Sometimes Bonuses Are Not Bonuses but Are Distributions of Profit

It happens a lot. Closely held companies will close out their books for the fiscal year and find they had a pretty good year financially and so the executives (also the owners) declare a bonus. We've talked about bonuses on these pages before. See for example this page. The basic criteria for allowability is that bonuses must be paid pursuant to an established plan or policy followed by a contractor so consistently as to imply, in effect, an agreement to make such payments. So, most contractors will have written policies and procedures and board minutes to support bonus plans - even if bonuses are discretionary from one year to another.

But there's additional criteria for closely held businesses. FAR 31.205-6(a)(6) states that compensation costs for certain individuals give rise to the need for special consideration. Such individuals include owners of closely held corporations, members of limited liability companies, partners, sole proprietors or members of their immediate families. For these individuals, compensation must be reasonable for the personal services rendered and not be a distribution of profits (which is not an allowable contract cost).

So, how does one go about determining whether a bonus is truly a bonus and not a distribution of profits? Therein lies the challenge. Government auditors, for certain, are going to take the position that any bonus paid to an owner of a small or closely held business represents a distribution of profits and therefore unallowable. That always puts the contractor on the defensive. Fortunately, there is some guidance on the matter from the ASBCA (Armed Services Board of Contract Appeals).

In Lulejian and Associates, the ASBCA looked at several factors to assess when a bonus was actually a distribution of profits (see ASBCA 20094 from 1976). These were:

1. Whether any dividends were declared (i.e. whether the bonus was actually a disguised dividend)
2. How large a share of the bonus pool was allocated to the top executive(s)
3. How "substantial" the rest of the compensation was.

In the Lulejian case, the Board ruled that because there were no dividends declared, the top four executives garnered 51% of the bonus pool, and their compensation was otherwise substantial, the bonus represented a distribution of profits and therefore unallowable. In a later case (see SplashNote Systems, ASBCA No. 57403), the Board found that no dividends were paid and the top executive garnered 71% of the pool. Although compensation was reasonable, the company failed the other two tests and therefore the bonus was a distribution of profits and unallowable.

Closely held corporations should assess the propriety of bonus costs using the three criteria established by ASBCA.