 |
||||||||||||||||||
|
AWR Articles
Executive Compensation Under Federal Government Contracts ON GOVERNMENT CONTRACTING
By Charles L. BonuccelliFor federal contractors, executive compensation has always been an area of complex rules and government scrutiny. Often, the public views government contractors as the “beltway bandits” making millions off the federal government. Yet the federal government has always had many regulations, controls and restrictions governing how many such contractors may pay its executives. Most of those rules still apply to smaller government contractors.
Government contractors may pay their executives any amount. The government does not restrict a company from doing so. However, the regulations provide a guideline on how much compensation should be considered reasonable, and the government does enforce such regulations.
A few years ago, executive compensation was simplified for many large government contractors because the government placed a cap on executive compensation under FAR 31.205-6(p) that states: Limitation on allowability of compensation for certain contractor personnel:
(1) Costs . . . for compensation of a senior executive in excess of the benchmark compensation amount determined applicable for the contractor fiscal year by the Administrator, Office of Federal Procurement Policy (OFPP) . . . are unallowable.
(2) As used in this paragraph—
(2) As used in this paragraph—
(i) “Compensation” means the total amount of wages, salary, bonuses, deferred compensation . . . and employer contributions to defined contribution pension plans . . . for the fiscal year, whether paid, earned, or otherwise accruing, as recorded in the contractor’s cost accounting records for the fiscal year.
(ii) “Senior executive” means
(iii) “Fiscal year” means the fiscal year established by the contractor for accounting purposes.
(iv) “Contractor’s headquarters” means the highest organizational level from which executive compensation costs are allocated to Government contracts. Thus, a new benchmark is established for every year by the government. For 2004, the benchmark was $432,851 and on May 4, 2005, it was increased to $473,318. These amounts apply to the contractor fiscal years 2004 and 2005 respectively.
(ii) “Senior executive” means
(B) . . . the five most highly compensated employees in management positions at each home office and each segment of the contractor, whether or not the home office or segment reports directly to the contractor’s headquarters.
(iii) “Fiscal year” means the fiscal year established by the contractor for accounting purposes.
(iv) “Contractor’s headquarters” means the highest organizational level from which executive compensation costs are allocated to Government contracts. Thus, a new benchmark is established for every year by the government. For 2004, the benchmark was $432,851 and on May 4, 2005, it was increased to $473,318. These amounts apply to the contractor fiscal years 2004 and 2005 respectively.
However, for small, closely-held businesses, executive compensation is still a complex set of rules. The government imposed executive compensation ceiling does not apply, since the government surveyed only companies over $50 million in revenues. This article will go over some of the more onerous rules that are imposed on smaller government contractors and what they need to do to comply with government regulations.
The basis of our discussions will be the rules set forth in FAR Part 31.205-6 that states in part:
(i) Compensation costs for certain individuals give rise to the need for special consideration. Such individuals include:
(ii) For these individuals, compensation must:
(iii) For owners of closely held companies, compensation in excess of the costs that are deductible as compensation under the Internal Revenue Code (26 U.S.C.) and regulations under it is unallowable.
(a) Owners of closely held corporations, members of limited liability companies, partners, sole proprietors, or members of their immediate families; . . .
(ii) For these individuals, compensation must:
(a) Be reasonable for the personal services rendered; and
(b) Not be a distribution of profits.
(b) Not be a distribution of profits.
(iii) For owners of closely held companies, compensation in excess of the costs that are deductible as compensation under the Internal Revenue Code (26 U.S.C.) and regulations under it is unallowable.
The government has used this paragraph in FAR as the basis for reviewing the executive compensation of private or closely held smaller companies. AWR’s experience has been that all companies $50 million or less in revenues may be subjected to executive compensation reviews by the federal government. The government, if it challenges executive compensation, will use reasonableness as its basis for questioning compensation costs.
Reasonableness
The government often uses salary surveys to assess compensation as previously defined in FAR above. The government enumerated the factors in FAR that it considered in determining what is reasonable. Factors that may be relevant include, but are not limited to, conformity with compensation practices of other firms of the same size, in the same industry and geographic area, and are engaged in similar non-government work under comparable circumstances.
