Executive Compensation: Unique Considerations for Government Contractors

HOST: SUSAN MOSER: Good afternoon. Welcome to Cherry Bekaert's GovCon podcast series. I am Susan Moser, industry leader of the Government Contracts Practice.

HOST: SUSAN MOSER: We receive many questions about compensation, and executive compensation in particular, from government contractors. Today's podcast discusses an overview of some unique considerations for government contractors and addresses commonly asked questions.

HOST: SUSAN MOSER: Joining me today are John Ford, a senior consultant in our Government Contracts Practice, and Deb Walker, our director of Compensation and Benefits. John has been with us for more than a dozen years and previously served at DCAA as deputy general counsel and in other roles. Deb advises clients on designing and developing various compensation plans, with a focus on executive compensation.

HOST: SUSAN MOSER: John, can you cover the basics of where compensation is addressed in the FAR, explain reasonableness, and discuss current limitations regarding executive compensation?


JOHN FORD: Let's start with reasonableness. The general reasonableness cost principle is found in FAR 31.201-3 and applies to all costs a contractor incurs. For a cost to be allowable, it must be reasonable, and the criteria for determining reasonableness are listed in FAR 31.201-3.

JOHN FORD: The overarching test for reasonableness is that a cost, in both its nature and amount, cannot exceed what a prudent contractor would incur in a competitive business. That test applies to compensation.

JOHN FORD: Compensation specifically is addressed in FAR 31.205-6. Paragraph (b) of that cost principle addresses the reasonableness of compensation and contains two subparagraphs. One deals with compensation resulting from a collective bargaining agreement; if the agreement was entered into at arm's length, those costs are generally considered reasonable.

JOHN FORD: The other subparagraph deals with compensation that is not the result of a collective bargaining agreement. In addition to the FAR 31.201-3 test, compensation must be reasonable based on factors considered appropriate by the contracting officer. Among those factors are compensation practices of firms of the same size, industry, and geographic location. These are generally the tests DCAA uses in determining reasonableness.

JOHN FORD: Administratively, compensation must be for services rendered in the current accounting period and cannot exceed amounts allowable for tax purposes.

JOHN FORD: There is a dollar limitation that applies across the board to employees. The current limitation is $568,000. The government will not reimburse a contractor for compensation that exceeds that cap for the covered elements of compensation.

JOHN FORD: That cap applies to salary and wages, bonus, deferred compensation, and employer contributions to defined contribution pension plans. Other types of compensation are not subject to that cap. Even when compensation is below the cap, it remains subject to the reasonableness tests in FAR 31.201-3 and FAR 31.205-6.


HOST: SUSAN MOSER: Another common question relates to required disclosures flowed down in some subcontract agreements that require subcontractors to disclose information about their five most highly compensated individuals. How does that reporting work?


JOHN FORD: The requirement is tied to annual registration in SAM. A contractor must report the names and total compensation of its five most highly compensated executives for its preceding completed fiscal year when three criteria are met.

JOHN FORD: First, in the contractor's preceding fiscal year, the contractor must have received 80 percent or more of its annual gross revenues from federal sources, which can include contracts, grants, cooperative agreements, loans, subgrants, and other federal financial assistance.

JOHN FORD: Second, the contractor must have received $25 million or more in annual gross revenues from federal sources. Third, the information must not be publicly available through periodic reports such as SEC filings.

JOHN FORD: All three criteria must be met before the contractor makes that disclosure in SAM. The statute and the clause place the burden on the prime contractor to obtain the same information from subcontractors and report it in a public government database.

JOHN FORD: Two points to note: this reporting can include compensation that exceeds the FAR compensation cap, and the reporting requirement does not indicate what portion of the reported compensation was charged to the government. Second, the computation of "total compensation" for this reporting requires consideration of almost all compensation the executive receives, not just elements subject to the $568,000 cap. The method of computing compensation under the clause, 52.204-10, differs from the compensation cost principle.


HOST: SUSAN MOSER: Deb, can you provide an overview of common executive compensation plans you work with government contractors on?


DEB WALKER: The most common plans involve equity and option plans. There are two kinds of stock options: incentive stock options and nonqualified stock options.

DEB WALKER: Incentive stock options can have favorable tax treatment for recipients, potentially qualifying for capital gains treatment if holding periods are met. Incentive stock options are limited by an annual vesting limit of $100,000, so some recipients receive both incentive and nonqualified options.

DEB WALKER: Employers lose the deduction for amounts not recognized as compensation, so employers sometimes prefer nonqualified stock options. Recipients may also be subject to the alternative minimum tax, which can be affected by incentive stock options, leading some individuals to prefer nonqualified options.

DEB WALKER: Stock appreciation rights provide the right to future appreciation in stock value without an exercise price, and restricted stock or outright stock grants transfer equity to the employee immediately but are often subject to time-based or performance-based restrictions.

DEB WALKER: Recipients of restricted stock can elect to recognize income when the stock is granted rather than when restrictions lapse by making a Section 83(b) election within 30 days of receipt. Startups often miss this election and lose potential tax benefits.

DEB WALKER: Deferred compensation can be elective or non-elective and may take forms such as phantom stock. Current rules require elections to defer salary or bonus to be made before the compensation is earned, and distribution timing generally must be fixed when the election is made. Distribution timing can be accelerated or deferred only in very limited circumstances.

DEB WALKER: The biggest compliance issue with deferred compensation is failure to follow the required election and distribution timing rules. For nonqualified deferred compensation, ensure compliance with Section 409A.

DEB WALKER: To summarize, equity plans require attention to exercise price rules and tax elections, and deferred compensation requires adherence to Section 409A rules.


HOST: SUSAN MOSER: John, any additional comments on the allowability of these types of executive compensation plans?


JOHN FORD: Most of these plans are addressed in the compensation cost principle. As Deb noted, for compensation to be allowable under the FAR, it must be recognized and acceptable for tax purposes. If the IRS will not recognize a plan under tax rules, those costs are generally not allowable.

JOHN FORD: The FAR specifically makes unallowable compensation that is based on changes in the value of stock. Stock option plans and phantom stock plans that base compensation on stock value changes are generally unallowable.

JOHN FORD: Deferred compensation requires analysis under CAS 415 to determine allowability. Incentive compensation related to M&A transactions, such as golden parachutes or golden handcuffs, is not an allowable cost. Contractors should structure M&A arrangements carefully with respect to executive payments.


HOST: SUSAN MOSER: This has been a high-level discussion of a complex area. When companies consider executive compensation plans, they should consider objectives, financial reporting ramifications, tax consequences for both the company and employees, and the allowability of costs under government contracting rules.

HOST: SUSAN MOSER: We typically approach these topics from a team perspective, involving tax, financial reporting, and government contracts compliance specialists. We will present additional podcasts this year on related topics.

HOST: SUSAN MOSER: For more information and our schedule, visit our website at cherrybekaert.com and follow our GovCon podcast series.