(Editor’s Note. Following our article on bonus expenses in the last issue we have received requests to address other elements of compensation found in FAR 31.205-6 so here it is. Our sources for this article are pretty much the same as those used for bonus costs: (1) one of our favorite texts – Accounting for Government Contracts, Federal Acquisition Regulation edited by Lane Anderson (2) an article by Karen Manos in the Dec. 2007 issue of Briefing Papers (3) the Defense Contract Audit Manual (DCAM) and (4) our own experience helping clients either challenge questioned costs or helping them develop policies that would be acceptable by auditors.)
Background
FAR 31.205-6 defines the term compensation as “all remuneration paid currently or accrued in whatever form and whether paid immediately or deferred, for services rendered by employees to the contractor.” Compensation includes payment made or to be made in the future in the form of cash, corporate securities such as stocks, bonds and other instruments or other assets, products or services.
FAR 31.205-6(a)(1) sets forth five general criteria that must be met if costs of personal compensation are to be allowable. First, with limited exceptions such as severance pay, deferred compensation, pensions or other post retirement benefits, the compensation is for work performed in the current year and may not be a retroactive payment for work in prior years. Second, the compensation in total must be reasonable for work performed as well as individual components where “reasonableness” is defined in FAR 31.201-3. Essentially it is what is normal for a comparable business, what is consistent with an established plan of the business, restraints imposed by business circumstances (e.g. highly competitive environment, absence of all cost reimbursable contracts) and what the IRS allows as a deduction. “Reasonableness” criteria usually translates into results of compensation surveys used by auditors. Third, the compensation must have been paid in accordance with an “established compensation plan or practices followed so consistently as to imply, in effect, an agreement to make the payment.” Despite recent DCAA assertions to the contrary, the plan or practice in existence need not be in writing (Systemetrics Engineering Corp, NASA 1270-20, Boeing Aerospace Operations Inc., ASBCA 46274). Fourth, there is no presumption of allowability where the contractor has made a major revision to its compensation plan or practice without notifying the ACO (the opposite is also true where there is a presumption of allowability where the contractor has notified the ACO and provided an opportunity to review the change). Fifth, costs considered unallowable under other cost principles are not considered allowable simply by being called compensation (e.g. cost of country clubs, “entertainment”).
We have addressed salaries and wages in numerous other articles as well as bonuses in the last issue. Here we address other selected areas of compensation.
Income Tax Differential Pay
The cost principle explicitly permits the cost of differential allowances such as housing expense allowances, higher living costs, transportation, bonuses and additional federal, state, local or foreign taxes. The cost of tax “gross ups” to compensate an employee for additional federal, state or local income taxes from domestic assignments are not allowable. However, tax “gross ups” for increased income cause by reimbursement of relocation costs are now allowable.
Severance Pay
Severance pay is compensation in addition to regular salary and wages for being involuntarily terminated. It is allowable if it is reasonable and is required by law, employee-employer agreement, an established policy that in effect constitutes an agreement or the circumstances of the particular employment. However, if the employee is employed by a replacement contractor or employed by the contractor or an affiliate under equal conditions as the replaced employee and with credit for prior service their severance pay is unallowable. “Normal” severance pay must be allocated to all of the work performed (i.e. charged indirectly). Accruals for “abnormal” or mass severance are unallowable but the cost principle states the government is liable for “its fair share” of any such payment. Nonetheless, contractors are not entitled to severance payments under fixed price contracts.
Retirement Incentives and Employee Release Arrangements
As opposed to involuntary severance pay, the cost principles explicitly allow costs for retirement incentives limited to the employee’s annual salary the year before their retirement. Earlier versions of the FAR disallowed both severance and retirement incentive payments but later versions were changed to allow both.
Employee release arrangements, where an employee receives more severance pay than normal in exchange for releasing the employer from liability for wrongful termination, used to be disallowed by DCAA on the grounds it was backpay for services not rendered. In the mid-90’s DOD rejected their position where DCAA published guidance prohibiting the disallowance and recommended auditors evaluate the reasonableness of such payments on a case-by-case basis.
Backpay
Before changes to the FAR in August 2003, the cost of backpay was allowable unless it (1) resulted from a violation of federal laws or the Civil Rights Act and (2) did not represent additional compensation for worked performed. After 2003, FAR revisions made all backpay unallowable unless it was for work performed but was underpaid.
