We have received a number of inquiries from clients related to cost allowability for Employee Stock Ownership Plans (ESOPs). In this Part II, we focus on the cost allowability rules and regulations for government contractors (Part I provided a more general description of ESOPs).
Employee Stock Ownership Plan, FAR and CAS rules
An Employee Stock Ownership Plan (ESOP) is an individual stock bonus plan which invests in a company’s stock. Regulatory requirements governing the allowability of ESOP payments are contained in FAR 31.205-6(q) and CAS 415. ESOP costs are allowable to the extent they are reasonable as long as they meet certain requirements. FAR 31.205-6(q)(2)(i) specifically incorporates the requirements of CAS 415 for measurement, assignment, and allocation of ESOP costs. Accordingly, CAS 415 requirements related to ESOPs apply even if the contract is exempt from cost accounting standards. The following general requirements apply under FAR 31.205-6(q):
- Contributions cannot exceed the deductibility limits of the Internal Revenue Code for that year, and contributions exceeding that limit are unallowable;
- Contributions in the form of stock are limited to the fair market value of the stock on the date of the transfer to the ESOT;
- Stock purchases by the ESOT in excess of fair market value are unallowable;
- For non-leveraged ESOPs, when stock purchases exceed the fair market value, the contractor must credit the amount of the excess to the same indirect cost pools that were charged for the ESOP contributions in the year in which the stock purchase occurs;
- For leveraged ESOPs, when the ESOT purchases the stock with borrowed funds which will be repaid over a period of years by cash contributions from the contractor, the contractor must credit the excess price over fair market value to the indirect cost pools pro rata over the period of years during which the contractor contributes the cash used to repay the loan;
- When stocks are not publicly traded, an independent appraisal must be performed to determine fair market value.
The following additional requirements apply under CAS 415 provisions:
- The cost is assigned to the cost accounting period in which the payment is made;
- The cost is the amount contributed to the ESOP by the contractor;
- The cost is measured by the contractor's contribution, including interest and dividends if applicable, to the ESOP;
- For stock or property, cost is measured based on the market value or fair market value of the stock or property at the time the contributions are made;
- ESOP costs are assignable to a cost accounting period only to the extent that the stock, cash, or any combination thereof resulting from the contribution is awarded to employees and allocated to individual employee accounts by the tax filing date for that period, including any permissible extensions;
- All stock or cash that is allocated to the individual employee accounts between the end of the cost accounting period and the tax filing date for that period must be assigned to the cost accounting period in which the employee is awarded the stock or cash;
- Any portion of the stock or cash resulting from a contractor's contribution which is not awarded to employees (or allocated to individual employee accounts) by the tax filing date for that period, including any permissible extensions is assigned to a future cost accounting period or periods when the remaining portion has been awarded to employees and allocated to individual employee accounts;
- This stock retains the value established when it was originally purchased by or otherwise made available to the ESOP.
Employee Stock Ownership Plan, Risks and Audit Concerns
- DCAA will apply the same reasonableness criteria to ESOPs that it applies to any other element of compensation, and will review it in relation to aggregate compensation for individual employees and consistency with contractor policies and practices. Accordingly, having written policies and procedures for ESOPs is critical.
- ESOPs for stock that is not publicly traded is particularly problematic. DCAA will attempt to discount the valuation of the stock for both the lack of marketability and to reflect a minority interest when the ESOT has not purchased a controlling interest in the company. Both discounts are highly subjective; however, a competent independent appraiser should have considered these in determining fair market value.
- DCAA guidance states in part “tax regulations allow companies with leveraged ESOPs to deduct dividend payments used to service ESOP debt. Some companies use the dividends applicable to allocated, unallocated, or both to satisfy their annual ESOP contribution requirements.” The guidance goes on to require DCAA auditors to question these costs as expressly unallowable dividend payments under the provisions of 31.205-6(i)(2) regardless of whether the dividends are paid directly to the employees, credited to employee accounts, used to service the ESOP debt, or used to acquire additional shares. FAR 31.205-6(q)(2) (which specifically addresses ESOPs) states the costs of ESOPs are allowable when in addition to other conditions, “(i) The contractor measures, assigns, and allocates costs in accordance with 48 CFR 9904.415.” CAS 415.50(f)(1) states “the contractor’s cost shall be measured by the contractor’s contribution, including interest and dividends (emphasis added) if applicable, to the ESOP.” Accordingly, we do not agree with DCAA’s position regarding the allowability of dividends with respect to ESOPs.
- Per DCAA guidance, contributions to the ESOT to cover the principal and interest on the loan taken out by the ESOT to buy stock are allowable. However, if the company takes out the loan (as opposed to the ESOT) and uses the loan proceeds to make the contribution to the ESOT, the interest on the loan will be expressly unallowable under the provisions of FAR 31.205-20. As with dividends, we do not agree with DCAA’s interpretation that this specific interest is unallowable.
- For leveraged ESOPs, there have also been some additional issues with respect to DCMA financial capability reviews because of the impact of ESOT loans on DCMA’s calculation of financial ratios (particularly debt to equity ratios).
Employee Stock Ownership Plans have risks, but properly implemented, they offer financial rewards to the company as well as its employees. If contemplating an Employee Stock Ownership Plan, Redstone Government Consulting can assist, particularly as it relates to maximizing cost allowability and minimizing audit risks.