As a successful company in the architecture and engineering (AE) industry, you probably secure the best hires possible by including an incentive and bonus plan as an element of the total compensation package for both rank and file employees, owners and future owners. For most closely held AE firms, bonuses paid to eligible employees are typically established at year-end and based on final profits of the firm. More often than not, bonuses paid out to the owners of those firms at the end of the fiscal year are clearly a distribution of profits. That is fine and dandy; however, some firms fail to realize payments made under such incentive and bonus plans could be deemed unallowable and excluded from your overhead rate charged on government contracts.

Luckily, this is entirely avoidable.

Compliance can be a big concern for AE firms. According to the Federal Acquisition Regulations (FAR), to be allowable, bonus payments must:

• Be allocable under government contracts
• Be reasonable in amount. “Reasonable” means that the cost is a normal part of a business, and the amount charged makes sense under both accepted business practices (inside your company as well as its industry) and applicable laws; and
• Does not represent a distribution of profits to owners.

FAR 31.205(6)(f)(1) further states that “bonuses and incentive compensation are allowable provided the:

• Awards are paid or accrued under an agreement entered into in good faith between the contractor and the employees before the services are rendered or pursuant to an established plan or policy followed by the contractor so consistently as to imply, in effect, an agreement to make such payment; and
• Basis for the award is supported.”

It is the AE firm’s responsibility to demonstrate that its bonuses are paid in compliance with the FAR’s. Following are our recommendations, which are proposed by the Internal Audit Office of the Washington State Department of Transportation and, for the most part, accepted by various other state departments of transportation.

First, bonus payments should be made pursuant to a written bonus policy to ensure that they are supported and allowable. Written bonus plans should include, at a minimum, the following components:

• Eligibility criteria
• Period of the bonus plan
• Performance criteria (e.g., individual expectations—must be measurable and verifiable criteria)
• Incentives awards/spot bonuses must be related to performance, as measured by quantitative and qualitative factors
• The form of payment to be received
• Distribution timeline

Allowable bonus costs are paid or accrued under an agreement entered into in good faith between the firm and the employee and established and communicated before the services are rendered. The basis for the award must be supported by sufficient documentation. The bonus plan and the awards paid under the plan should be based strictly on measurable performance criteria such as productivity, cost containment, individual contributions toward revenue, or individual employee performance.

Best practices indicate that the bonus pool should be determined early in the fiscal year with documentation of management’s intent to use that pool for bonuses. Many firms accrue their bonus and then pay out that accrual before year-end, which is an appropriate method.

As mentioned above, basing bonus payments solely on the profitability of the firm does not comply with FAR’s. However, a firm may wait until or near year-end to establish the bonus pool and base its bonus in part on the profitability of the firm. When a firm bases its bonus in part on profitability, it is important to remember it will need to demonstrate this overarching condition of profitability and/or funds available was communicated to the employees before the services were rendered.

Two criteria are key to allowable bonuses when a firm waits toward year-end to establish the bonus pool and/or bases its bonus in part on the profitability of the firm:

• Communication with the employees prior to the services being rendered that an overarching condition of receiving a bonus is the firm’s profitability and/or available funds.
• Measurable performance criteria (quantitative or qualitative) having been met by the individual employee as the basis for a bonus award. The auditor should be able to verify the employee bonuses using the company’s methods.

Bonus plans are an important feature in attracting and retaining talented staff. For those contracting with government agencies, discounting the importance of a properly designed and documented bonus plan could hurt your firm in the long run. Staying in compliance with a properly designed bonus plan serves everyone.

If you would like more information or have any questions about how you can create a compliant bonus plan for your AE firm, contact our advisors.