Rental/Occupancy/Lease costs Allowable with Restrictions

Cost of renting or leasing real or personal property can be classified under two major categories: Capital Leases or Operating Leases.

Auditors are concerned with the proper classification of a lease as either capital or operation.  Most small businesses rent/lease their space under an Operating Lease.  You know the month-to-month lease you pay for renting space, equipment, or any other real or personal property.  Capital Leases are generally involved with a purchase option or transfer of ownership by lease end.  I briefly discuss capital as well as related party leases later on in this article, but I would like to first discuss the most common form that small businesses identify as cost in their indirect cost pool.

Operating Leases Any lease that is not a capital lease is an operating lease.  FAR 31.205-36 applies to all operating leases including those that involve information technology equipment.

How do you know if your operating lease (rent or lease cost) is allowable?  The main criterion for allowability is Reasonableness.  And what defines reasonableness?  Back to the fundamentals.

A cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of competitive business.  The auditors are not to have a presumption of reasonableness attached to the incurrence of costs by a contractor.  The burden of proof shall be upon the contractor to establish that such cost is reasonable.

This gets back to my insistence that you as a small contractor always have support and documentation for all incurred and proposed costs.  What is reasonable depends upon a variety of considerations and circumstances including ?

1. Whether it is the type of cost generally recognized as ordinary and necessary for the conduct of the contractor's business or the contract performance;
2. