Employee Bonuses

We recently came across a situation where a State agency, auditing under FAR cost principles took exception to employee bonuses a contractor paid to its employees because the payout did not comply with FAR requirements. The State auditors were correct in their interpretation and the contractor was unable to recover those bonuses under the State contract. We are also aware of other cases where auditors are agressively pursuing claimed bonus costs. In one case, auditors have assessed penalties against a contractor for claiming "specifically unallowable costs". Its a good time for contractors to review their bonus and incentive compensation policies to ensure they are in compliance with the regulations.

According to FAR 31.205-6(f), bonuses and incentive compensation are allowable provided the 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 payment and the basis for the award is supported.

First of all, there needs to be a written agreement between a contractor and its employees. Too often, companies will come to the end of a successful and profitable year and want to reward its employees by giving them bonuses. That's fine to do so but don't claim the costs as compensation - it doesn't meet the requirements because there was no formal agreement in effect before the services were rendered. A certain level of specificity is implied in this requirement. A policy that provides for an unspecified amount and/or has a discretionary element to it, will not meet the FAR requirement.

Secondly, the bonus (or incentive compensation) must be supported. "Supported" means that the payout must have been calculated and disbursed pursuant to the formal agreement.

Thirdly, as in all matters related to compensation, the amount must be reasonable.

Contractors must have written plans where the criteria for award are clearly stated and understood by the employees. This usually means that the bonuses are performance related. Some contractors have based bonuses on employee performance appraisals. This might work if the appraisal is based significantly on objective rating factors. Bonuses based on subjective appraisals are at risk of being challenged by the Government.

Contractors need to be especially careful about bonuses paid to owners. Bonuses based on profitability is sometimes viewed as a distribution of profits and therefore unallowable.