The allowability requirements for employee compensation in FAR Part 31.205-6 , Compensation for personal services, often become a point of contention between contractors and government agencies when reviewing indirect cost rates.  While the regulatory compensation cap specified in FAR 31.205-6(p), Limitation on the allowability of compensation, of $589,000 for calendar year 2022) represents a defined and objective measurement for total allowable compensation.  Other provisions within the Compensation section introduce further “reasonableness” requirements.  This secondary, subjective criterion generates significant debate and disagreements.

Companies typically use salary surveys to assess whether compensation paid to employees is reasonable based on their roles and responsibilities.  The National Compensation Matrix (NCM) issued by the American Association of State Highway & Transportation Officials (AASHTO) provides one option for salary survey data; however, it only applies to companies with total revenues of less than $500M.  Further, the NCM only covers a very narrow range of executive positions, and it is often difficult to map the NCM’s executive positions to an individual company’s organizational structure.  Further, the mechanics of the NCM’s salary calculations are obscure and the supporting survey data are not transparent and subject to conjecture.  As if all of that is not bad enough, our experience is that companies using the NCM typically have poor outcomes (i.e., significant executive compensation disallowances).

Alternatively, and as a best practice, companies should obtain their own salary surveys and use them in the reasonableness portion of the excess compensation analysis.  Again, this presents difficulty in the ability to obtain survey data which perfectly align with a company’s industry, geographic location, scale of operations, etc.  This is particularly true for smaller, privately-held companies.  Should a company overcome these hurdles, it still faces the arduous task of claiming “superior performance.”  

Recent Trends –

•    Many government agencies expect companies to uniformly apply survey data based on the 50th percentile rather than a higher tier (i.e., 75th percentile) without consideration for current fiscal year performance.  This would seem to suggest that half of all companies are overpaying their employees while the other half are underpaying their employees – the logical and statistical validity of which is questionable at best.  

•    Compensation Awards – Various agencies also routinely question specific types or employee compensation, such as bonuses.  Although the FAR requires that the basis for such awards is supported, companies rarely follow the rigid formulaic approach preferred by the regulatory agencies but not specifically required under the relevant guidance.  For instance, state DOT’s sometimes impose additional arbitrary requirements on bonus payments in an effort to disallow the bonuses leading to disagreements.

•    Closely-held Companies – Smaller, closely-held companies face even greater scrutiny in that any compensation awarded to the owners is questioned as a potential distribution of profit.  This can create form-over-substance debates in that bonuses are generally allowable but profit distributions are not.  From a practical standpoint, smaller companies focus on overall cash management and the payment of cash as bonus vs. profit has the same effect on the bottom-line, which contributes to the classification of these payments as a gray area.

These current trends in excess comp as part of indirect cost rate reviews by government agencies add to the frustration of companies that have made a good faith effort to properly evaluate compensation and calculate their rates.  Navigating the regulatory compensation guidance and understanding the nuances between federal and state & local agencies can be a complex and frustrating challenge.  

Please contact us to learn more about how we can help your company.