• Income Tax Differential Pay

• Bonuses and Incentive Compensation

Use of bonuses has proliferated in recent years, especially where bonuses and incentive pay are based on corporate performance.  Some considerations include if the bonus or incentive pay is deferred, the costs must satisfy the allowability criteria for deferred compensation (discussed below) or if they relate to business acquisitions and mergers special rules apply (also discussed below). Auditors will commonly look for ways to challenge the basis for payment.  For example, bonuses paid on the basis of total sales might be questioned because they would result in an improper cost-plus-percentage-of-cost contract. Or, auditors may assert that bonus or incentive compensation was not paid pursuant to an agreement entered into before the services were performed.  To counter this assertion it should be noted that employees need not have had the right to receive the bonus provided there was a reasonable expectation the bonus would be paid (Boeing Aerospace, ASBCA 46274). Also, Appeals boards have held that some management discretion in making payments is permissible (Boeing Co., ASBCA 24089).

• Severance Pay

Severance pay is considered payment in addition to salary and wages to workers whose employment is being involuntarily terminated.  The costs must be reasonable and either required by law, employee-employer agreement, established policy that effectively constitutes an implied agreement or part of the circumstances for employment. The payment is unallowable if the employee is employed by a replacement contractor or employed by an affiliate of the contractor.  “Normal” severance pay must be allocated to all work performed in the contractor’s plant. Though accruals for “abnormal” or “mass” severance is not permitted, the Government is obligated to pay “its fair share” of the payment.  ITT Federal Services Corp (ASBCA 46146) held that the contractor is not entitled to recover severance costs under fixed-price contracts if not included in its proposed overhead rate.

Though earlier regulations prevented both severance and early retirement pay, later changes to the cost principle allows the cost of both as long as the present value of the early retirement pay package does not exceed the employee’s annual salary for the fiscal year before their retirement (J)(6)(iv).

There have also been changes to employee release agreements where employees are given more severance pay than they would otherwise receive in exchange for releasing the contractor from potential liability for wrongful termination.  DCAA initially took the position such costs were unallowable because they represented payment for work not performed. DOD firmly rejected DCAA’s position, forcing DCAA to issue guidance prohibiting auditors from questioning such payments because they are unallowable backpay for work not performed and directed auditors to examine such payments on a case-by-case basis for reasonableness.

Special rules were adopted for severance pay to foreign nationals employed under service contracts performed outside of the US.  Such costs cannot exceed amounts typically paid to employees providing similar services within the US and they are not allowable if the foreign national’s employment was terminated as a result of a closing or curtailment of activities at a US facility at the request of that country’s government. This limitation used to apply to only DOD but recent services contracts let by other agencies have made the limitation apply government-wide.

• Backpay

The most substantive changes made in 2003 were changes affecting section (h) of the cost principle, backpay.  Before the changes cost of backpay was unallowable only when it resulted from a violation of federal labor laws or the Civil Rights Act. The 2003 revision made all backpay unallowable unless it was for work performed but underpaid.  Commentors to the proposed changes stated several types of reasonable backpay compensation would be unallowable under the changes e.g. retroactive adjustments to salary and wages, payments made before there was any ruling about federal labor or civil rights violations, settlements made to wrongful discharge cases to reduce litigation costs. In spite of what the author states was a significant change, the government simply asserted the 2003 changes were nothing more than “clarifications” of earlier rules.

• Corporate Securities

Compensation, especially for executives, frequently includes payments in the form of contractor’s corporate securities such as stock options and stock appreciation rights. The government has imposed additional restrictions on allowability of this form of compensation:

1. Securities must be valued at their fair market value on the “measurement date” (the first date the number of shares awarded is known).

2. Accruals for the cost of the securities before issuance to employees must take into account the possibility some employees’ interests in the accrual will be forfeited.

