Allowable or Unallowable?
Most business owners try to avoid nondeductible expenses for tax purposes per the Internal Revenue Service (IRS) rules. Government contractors take this a step further by avoiding unallowable costs as per Federal Acquisition Regulations (FAR). What makes a cost unallowable? To answer this question, let us first take a brief look at what an allowable cost is.
FAR 31.201-2 lists the criteria for allowable costs. A cost must;
…be reasonable per FAR 31.201-3. This includes not only the amount but also the nature of the cost.
…be allocable per FAR 31.201-4. A cost must have the ability to be assigned to a specific job or necessary to the overall operation of a business and the work it performs. Examples of overall operations includes employee benefits, overhead, and general & administration costs.
…meet the Cost Accounting Standards (CAS) or Generally Accepted Accounting Principles (GAAP),
…fulfill the terms of the contract, and
…meet any limitations set by FAR.
Unallowable costs are any costs not meeting all five of the above criteria. FAR 31.205 expands on the allow-ability of specific costs. Some cost types can be either allowable or unallowable depending on circumstances. Here are some highlights;
To be allowable must be required by the contract and focused on sales to the US Government. If the advertisement is for recruiting employees than the cost must also meet the criteria for FAR 31.205-34 Recruitment costs. If the advertising costs do not meet these allow-ability rules than they are unallowable.
Gifts to employees are unallowable; however, performance and achievement rewards are allowable.
Interest expenses are generally unallowable. Examples of interest expenses are interest on loans and lines of credit. Financial costs also are generally unallowable and include things such as renewal fees on lines of credit and annual fees on credit cards. There are a few rare exceptions in which interest and financial costs could be allowable when they fall under FAR 31.20541(a)(3).
Federal, state, and local taxes are allowable. Federal allowable taxes includes excise taxes as per FAR 29.201. However, federal income taxes are unallowable. Keep in mind fines and penalties charged with taxes are unallowable as they are not considered taxes.
As with any set of rules/laws there are many ‘if this then that, but if that then this’ exceptions. These exceptions can create confusion as to whether a cost is allowable or unallowable per FAR. Unallowable costs affect billing rates charged to the government which affects profit, so these type of costs should be understood and kept to a minimum. For this reason it is vital for government contractors to hire an accountant who specializes in government contract accounting.
Contributed by Jamie M. Shryock, CPA