behavioral control, financial control, and the relationship of the parties. For example, if you require a commission-based salesperson to work certain hours, use your CRM, and attend weekly meetings, they are likely an employee. If they set their own schedule, use their own tools, and work for multiple businesses, they may be a contractor.

State Law Example: California uses the "ABC test" for most workers. To classify a worker as an independent contractor, you must show that:

1. The worker is free from control and direction in performing the work, both under the contract and in fact;
2. The work performed is outside the usual course of the hiring entity's business; and
3. The worker is customarily engaged in an independently established trade, occupation, or business.

Most commission-based sales roles for a business's own products or services will not meet the "B" prong, so they must be classified as employees in California.

Checklist for Avoiding Misclassification:

• Review how much control you exercise over the worker
• Assess whether the worker can work for others
• Check if the worker provides their own tools and sets their own schedule
• Consult IRS, DOL, and state guidance
• Document your classification analysis

When in doubt, classify as an employee and use a compliant commission agreement. Misclassification can result in audits, back pay, tax penalties, and liability for benefits.

What to Include in an Employee Commission Agreement

A well-drafted employee commission agreement should be clear, specific, and tailored to your business. Here is a checklist of key terms to include:

• Commission structure: Describe how commissions are calculated (percentage, flat fee, tiered rates, accelerators, etc.). For example, "10% of net sales up to $100,000 per quarter, 15% above $100,000."
• Payment timing: State when commissions are earned (for example, at sale closing, payment receipt, or delivery) and when they will be paid out (monthly, quarterly, etc.).
• Chargebacks and adjustments: Explain what happens if a sale is canceled, refunded, or unpaid. Specify if and when commissions can be clawed back from future payments.
• Draws against commission: If you pay a draw (advance) against future commissions, describe how it works and how it is reconciled. For example, "Employees receive a $1,000 monthly draw, which is offset against commissions earned each month. If commissions do not exceed the draw, the difference is carried forward."
• Minimum wage and overtime: State that the employee will be paid at least minimum wage and overtime as required by law, and explain how commissions factor into these calculations.
• Termination and final pay: Set out how commissions are handled if the employee leaves or is terminated. Clarify which commissions are still owed and when they will be paid. For example, "Commissions on sales closed before termination and paid by the client within 60 days of termination will be paid on the regular commission schedule."
• Dispute resolution: Include a process for resolving commission disputes, such as internal review, mediation, or arbitration.
• Governing law: Specify which state's law applies to the agreement, especially if you have remote employees in multiple states.
• Examples and sample calculations: Provide concrete examples of how commissions are calculated and paid in different scenarios.

For instance, a retail business might include a provision like: "If a customer returns a product within 30 days of purchase, the commission paid on that sale will be deducted from the employee's next paycheck, provided such deduction is permitted by state law."

Remember to update your agreement if you change your commission structure, product mix, or payment timing. Both parties should sign the agreement, and the employee should receive a copy.

Industry Caveats: In some industries, such as securities or insurance, commission arrangements may also be subject to federal or state licensing requirements, disclosure rules, or industry codes of conduct. For example, registered representatives in the financial sector must comply with FINRA and SEC rules regarding compensation disclosure and timing.

Common Mistakes and How to Avoid Them

Many startups and small businesses run into trouble with commission agreements because of avoidable errors. Here are some of the most common mistakes and how to prevent them:

• Not putting the agreement in writing: Verbal agreements are difficult to enforce and may not meet state law requirements. Always use a written contract.
• Unclear commission terms: Vague or ambiguous language about how commissions are calculated or paid can lead to disputes. Be specific and use examples.
• Ignoring state law differences: Using a generic agreement without checking state-specific rules can result in noncompliance, especially in states like California, New York, or Illinois.
• Misclassifying workers: Treating commission-based employees as contractors without meeting legal tests can lead to fines and back pay claims.
• Missing minimum wage or overtime obligations: Failing to track hours or include commissions in overtime calculations can violate wage laws.
• Improper deductions or chargebacks: Deducting amounts from commissions after termination or for reasons not allowed by law can create liability.
• Failing to update agreements: Not revising commission agreements when your business changes its pay structure, products, or services can cause confusion and disputes.
• Poor recordkeeping: Not keeping accurate records of sales, commissions earned, and hours worked can make it difficult to resolve disputes or defend against claims.

Practical Example: A startup offers a sales employee a 5% commission on all closed deals but does not specify in writing when commissions are earned or what happens if a client cancels. The employee closes a large deal, but the client cancels before payment. The employee claims the commission is owed, while the employer disagrees. Without a clear agreement, this dispute could escalate to a wage claim or lawsuit.

Checklist to Avoid Common Mistakes:

• Always use a written agreement, signed by both parties
• Clearly define how, when, and on what basis commissions are earned and paid
• Include state-specific language where required
• Review classification of each worker (employee vs contractor)
• Comply with minimum wage and overtime rules
• Spell out rules for deductions, chargebacks, and final pay
• Update agreements as your business evolves
• Maintain accurate records of all commission calculations and payments

When in doubt, consult a qualified professional before hiring or changing your commission arrangements.

FAQs

Are commission-only employees legal in the US?

Commission-only pay is legal for employees in many cases, but there are important restrictions. Under federal law, employees must still receive at least the minimum wage for all hours worked, and most are entitled to overtime pay. Some states have stricter rules or require a base salary in addition to commissions. Always check both federal and state law before using commission-only arrangements.

Do I have to pay commissions after an employee leaves?

Whether you must pay commissions after an employee leaves depends on the terms of your agreement and state law. Many states require employers to pay all earned commissions at termination, even if the employee is no longer with the company. Your agreement should clearly state when commissions are considered earned and how final pay is handled.

Can I deduct chargebacks or refunds from commissions?

Employers can usually deduct chargebacks or refunds from commissions if the agreement allows it and deductions are permitted by law. Some states restrict when and how deductions can be made, especially after termination. Make sure your agreement is clear and complies with state rules.

What is the difference between a draw against commission and a salary?

A draw against commission is an advance payment that is later offset by earned commissions. If the employee does not earn enough commissions to cover the draw, the agreement should explain whether the difference must be repaid. A salary is a fixed regular payment that is not tied to sales or performance. The two can be combined, but the terms must be spelled out in writing.

How do I handle commissions for remote employees in other states?

If you have employees working remotely in other states, you must comply with the wage and hour laws of the state where the employee works. This includes written agreement requirements, minimum wage, overtime, and final pay rules. Review each state's laws and update your agreements as needed.

Key Takeaways

• Employee commission agreements must be clear, specific, and comply with both federal and state law.
• Federal law sets the baseline for minimum wage and overtime, but many states have stricter rules and written agreement requirements.
• Misclassifying commission-based workers as contractors can lead to serious legal risks.
• Common mistakes include unclear terms, missing written agreements, and ignoring state differences.
• Review your agreements regularly and seek legal guidance if you hire in multiple states or have industry-specific rules.

If you need help drafting or reviewing an employee commission agreement, or have questions about hiring on commission, contact our team at (888) 449-8437 or team@sprintlaw.com. Where legal services are required, they are delivered by licensed lawyers at trusted US law firms through the Sprintlaw platform.