COMPENSATION FOR PERSONAL SERVICES: Criteria for Allowability
Five general criteria, FAR 205-6(a)(1) through (5), must be met for costs of personal compensation to be allowable.
1. With limited exceptions such as severance pay, deferred compensation, pension and other post retirement benefits compensation must be for work performed in the current year and may not be for retroactive payment for work performed in prior years.
2. Compensation in total must be “reasonable” for the work performed. The cost principle has undergone considerable changes in clarifying what is “reasonable” which is defined in paragraph (b) which we will discuss below.
3. Compensation must be paid in accordance with “an established compensation plan or practice followed so consistently as to imply, in effect, an agreement to make payment”. Does this mean it needs to be in writing? Boards of Appeals have ruled that a compensation policy can be held to exist without being in writing even when costs were incurred for the “first time” (Boeing, ASBCA 46274). On the other hand, a Board disallowed bonus payments when a survey of employees indicated the majority of employees said they did not believe a promise or agreement existed (Petroleum Operations & Support Services, EBCA 291-6). It certainly is easier to prove an established policy or practice if the compensation program is set forth in writing and communicated to employees.
4. There is no presumption of allowability where the contractor has failed to notify the contracting officer of a “major revision” to its compensation plan or practices. Conversely, the author states there will be such a presumption if the contractor notifies the ACO and gives them the opportunity to review the change.
5. Costs unallowable under other cost principles are not considered allowable simply because they are called “compensation”. For example, costs of membership in social, dining or country clubs made unallowable under “Entertainment Costs” are still unallowable even if reported as income to employees.
In addition to these general criteria, the cost principle states that special consideration is required for (1) owners of closely held corporations, members of limited liability companies, partners, sole proprietors or members of immediate family and (2) persons who are contractually committed to receiving a substantial interest in the company. For these people, compensation must not only be “reasonable” but must not constitute a distribution of profits and for owners of closely held corporations, the compensation must be tax deductible.
What is Reasonable
For compensation costs to be considered reasonable, (1) compensation “in total” must be reasonable and (2) each of the allowable elements of the compensation package must also be reasonable.
FAR 31.201-3 provides a list of factors for a cost to be considered “reasonable.” In sum they include the prudent person rule i.e. what such a person would do under normal circumstances. Reasonableness is to be determined on a case-by-case basis and factors to be considered include: (1) whether the cost is recognized to be “ordinary and necessary” “ for conduct of its business (2) results from sound business practices conducted at arm-length and (3) do not significantly deviate from contractors’ established practices.
In addition to the above general factors COs are instructed to consider “other relevant factors” such as (1) general conformity with the compensation practices of other firms of the same size (2) firms in the same industry (3) firms in the same geographic area (4) firms engaged in predominately non¬government work and (5) cost of comparable services that are obtainable from outside sources. Though the regulations give the contractor the discretion to determine which of the above factors are relevant, FAR 31.205-6(b)(1) states the “appropriate factors are representative of the labor market for the job being evaluated”. So, for example, if the firms competing for a contractor’s top executives are larger, national corporations in the same industry, the compensation practices of those firms might be more relevant than comparable practices of companies of the same size or in the same geographic areas.
The author addresses the evolution of these factors. An interesting change was that the burden of proof has changed where it is now put on the contractor when the government challenges total compensation or any element within it. Such a burden is important where, for example, in an earlier case before the change, the courts held that compensation that was 30% higher than average was upheld because the government had not “effectively rebutted” the contractor’s argument its salary was within the range of reasonableness (Lulejian & Associates, ASBCA 20094).
Offsets
Though total compensation and each element of the comp package must be reasonable, offsets between allowable elements are permitted. There have been numerous modifications to the offset provisions through the years but currently section (b)(1) provides that the government will consider not only circumstances surrounding the compensation item being challenged but also the magnitude of other compensation elements which may be lower than would be considered reasonable. The cost principle imposes certain limitations:
1. Offsets will be allowed only between the following compensation elements: (a) wages and salaries (b) incentive bonuses (c) deferred compensation (d) pension and savings plan benefits (e) health insurance benefits (f) life insurance benefits and (g) compensated personal absence benefits.
2. Elements whose amounts are not measurable cannot be used as offset items.
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