Finally, we bring to a close our series on compensation costs. The FAR (Federal Acquisition Regulation) cost principle governing compensation is by far the longest and most complex of all the cost principles. Compensation costs often represent the most significant cost element in contract pricing and incurred costs. As far as the Government is concerned, compensation represents one of, if not the area of greatest risk.
An Employee Stock Ownership Plan (ESOP) is a stock bonus plan designed to invest primarily in the stock of the employer corporation. The contractor's contribution to an ESOP is made with cash, stock, or other property. It is difficult to find someone in the acquisition field that is familiar with ESOPs. Most auditors and contract administrators will spend an entire career without ever having to learn about ESOPs much less having to make recommendations or decisions.
As a general rule, the costs of ESOPs are allowable but there are a few conditions. Some ESOPs meet the definition of a pension plan. Costs of those ESOPs must comply with CAS 412 (compensation and measurement of pension costs). ESOPs that are not pensions, must comply with CAS 415 (deferred compensation). Additionally, contributions in any one year that exceed the deductibility limits of the IRS Code are unallowable.
When ESOP contributions are made with company stock, the value of the stock is limited to the fair market value of the stock on the date that title is effectively transferred to the trust. When the contribution is in the form of cash, stock purchases by the trust in excess of the fair market value are unallowable. Determining fair market value of publicly traded companies is easy. However, in the case of a closely held corporation, the fair market value is not readily determinable so this regulation requires that the valuation be made on a case-by-case basis taking into consideration the guidelines for valuation used by the IRS. As many closely-held companies know, valuation is more art than science and the true value of a company is the price that a willing buyer and seller agree upon. Closely held companies that produce a valuation to support ESOP contributions can expect close scrutiny by the Government.