3. Compensation calculated or valued on the basis of changes in the price of the securities (e.g. stock appreciation rights, phantom stock plans and junior stock conversions) are unallowable.  This is true even if the payments otherwise meet the criteria for incentive compensation. Prior to 1996, the cost principle was frequently revised to account for new creations of stock-based compensation e.g. stock appreciation rights, phantom stock plans, etc.  In 1996 the cost principle was revised to provide a “general allowability rule” for stock-based compensation not tied to any particular type.

4. For stock options, allowable costs are limited to the difference between the option price, if lower and the market price of the stock on the first date both number of shares and option price are known. Since option prices are generally equal or greater than the market price, stock options are generally unallowable.

5. Compensation in the form of dividend payments are unallowable because they are considered “distribution of profits”.

• Pension and Other Post Retirement Benefits

Pension Plans. Paragraph (j) contains rules governing allowability of pension costs. There are two types of pension plans: (a) defined benefit, where benefits are determined in advance and the contractor makes contributions deemed necessary to provide the benefits and (b) defined contribution, where contributions are defined in advance and benefits vary depending on the plan’s actuarial and investment experience. The “funded pension cost” is the portion paid to a funding agency established to accumulate the contributions and subject to limitations in (j)(1) through (6) the costs of the pension plans are allowable provided they are measured, allocated and accounted for in accordance with CAS 412 and 413. Pension payments must be reasonable, paid pursuant to a good faith agreement entered into before the work or services were performed and consistent with an established pension plan. Cost of living adjustments are allowable if part of a policy or practice.  Pension costs must be funded by the time set for filing the contractor’s federal income tax (including any extension for filing). If not funded and absent a waiver under the Employee Retirement Income Security Act of 1974, any pension costs assignable to the current year are unallowable and may not be charged to any future year.  Moreover, increased costs caused by delays in quarterly contributions are also unallowable. On the other hand, premature funding of pension plans must be charged to the period they would be assignable. The costs of changes in a pension plan that are discriminatory to the government or not intended to be applied consistently for all similarly situated employees are unallowable. With the exception of early retirement benefits, one-time only supplemental benefits not available to all participants of the basic plan are unallowable unless they represent a separate pension plan and the benefits are payable for life at the option of the employee.

Early Retirement Benefits. These costs must be accounted for and allocated in the same manner as pension costs – payments must be made in accordance with the contractor’s early retirement incentive plan and applied only to active employees.  In addition, the total allowable amount of such incentive payments may not exceed those employees’ annual salary for the fiscal year prior to retirement.

Post Retirement Benefits.  Like other costs, PRB must be reasonable and incurred pursuant to law, employee-employer agreement or an established plan. PRB costs must be accounted for on a cash, terminal funding or accrual basis.  Like pension costs, they must be funded by the federal income tax return filing date and increased costs caused by delays to quarterly payments are unallowable. The allowability of PRB attributable to past service is limited to the amount that would be assigned under the “delayed recognition” provisions of Financial Accounting Standards Statement 106 no matter what method was used by the contractor for financial accounting purposes.  Most notably, though FAS 106 requires use of the accrual basis for financial purposes, a government contractor may select the cash basis (recognized when benefits are paid) or terminal funding (lump sum liability paid is amortized over 15 years) for government costing purposes.

• Employee Stock Ownership Plans

The compensation cost principle defines an employee stock ownership plan (ESOP) as “a stock bonus plan designed to invest primarily in the stock of the employer corporation.”  ESOPs are generally administered by an employee stock ownership trust (ESOT) to which the employer makes annual contributions in the form of stock, cash or property. ESOP benefits must be paid or is payable at the option of the employee for life. ESOPs are classified as leveraged or non-leveraged. Under a leveraged ESOP, the ESOT borrows money to purchase the stock of the contractor where the stock is held by the lender as collateral until the loan is paid. Thereafter, the contractor makes contributions to the ESOT in an amount equal to the principal and interest on the ESOT’s loan and the ESOT uses the contribution to pay off the loan (one of the few times “interest” costs are allowable). As the loan is repaid, the lender releases the stock which is then distributed to the ESOT to participating employees where they, in turn, typically receive the stock or cash equivalent upon retirement or termination from the plan.

