Federal income taxes are unallowable under FAR 31.205-41 while state and local taxes, including property, frnachise, and income taxes are allowable contract costs according to the same cost principle. This is a fairly straight-forward cost principle except when it is applied to Subchapter S Corporations, LLCs, or LLPs.
Contractors that elect one of these "pass-through" entities are not taxed at the corporation level and thus are not normally required to pay state or local income taxes. Instead, the corporate income passes through to the shareholders and is taxed on the shareholders' personal income tax returns. The Department of Defense has taken the position, that state and local taxes that are passed through to the shareholders are not expenses of the contractor and as a result, not allowable costs under Government contracts.
Auditors are being instructed to ensure that these contractors are claiming only those taxes which are required to be paid or accrued by the contractor. Individual shareholder state and local income taxes claimed by the contractor on their pass-trhough income to the shareholders are unallowable and should be questioned.
This might not seem fair to "pass-through" entities but there you have it. Of course the FAR cost principle doesn't really come out and state the DoD position. Possible they are relying on the FAR provision that state and local income taxes must be paid or accured in accordance with GAAP (generally accepted accounting principles) to be allowable. Under GAAP, taxes on pass-through income is not recorded in GAAP compliant accounting records.