In practice, we have seen the government determine that the same industry refers to your SIC code and uses the median national average in determining the executive compensation practices of other firms. It uses more than one executive salary survey to determine what salaries are applicable to specific positions. It then averages the national median salary for each executive position from the surveys and adds 10%.
This process, however, disregards that companies of the same size and in the same industry perform better or worse than average. Using national averages also ignores geographic differences in wages. It also pays no attention to the fact that government contractor executives are governed by laws and regulations with civil and criminal penalties for activities that may simply be breech of contract in the non-government environment. Also, some government contractors are working in hazardous conditions or under strict security for which there is no comparable circumstances in industry.
Taken together, the regulations provide a reasonable basis for measuring executive compensation. Simply put, a company should pay its executives no more than executives in the same industry, engaged in similar commercial work under comparable conditions, in the same area and of the same company size. This is logical in theory but difficult in practice to measure. However, the government at any time can challenge the reasonableness of the executive salaries and the burden of proof is on the company. The FAR states:
31.201-3 — Determining Reasonableness. If an initial review of the facts results in a challenge of a specific cost by the contracting officer or the contracting officer’s representative, the burden of proof shall be upon the contractor to establish that such cost is reasonable (Emphasis added).
The government has taken its responsibility seriously and does not question executive compensation on a whim, but it often applies general rules to contractors that do not fit every single set of circumstances. Thus, every time the government challenges the reasonableness of the executive salaries, the company must respond in a factual and supported way.
The company is given the recommended cost disallowance and compensation survey conducted by the government to review and comment on. The survey indicates that the company is paying its executives too much. The first task for the company is to analyze the government’s compensation review for obvious mathematical errors, omissions or misstatements of facts.
Sometimes, a company can add its own more relevant survey to the government results or demonstrate that one of the surveys used is inappropriate. Other times, the wrong revenue amount is used for the company. As the incorrect data is identified, the government may revise its data and adjust its result.
The second task is to analyze the assumptions used by the government. This may address what the government did not consider more than what it did consider.
Often, the government takes a simplified approach to analyzing executive compensation. Significant questions that arise in this area are:
- Did it consider company performance orunique operating circumstances that make it harder to attract and retain qualified executives? This is certainly the case when the executives require security clearances.
- Did it adjust for the unique conditions that executives work under? An example is that operating a munitions factory is not the same as operating a widget factory.
Let us also face the fact that some companies are better run than others. The executives of well-run companies are normally compensated better than poorly run companies. Applying a peanut butter approach to compensations reviews will understate the value of executives at well-run companies. The company may use standard financial measures and compare them to the average industry measures to demonstrate how well the company is performing.
The third task for the company is to get an independent firm to conduct an executive compensation survey and compare the results with the results the government came up with. This is a reasonable way to justify differences and adjust the unallowable costs to an appropriate amount. The government is willing to consider such surveys where the methodology takes into account the unique requirements of FAR 31.025-6. The independent executive compensation surveys can also quantify the differences between the blanket approach in most government surveys with a tailored approach suited to the company.
Recommended Approach
The best approach is for a company to be proactive. Periodically, the company should have an executive compensation survey completed by an outside firm tailored to the unique circumstances of the firm. The survey should be completed before a government audit of provisional indirect cost rates or an incurred cost audit is done. There are several reasons for such a survey to be completed before the government completes its own:
- It is a good management tool to assess that your executives are being compensated appropriately.
- The data can be used for planning purposes.
- Such data is the support for amounts included in overhead and G&A submissions.
If a company has a good process in place to assess the reasonableness of the executive compensation and the executive compensation is at or below that amount determined by the process, the government may use the results of the survey. The government will review the process and the assumptions used by the company. As long as those assumptions comply with the requirements of FAR 31.205-6, they will accept the result.
AWR has helped a number of clients in the executive compensation area. In all cases, our clients were able to reduce the amount of executive compensation disallowed by the federal government. The government openly discussed and agreed to the reasonable adjustments we recommended based on our observations, additional data or the executive compensation surveys we conducted. AWR also conducts executive salary surveys for clients that objectively determine reasonable executive compensation based on the requirements of FAR 31.205-6.
Companies with less than $50 million in revenues need to realize that executive compensation is still an area that the government will review. Ultimately, it would greatly benefit a company to have an independent firm conduct an executive compensation survey for planning and budgeting purposes before the government conducts its own and questions executive compensation costs.