Though the article addresses a lengthy history of regulations affecting ESOP costs, the final rule changes in 2004 are the most comprehensive. The changes (1) moved ESOP coverage to a new paragraph (q) in the cost principle (2) if an ESOP meets the definition of a pension plan its costs must be measured, assigned and allocated in accordance with CAS 412, pension costs while if it does not meet the definition of a pension plan, the ESOP costs must be so measured in accordance with CAS 415, deferred compensation (3) ESOPs must be funded by the time set for filing federal income tax returns, including extensions (4)  ESOP contributions exceeding tax deductibility limits are unallowable (5) if contributions are in the form of stock, the cost is limited to the fair market value of the stock on the date title is transferred to the trust (if FMV is not easily determinable – say, closely held corporations then the valuation is made on a case-by-case basis using IRS valuation guidelines) and (6) when contributions are in the form of cash, stock purchases by the ESOT in excess of fair market value are unallowable. If stock purchases are in excess of fair market value the contractor must credit the amount of excess to the same indirect cost pool that were charged for the ESOP contributions in the year of the stock purchase.

• Deferred Compensation

Deferred compensation refers to compensation in a future cost accounting period for services in one or more prior periods.  It does not include year-end accruals for salary, wages or bonuses paid within a reasonable period of time. To be allowable, deferred compensation must be based on current or future services and be measured and accounted for in conformity with Cost Accounting Standard 415 (whether or not the contractor is CAS covered). CAS 415 requires costs be (1) measured by the present value of future benefits to be paid using the discount rate established by the Secretary of Treasury at the time the cost is assigned and (2) assigned to the cost accounting period the contractor incurs the obligation. Six other conditions must be met for deferred compensation to be allowable in the current period:

a. The requirement to make future payments cannot be unilaterally avoided by the contractor
b. The compensation award must be satisfied by future payment of cash, stock or other assets
c. he amount of future payment must be determinable with reasonable accuracy
d. The recipient of the award must be known
e. If receipt of the award is based on occurrence of future events, there must be a reasonable probability that such events will occur
f. For stock options, there must be a reasonable probability the options will ultimately be exercised.

If any of these conditions are not met, then the cost must be assigned to the cost accounting period the payment is actually made.

• Payments Related to Mergers and Acquisitions

Two types of employee payments related to M&As are unallowable. First, “golden parachutes” where payments are made to employees under agreement where they receive special compensation in excess of normal severance pay if their employment is terminated as a result of a change in management control or ownership.  Second, “golden handcuffs” are unallowable as part of payment made to keep employees when management control or ownership changes.

In addition, DOD Appropriations Acts since 1996 have prohibited bonus costs in excess of normal salary when such payments are part of the restructuring costs associated with a business combination.  This limitation does not apply, however, to severance payments or early retirement payments.

• Fringe Benefits

Fringe benefits are defined as allowances in addition to regular wages and salaries.  Fringe benefits commonly include free parking, use of company-owned cars, life and disability insurance and ownership in social, dining or country clubs as well as normal fringe benefits provided to all employees (e.g. health insurance, vacation/sick/holiday leave, etc.). To be allowable, the costs must be reasonable and required by law, employer-employee agreement or established policy.

Fringe benefits, whether or not included as taxable income to the employee, are also considered in determining the overall compensation paid to the employee which must be reasonable. The statutory “cap” imposed by the Department of Defense in earlier years included fringe benefits but that has been eliminated where now the cap does not include fringe benefits.

Certain fringe benefits are unallowable. These include (1) employee rebates and purchase discounts (2) personal use of company-furnished automobiles, including home-to-work transportation and (3) costs of memberships in social, dining and country clubs.

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