Recent guidance calls for compensation reviews of high risk individuals during incurred cost audits if no compensation system review audits are conducted. Under detailed compensation reviews internal controls are evaluated to assure compensation is reasonable. When these internal controls are deemed adequate (discussed in more detail in a future article) the scope of review of non-high risk employees are often reduced. Since high risk individuals are often not subject to contractors’ normal internal controls recent guidance indicates such lessened scope should not apply to them.

Auditors are also told to review compensation of high risk employees who do not necessarily hold high level titles. A president’s son may be an engineer or a partner may be one of several scientists working in research. Auditors are told not to accept their compensation as reasonable without checking to see whether the high risk individuals have equal duties and compensation as the other members of the same class for they may be overgraded considering the work they do or simply paid more than others doing the same work.

Unless the company is large, executive positions within a company are usually unique. Whereas larger companies may have a class of employees performing at, say, a vice president level, most executives in other companies are not part of a class of employees and hence their compensation must be evaluated on an individual basis. Auditors are told to evaluate these positions with comparable ranks, function and responsibility in other firms of similar sizes.

Auditors will also determine whether compensation is reasonable for the personal services rendered. A distribution of profits, as opposed to compensation, is considered unallowable and we have long cautioned our clients to avoid an appearance of the former. We were glad to see the DCAM add a note that payments made to owners where the accounting records indicate a distribution of profits are not automatically unallowable. The guidance notes that some smaller firms, including sole proprietorships and partnerships, regularly compensate owners through distribution of profits and these amounts are to be questioned only if the total compensation paid to the individuals exceeds an amount reasonable for the services performed.

New guidance addresses amounts of compensation considered deductible by the Internal Revenue Service which states just because the IRS does not challenge an executive or owner’s compensation does not, in itself, indicate the amount claimed is reasonable for government contracting purposes. Different perspectives between IRS deductions and allowability for government costing purposes are that (1) the IRS rules, that covers compensation for like services by enterprises under like circumstances, considers those payments existing at the date of agreement while for government cost purposes cost of services are considered those on the date when the amount is questioned and (2) excess compensation received by shareholders is considered by the IRS to be a constructive dividend based on distribution of earnings upon stock owned that could be deductible for tax purposes but not considered allowable for government costing purposes.

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