The Looming Catastrophe for Small Businesses – Prepare for the Recession in 2024
The Federal Reserve causing higher interest rates has led to lower economic activity. For instance, Real GDP Growth in the fourth quarter of 2023 was a robust 3.5%. However, in the first quarter of 2024, Real GDP Growth dropped to just 1.6%. (See U.S. Bureau of Economic Analysis economic data report.) So, the Federal Reserve’s actions and the Gross Domestic Product growth rate decrease are definitely not a good sign for small businesses. But alas, these two things aren’t what is looming either.
According to a recent article at Morningstar, consumer spending is also down. Stock prices of companies like Starbucks and McDonald’s are suffering as consumers forgo Venti lattes and eating out. Typically, when food prices go higher, companies like McDonald’s see a boost in income. So, this drop in consumer spending is ominous. However, it isn’t the looming catastrophe that will ultimately lead to the Recession in 2024 either.
Yes, Economic Conditions Are Challenging. But in the Coming Months, a Huge Challenge Is on the Horizon!
Right now, small business owners are in a boat with multiple huge holes in the bottom. They are desperately trying to keep the boat floating by bailing water, incurring debt through small business loans with high interest rates or business credit cards.
However, on July 1, 2024, a torpedo will hit these boats, and most of these entrepreneurs won’t even see it coming! This torpedo is the new overtime rules for salaried employees that take effect in July of 2024 and January of 2025.
Employment Rules for Salaried Employees | New Overtime Rules for Salary Employees
The Fair Labor Standards Act (FLSA) of 1938 established federal standards for minimum wage and overtime pay. The original FLSA exempted executives, administrative personnel, and professionals (“EAP Exemption) from overtime rules (also known as “White-Collar” Exemptions to the FLSA). The logic behind the exemption (if there was any logic) was that these white-collar roles typically paid way more in salary than what a typical worker could make in hourly wages. So, these roles were exempt from receiving time-and-a-half wages for working more than 40 hours per week.
The original legislation made the determination of who should receive these white-collar exemptions pretty straightforward. If an employee worked in one of these roles, the worker was exempt. However, the United States Department of Labor (DOL) began setting additional “rules” in 1940. For instance, the created a salary threshold for these exemptions. This salary threshold for exempt status has been periodically updated, increasing the financial burden on small businesses. When thresholds rise, small businesses must either increase salaries to maintain exemptions or reclassify employees as non-exempt, thus incurring overtime pay costs. Unlike larger corporations, small businesses often lack the financial flexibility to adapt to these changes smoothly.
In addition, small business owners often lack extensive human resources departments. So, many struggle to classify employees correctly, create costly compliance errors, and set themselves up for potential litigation. This is where the changes in the white-collar rules and lack of publicity about the changes can be very dangerous for small businesses.
Unintended Consequences of an Increase in the Overtime Salary Threshold.
The salary threshold was increased in 2019 to $35,568. This was a 65% increase in the minimum salary to be exempt from overtime. Most people will look at that number and say, “So what? That doesn’t seem like a huge salary.” In and of itself, it isn’t a huge salary. However, the artificial increase created a huge chain of events.
The first and basic consequence is that anytime small business costs go up, prices of the goods and services offered often also go up. If the small business doesn’t increase prices, the owner will often reduce personnel, so service drops. This just makes the inflation challenge even more challenging.
Another challenge happens because most small business owners have graduated salaried tiers. For instance, when the salary exemption base was $23,660, a small business owner might give new employees $25,000. A more experienced person might make $35,000. Other, more experienced employees may make $45,000, $55,000, or $65,000. Well, the moment the base increased to $35,568, this system gets very complicated. The owner can’t afford to give everyone raises. The easiest solution is to fire the newest people.
The DOL Has Issued Huge Increases in the FLSA Salary Threshold. This Will Guarantee a Recession in 2024 and 2025.
Yup, torpedo.
Let’s do the math for a $1 million business with five employees plus the owner. The average profit margin for a small business is about 7.75%. At 7.75% profit, the owner would average $77,500 left over at the end of the year. Most companies allocate 15%-30% of revenue for payroll. Even on the high end, 30% of $1 million is $300,000. When you divide that by six people (assuming the owner takes a salary), that’s an average of $50,000 per person. Since that $50,000 is the average, if one employee is making $75,000, then another would have to make $25,000, or the $77,500 profit would have to go down.
On January 1, 2025, each employee would have to be paid a minimum of $58,656. That new total ($6 X $58.656) is $351,936. That is a minimum additional cost of $51,936. (And that is only if anyone who was already making more than $58,656 takes a pay cut.) The profit will go down to $18,844. (That is just a 1.8% profit margin.) Keep in mind that small businesses also pay an average of 25% of payroll in payroll taxes like FICA and benefits as well. So, the real profit will likely be much, much lower.
And that is the best possible scenario. If the costs go up based on higher prices for materials, the owner won’t have enough margin to cover them. Or the owner may charge customers high prices. But that will probably lead to a decrease in new orders. It is really a no-win situation.
As Bad as the Near Term Challenges Are, the Real Devastation to the U.S. Economy Will Occur in the Next Two Years.
Remember what I said about small business owners not having HR professionals? The real drop in economic growth will drop in the coming year or two. Every other time that the DOL has increased this threshold, the number of FLSA lawsuits has increased exponentially. The unknowing business owner focuses on inflation, tighter margins, and how to make the next payroll. The owner misses that the threshold increased.
“We’re putting more money in the pockets of millions of American workers. Because you earned it.” – Joe Biden
All it takes is a single disgruntled employee to file a lawsuit for back pay. The business owner has no defense. And, because of the global economy, the owner also has no cash reserves to fund a lawsuit. Even if the entrepreneur could pay the exorbitant attorney fees to go to court, the FLSA law requires the business to pay the employee’s attorney fees as well if the owner loses. Many of these small businesses will go bankrupt. When they do, all of the company’s employees now lose their jobs.
In 2004, over 2500 FLSA lawsuits were filed. In the next two years, though, these lawsuits soared to 4000 in 2005 and then almost 7000 in 2006 before leveling off. When the last FLSA salary threshold increase was issued in 2019, lawsuits and claims actually decreased in 2020. However, the pandemic likely caused the drop in litigation that year. The pre-pandemic levels of lawsuits were up. And in 2021 and 2022, the number of lawsuits hit record highs.
So, a regulation to stimulate wage growth will often increase the unemployment rate.
There Is Hope to Stave Off a Recession in 2024 — Although Very Slight.
The judge said that the 2016 rule created a salary-only test for exempt status that supplanted the duties test. In effect, millions of employees who have been performing exempt duties would suddenly be non-exempt. And they would lose the exemption solely because their existing salary falls below the new threshold.
The judge said, “Congress, the court said, intended these ‘white collar’ exemptions to apply to employees doing actual executive, administrative, and professional duties. If Congress intended the salary requirement to supplant the duties test, then Congress, and not the [DOL], should make that change.”
The 2024 rule is almost identical to the 2016 rule. The DOL just broke up the huge increase into two smaller (but still huge) increases. The same three-year automatic adjustments are still included in the 2024 rules. And the first lawsuit against the DOL was filed last week in the same court that overturned the 2016 rule.