I am often asked about compensation in a private small business environment. Often DCAA raises this issue in its audit reports questioning the costs as unreasonable or unallowable. It is a focus area for DCAA for sure. The FAR itself also focuses on it suggesting it requires special treatment. It is a crucial item requiring special attention.
The allowability of compensation is governed by FAR 31.205-6. To be allowable the cost must be reasonable. It must be for services provided. It cannot be for services provided in a prior year. Labor costs paid in the current year for a prior year are unallowable. The burden of proof for reasonableness is on the contractor not the government. That is DCAA can question the cost without substantiating their position. It is the responsibility of the contractor to demonstrate that the cost is reasonable.
Reasonableness is defined as what a prudent business person would do. In other words what is reasonable in light of industry established practices. The government usually assesses reasonableness of compensation by using salary surveys. DCAA uses a selected survey and varies from agency to agency. Often the government will judge the reasonableness of compensation without any survey at all. It will make a subjective determination from their own personal vantage point. The burden is on the contractor to demonstrate reasonableness.
Another important point for privately or closely held contractors is that owner compensation cannot exceed the amount that is deductible as compensation under the Internal Revenue Code. Any excess would be unallowable.
An even more common DCAA questioned cost is bonuses or incentive compensation. Practically every privately owned closely held contractor maintains some form of a bonus program. These programs are usually informal and subjective. In this form, the cost is unallowable. For this reason it is a hunting ground for DCAA auditors, a gold mine for DCAA to cherry pick questioned costs.
Bonuses and incentive programs are allowable costs if certain criteria are met. These include:
1. The bonuses must be based on a written agreement, plan or policy implying an agreement.
2. The criteria should avoid subjective evaluations. The more objective the evaluation criteria the better.
3. The basis for the award is supported. This means the criteria for award must be supported and documented.
1. Maintain support for owner and executive compensation. This can be industry statistical comparisons, salary surveys, etc. The challenge is to secure relevant data that resembles the personnel in question. Often these surveys are to general. Remember burden of proof for reasonableness is the responsibility of the contractor. DCAA may question the costs without this support. DCAA very well may question the cost any way if it exceeds what they consider reasonable. In any event you will have a basis to refute whatever the DCAA position is.
2. Develop agreements, plans or policies to address bonuses. This must be written. It is best to base the bonus compensation on objective criteria versus a subjective year end evaluation. Profit distribution concepts should be avoided as DCAA may conclude the bonus is a profit distribution. Profit distributions are unallowable.Please contact me if you have questions about the FAR position on compensation of bonuses.