The Defense Contract Audit Agency (DCAA) created the Mid-Atlantic Compensation Team outside Philadelphia to centralize the process for reviews of executive compensation. The MCT follows a very rigid process to determine the reasonableness of executive compensation for contractors. However, recent court cases have challenged their processes and provide new weapons for the contractor to defend such attacks.

FAR 31.205-6(b)(2) states that compensation must be reasonable. It further defines distributions of profits commonly found in an S Corp or LLC as unallowable costs. Thus, as a privately held company, there is an incentive for the owner to attempt to include profit distributions in his/her individual compensation, which would then be paid for by the government through indirect rate reimbursement.

DCAA’s process

In general, the contractor is required to complete Schedule T found in the Incurred Cost Submission Template. Schedule T is then sent to MCT for analysis. The analysis consists of comparing the information in Schedule T to salary surveys the government subscribes to using the following criteria:

• Employee Title, i.e., president, CEO, CIO, CFO
• Company Revenues
• Company Location
• Primary North American Industrial Classification System (NAIC) Code

DCAA’s survey analysis (DCAA generally picks three surveys) utilizes the 50th percentile plus a 10% range of reasonableness. This value is compared to the compensation in Schedule T to determine the value of unallowable executive compensation. In theory, DCAA is comparing a contractor’s executive compensation to the executive compensation of like or similar businesses.

Court cases

Court cases define contractor strategies to contest the disallowed executive compensation

In 1996, the TechPlan case established the use of contractor financial performance metrics to justify a percentile above the standard 50th percentile used by DCAA. Many contractors now argue that their strong financial performance metrics justify use of the 75th percentile.

In 1997, the ISN case eliminated the contractor’s “multiple hats” argument, in which the contractor argued that if an executive performed multiple roles, such as CEO and CFO, allowable compensation should reflect the compensation of two positions and not one. The ISN case limited allowable contractor executive compensation to only one executive position for each executive employee.

In 2012, J.F. Taylor successfully challenged DCAA’s findings that the compensation of four executives was unreasonable. J.F. Taylor successfully argued that the methodology used by DCAA was statistically flawed and therefore unreasonable. This case is forcing DCAA to rethink their methodology and provides the contractor with new defenses when challenged.

In 2012, Metron, a company staffed with statisticians, proved that the surveys used by DCAA were not applicable to their business. Metron successfully argued that only one salary survey, Radford, was representative and applicable when determining reasonable executive compensation. The Metron case provides the contractor with the ability to challenge the selection of the surveys utilized by DCAA.

The J.F Taylor and Metron cases question whether the processes used by the MCT are a reliable and reasonable basis for disallowing the executive compensation of contractors. These cases may make it easier for a contractor to successfully reduce or eliminate executive compensation costs deemed unallowable by DCAA.

What can contractors do?

1. Obtain a working knowledge of the DCAA processes.
2. Request copies of the surveys used by DCAA to verify that they are applicable to your business. Look for small sample sizes that may result in skewed and unreliable compensation data, and for surveys that are poor fits to your business.
3. Complete Schedule T carefully so that the executive titles and NAICS code yield the highest executive compensation.
4. Have written compensation policies that include bonuses, 401K matches and any compensation that is specific to executives.
5. Obtain your own survey to reasonable compensation.
6. Challenge the 50th percentile used by DCAA with financial performance metrics and discriminators that include security clearances and proposal win rates.

8(a) contractors

8(a) contractors also must comply with the compensation limits found in CFR title 13, section 124.113. Distributions to pay taxes under an S or LLC corporate structure are excluded from the compensation limits.

The DCAA is looking at eliminating the salary survey process and replacing it with a cap equal to the $199,700 salary of senior federal executives. This amount is significantly less than the current cap of $763,029.

Summary

I recommend that you understand the DCAA process used to disallow executive compensation and the strategies used by contractors to challenge the executive compensation. These strategies may be more effective today because of the recent successful court challenges, J.F. Taylor and Metron.

Wayne Clark, CPA is a Senior Manager with Federal Strategies Group, LLC. He provides government contract and management consulting, M&A advisory, forensic accounting and expert testimony to the government contracting industry. He can be reached via email at WayneC@FedStrat.com.