Corporate Securities
Corporate securities such as stock options and stock appreciation rights are one of the most common forms of long term incentive compensation for executives. Certain restrictions apply such as (1) the securities must be valued at their fair market value on the measurement date which is defined as the first date the number of shares is known and (2) any accruals for the cost of securities before issuance to the employees must take into account the possibility the employees’ interest in the securities may be forfeited. Any compensation that is calculated based on changes in the price of the securities (or represented by or calculated based on dividend payments) is unallowable. This is true even if the payment otherwise meet the criteria for incentive compensation. Prior to 1996, cases focused narrowly on specific types of securities (e.g. phantom rights, stock appreciation rights) that were deemed unallowable after which a general cost principle for all stock based securities was put forth that is not tied to any particular security. Now any compensation that is calculated or valued on the basis of a change in the price of the contractor’s securities is unallowable. Similarly, compensation paid in the form or calculated based on dividend payments is unallowable. Also, compensation paid in lieu of receiving a right, option or benefit that is unallowable is also unallowable.
Pensions
The cost principles recognize two types of pension plans
– defined benefit and defined contribution. The “funded pension cost”, the amount paid to a funding agency for the accumulation of the contributions of either plan, are generally allowable as long as they are measured, allocated and accounted for in accordance with CAS 412 and 413. Ms. Manos details several changes made in the recent past but they are too involved to recount here.
Employee Stock Ownership Plans (ESOPs)
ESOPs are employee bonus plans intended to invest in the stock of the employees’ company where the contractor makes annual contributions to an employee stock ownership trust (ESOT). ESOPs may be leveraged or non-leveraged where under a leveraged ESOP the ESOT borrows money, buys the stock which is held by the lender, the company pays down principle and interest (which is allowable) where the stock is gradually released, assigned to individual employees and when they retire, they receive their share of stock or cash equivalent. Following a long history of FAR and CAS proposals, FAR 31.205(q) was passed that provided ESOPs meeting the definition of a pension plan would be covered by CAS 412 and not meeting the definition would be covered by CAS 415. All ESOP payments would be allowable if made by the federal tax filing date. Conditions of allowability include (1) they don’t exceed the tax deductibility limits (2) when contribution to an ESOT consists of stock, the amount allowable is limited to its fair market value measured on the date the stock is effectively transferred and (3) when the contribution is in cash, stock purchases that exceed the fair market value of the stock is unallowable.
Deferred Compensation
Though we discussed this form of compensation in the past, we will summarize it by saying deferred compensation consists of payments made to an employee in a future period for work performed in an earlier period. It is covered by provisions of CAS 415, whether or not a contract is CAS covered which generally requires the amount of future payments recognized in the current period will be measured by the net present value of these future payments using the discount rate established semi-annually by the Sec. of Treasury. There are several conditions required for the deferred compensation to be allowable in the current period: (1) the contractor may not unilaterally void the requirement to make future payments (2) the compensation award must be satisfied by payment in cash, stock of the contractor or other means (3) the amount of the future award must be determinable with reasonable accuracy (4) the recipient of the award must be known (group plans can avoid this requirement for identifying individuals) (5) if receipt of the award is based on occurrence of future events there must be a reasonable probability those events will occur and (6) for stock options, there must be a reasonable possibility they will be exercised. If any of these conditions are not met, the cost must be assigned to the period the payment is made.
Fringe Benefits
The term “compensation” is often linked with “fringe benefits” which are defined as allowances and services provided to employees in addition to their regular wages and salary. Similar to other types of compensation, they must be reasonable and required by law, employee-employer agreement or an established policy of the company. Some fringe benefit costs, whether or not they are considered to be taxable income and even reasonable, are unallowable such as rebate and purchase discount plans, personal use of a company car and costs of social, dining or country club fees. When determining whether levels of compensation are reasonable, whether using annual salary caps established by the government or surveys used by DCAA, fringe benefits which can constitute 40 percent or even more of salary and wages, are not to be included as benchmarked compensation but is rather to be evaluated for reasonableness separately.
© 2024 Government Contract Associates. All Rights Reserved.
