Reasonableness of Executive Compensation

Executive compensation is a hot topic and has been widely discussed in industry blogs, presentations, webinars, etc. Our discussion of executive compensation applies to all government contractors, whether the compensation of their executives reaches the government compensation cap or not. The 2022 Executive Compensation limit is $589,000.

What is included in “total compensation”?

Before “reasonableness” can be determined, the contractor should first determine each employee’s annual “total compensation,” which includes:

• Annual Base Salary
• Annual Bonus
• Pension or 401(k) Match
• Health/Life Insurance Benefits Paid by the Company
• Auto Allowance
• Other Incentive Compensation (See Aprio’s article on Recommendations on Long-Term Incentive Stock Compensation)

Who qualifies as an “executive”?

DCAA does not specifically define who an “executive” is. Typically, the auditor requests a listing of employees with total compensation greater than $200K and/or the top 5 highly most compensated employees. An “executive” can be defined as an employee who has authority, influence or supervisory responsibilities within the company.

What determines “reasonable executive compensation”?

FAR 31.205-6(b)(2) states that compensation “must be reasonable for the work performed” and Merriam-Webster defines reasonable as “not extreme or excessive.”

“Reasonableness” in government contracting is best measured by comparing compensation to contractors:

• Of the same size;
• In the same industry;
• In the same geographic area; and
• Engaged in similar non-government work under comparable circumstances.

The FAR criteria noted above are fairly objective and are typically the basis for the initial assessment of reasonableness by way of salary surveys. There are a number of surveys in the marketplace and each one provides data based on a different underlying data set. Surveys can be based on data that is nationwide, industry specific, limited based on geography, company size, whether revenues or number of employees, etc. Contractors should utilize the survey data that best approximates their environment.

What are the “subjective” criteria to determine reasonableness?

Once a preliminary compensation range has been determined, contractors can use subjective criteria to influence the specific compensation determination along the range. The subjective criteria, which could cause a contractor to pay an amount higher or lower than the industry average, include, but are not limited to:

1. Experience in the Marketplace/Industry
2. Clearance Level
3. Responsibilities
4. Accomplishments
5. Professional Certifications (CPA, CFE, etc.)
6. Education (MBA, Master’s degree in a relevant area, etc.)
7. Tenure and Contribution to the Success of the Company

Ideally, contractors should sufficiently document all factors which have influenced a particular compensation determination in a manner that would allow defense against audit/inquiry.  This documentation should be provided to the government auditors (DCAA) when requested at the time of audit. Performing this process prior to the government starting the executive compensation audit will ensure that the DCAA will have to prove the contractor’s analysis is wrong, and will have a higher probability of acceptance of the company’s position.

Once “reasonableness” has been established, during the Incurred Cost Submission development process, the company should compare each selected employee’s total compensation to the current year’s annual compensation cap (for 2022, the compensation cap is $589K). The amount over-the-cap should be disallowed and not claimed in the company’s Incurred Cost Submission for the current year. The cost over the cap, if claimed, will be questioned by DCAA as explicitly unallowable and subject to penalty.

It is important to note that for a majority of contractors, the Defense Contract Audit Agency (DCAA) assesses the reasonableness of contractor compensation, through review by DCAA’s executive compensation review team, during audits of contractor Incurred Cost Proposals. When the DCAA measures reasonableness, they utilize the 50% salary for the executive’s position from three salary surveys.  The average of the three surveys has a 10% range of reasonableness (RoR). This results in a conservative compensation benchmark for each company.  If a contractor uses a percentile other than 50% of a salary survey, it is imperative that the company has adequate documentation supporting the executive(s) compensation.  For example, have HR prepare written support explaining why each executive’s compensation is reasonable for the role.

A federal contractor can pay any amount they feel is necessary to recruit and retain an executive.  However, the amount of allowable compensation that can be included in the company’s Incurred Cost Submission is limited by the reasonableness factors and the annual compensation cap, discussed above.  It is up to the contractor to support why the compensation is reasonable if questioned by the DCAA.

Schedule a consultation with Aprio’s Government Contracting team for help with navigating your reasonableness evaluation.