One key component to winning the war on talent is to have a quality compensation package that includes bonuses and incentives. Bonus and incentive compensation can be calculated in many ways, take many forms, and be paid out over the short term or the long term.
If you perform work on a government contract, the FAR (Federal Acquisition Regulation) requirements for bonuses and incentives are complex. On top of the complexities, government auditors have a long history of being far-reaching when it comes to disallowing bonus costs. The last thing you need is an awarding agency or government auditor categorically removing incentive pay from your allowable costs, as it often accounts for up to 12% of a firm’s overhead rate. Understanding what incentive and bonus compensation is allowable and documenting your plan appropriately will help you and your employees get the most out of your FAR-compliant incentive and bonus pay.
How Do I Calculate Bonuses and Incentive Pay?
FAR 31.205-6(f)(1) Bonuses and Incentive Compensation says that bonuses and incentive compensation are allowable provided that:
(i) Awards are paid or accrued under an agreement entered into in good faith between the contractor and the employees before the services are rendered, or pursuant to an established plan or policy followed by the contractor so consistently as to imply, in effect, an agreement to make such a payment; and
(ii) Basis for the award is supported.
In other words, you must have an explicit agreement in place OR have a history of bonus payments that is consistently followed, so it functions similarly to an explicit agreement. In addition, either the agreement or the established plan or policy must be in place and understood before the work is performed. Finally, you must support the basis of bonus calculation according to your policy with measurable and verifiable evidence.
While basing bonuses on financial performance is allowable, any calculation based on changes in the price of corporate securities, even if paid in cash, and also dividend payments, are unallowable per FAR 31.205-6(i). Additionally, distribution of profits to related parties is not allowable per FAR 31.205-6(a)(6)(ii)(B). For this reason, we often advise that your policy uses individual performance metrics rather than overall company financial performance leaving no room for misinterpretation.
When Can I Pay Bonus and Incentive Pay?
Ideally, bonus and incentive pay should be paid and allocated to the period in which the bonus objectives were met. There are cases where the bonus obligation cannot be determined prior to payment and may be for work performed in prior periods. FAR 31.206(k)(1) allows costs under that circumstance to be assigned to the period in which the payment is made. At the same time, FAR 31.206(k)(2) says deferred bonuses are unallowable if the bonus is granted after the period when the work was performed. Since this is somewhat vague and confusing, I would avoid this situation and design your bonus so that bonuses are paid and allocated to the period when the work was performed.
For related parties with 50% or more ownership, FAR 31.205-6(a)(6)(iii) defers to the IRS code and states that a company must claim the cost of bonus or incentive pay to majority owners in the same period that it was paid.
How Much Can I Pay as Bonus and Incentive Pay?
A good guide to how much compensation, including bonuses, is allowable is FAR 31.205-6(3), which says that compensation must be reasonable for the work performed. Keep in mind, the burden of proof for reasonableness is on the contractor, not the government. A good rule of thumb is what a prudent business person would do according to industry-established practices.
If you pass all other tests of allowability, finally, your bonuses will be limited by inclusion in the total compensation, which is capped by FAR 31.205-6(p).
Best Practices for the Audit File
Without a doubt, the best practice is to have a written plan or policy in place. The plan/policy should clearly define the effective date, period of the plan, eligible employee or class of employees, performance criteria, bonus calculation with verifiable inputs, the form of payment, when the bonuses are to be paid. The plan/policy should be written to enable an outsider to link an individual to a plan, recalculate the bonus with measurable and verifiable evidence and determine when the bonus should have been paid. If possible, include the FAR reference in any plan or policy to demonstrate an understanding of FAR compliance and internal controls.
It’s best to pay cash bonuses to avoid confusion over the allowability of the form of payment. Try your best to award and pay bonuses and incentives in the period for which they were earned. And always retain support for each employee’s bonus.
Finally, the employees should have a clear understanding before the bonus period of what performance requirements are needed to earn a bonus and be able to explain it to an auditor.
While there may be reasons to deviate from the traditional methods of paying bonuses based solely on financial performance, paying bonuses in stock, or paying bonuses in periods other than performed, it’s always good to consider the administrative headaches that might accompany that decision. This may include needing to explain the matter to those responsible for administering your contracts, reviewing proposals, and ultimately making payment.
To learn more about maximizing your FAR compliant bonus and incentive plan, register for our upcoming webinar.
David brings experience from the government side, having worked within government agencies, both General Services Administration and DCAA. David has a clear understanding of how the system operates to work for your firm. David’s expertise in government procurement across different agencies and interpreting FAR requirements will significantly strengthen your ability to work successfully with government contracts.