Government Contractor Accounting and Deductions: Allowable Isn't Deductible, the Indirect Rate Pools, and the Incurred Cost Submission

A small business that wins a federal contract inherits a second set of books. The government decides which costs it will reimburse under the Federal Acquisition Regulation's cost principles; the IRS decides which costs are deductible under the tax code. The two lists overlap but do not match, and a contractor's accounting system has to answer both — tracking every cost by contract, separating direct from indirect, pooling indirect costs into rates, and recording hours daily. The tax return is built from the same ledger, with the differences reconciled.

Allowable is not the same as deductible

The cost principles in FAR Part 31 list costs the government will not pay: interest, entertainment, alcohol, bad debts, lobbying, most advertising, fines and penalties, contributions, certain legal costs, and compensation above a federal cap. Several of those are deductible for tax — interest and bad debts, for example — and some tax deductions have no place in a cost proposal, such as depreciation claimed under bonus rules faster than the government recognizes. The accounting system must identify unallowable costs so they are excluded from billing rates and proposals, while the tax return takes every deduction the code allows. Failing to segregate unallowable costs is a common audit finding, and unallowable costs left in a final indirect cost rate proposal can draw penalties; on the tax return, deducting the ones the code allows is correct.

Job costing and the direct–indirect line

Every cost is either direct — traceable to one contract (labor on the job, materials, travel for it, subcontractors) — or indirect, benefiting more than one (rent, management, accounting, benefits). Direct costs are charged to the contract that caused them. Indirect costs are collected in pools and allocated across contracts by a base that reflects how they are consumed. A cost cannot be direct on one contract and indirect on another; consistency is itself a compliance requirement.

The rate pools

| Pool | Typical contents | Typical allocation base | |---|---|---| | Fringe | Payroll taxes, health insurance, retirement contributions, paid leave | Total labor dollars | | Overhead | Costs of supporting the people who do the work: supervision, facilities for project staff, project equipment | Direct labor dollars (sometimes separate pools for on-site and off-site work) | | General and administrative | Executive salaries, accounting, legal, business development, corporate facilities | Total cost input (all costs except G&A) |

Each pool's rate is the pool's allowable costs divided by its base. Provisional billing rates — estimates set at the start of the year — are used to bill cost-type contracts during the year; actual rates are computed after year-end, and the difference is settled. Rates matter for pricing fixed-price work too, since they are the cost base the proposal is built on.

Timekeeping

Labor is usually the largest cost and the one the government trusts least. Every employee, including owners, records hours daily by contract or indirect account; changes are documented; supervisors approve; and the system prevents after-the-fact revisions without an audit trail. Floor checks — unannounced verification that people are working on what their timesheets say — are a standard audit step. The same records support the tax return's wage allocation and, for research work, the research credit.

The incurred cost submission and the accounting system review

Contractors with cost-reimbursement contracts submit an annual incurred cost proposal within six months after the fiscal year-end, reporting actual costs and rates so the government can settle the year. Before awarding a cost-type contract, the government reviews the accounting system against a checklist (the SF 1408 criteria): proper segregation of direct and indirect costs, consistent allocation, timekeeping, identification of unallowable costs, and the ability to accumulate costs by contract. A commercial accounting package can pass if configured for job costing and supported by written policies; many small contractors use specialized software.

Tax issues specific to contractors

The research credit excludes funded research — work where the contractor keeps no substantial rights in the results or is paid whether or not the research succeeds — so most cost-reimbursement research contracts do not generate the credit, while fixed-price development work where the contractor keeps rights may. Long-term contracts to manufacture, build, install, or construct property (not service contracts) may fall under the percentage-of-completion rules for tax. Work performed at government sites in several states creates income tax and payroll obligations in those states, and prevailing-wage requirements on construction contracts add certified payroll. Government payments are reliable but slow; the Prompt Payment Act pays interest on late invoices, which is taxable income.

Worked example. A 20-person engineering firm holds two cost-plus contracts and one fixed-price contract. Its fringe rate is 32 percent of labor, overhead 45 percent of direct labor, and G&A 14 percent of total cost input. An engineer billed at $100,000 of direct labor carries $32,000 of fringe, $45,000 of overhead, and $24,780 of G&A (14 percent of the $177,000 subtotal) — $201,780 of loaded cost the government reimburses, before fee. The firm paid $9,000 of interest on its line of credit and spent $6,000 on a client appreciation dinner: both excluded from the pools as unallowable, both deducted on the tax return (the dinner as a 50 percent business meal; any entertainment portion, such as a show, is not deductible at all). Its incurred cost submission is due six months after year-end, and the actual overhead rate came in at 43 percent — the over-billing at the 45 percent provisional rate — $2,000 on this engineer's $100,000 of labor, plus the $280 of G&A on it — is refunded to the government.

Official sources

The Defense Contract Audit Agency explains: “This checklist should be used by contractors new to government contracting, that have cost reimbursement contracts, or contractors that are receiving progress payments, to document how their accounting system is designed to meet the SF 1408 criteria.” — Defense Contract Audit Agency, Pre-award Accounting System Adequacy Checklist, https://www.dcaa.mil/Checklists-Tools/Pre-award-Accounting-System-Adequacy-Checklist/

The Federal Acquisition Regulation provides: “Costs that are expressly unallowable or mutually agreed to be unallowable, including mutually agreed to be unallowable directly associated costs, shall be identified and excluded from any billing, claim, or proposal applicable to a Government contract.” — Federal Acquisition Regulation, Part 31 - Contract Cost Principles and Procedures, https://www.acquisition.gov/far/part-31

The IRS explains: “The exclusion for "funded research" under section 41(d)(4)(H) provides that the credit shall not be available for qualified research to the extent funded by a contract, grant, or otherwise by another person (or governmental entity).” — Internal Revenue Service, Audit techniques guide: Credit for Increasing Research Activities (i.e. Research Tax Credit) IRC § 41 - Qualified research activities*, https://www.irs.gov/businesses/audit-techniques-guide-credit-for-increasing-research-activities-ie-research-tax-credit-irc-ss-41-qualified-research-activities

Related guides

• Government Contractor Entity and Estimated Taxes: The Ownership Rules Behind Set-Asides, the Slow-Paying Customer, and the Cost-Plus Quarter
• Research Credit for Small Businesses: Form 6765 Guide
• Percentage of Completion: Section 460 for Contractors
• Income Tax in Other States: Nexus and Apportionment
• Business Meal Deduction Rules: The 50 Percent Limit

Next step

Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our bookkeeping team sets up job costing, the indirect pools, and the unallowable cost accounts so the same ledger serves the government and the tax return. See pricing or book a free fit call.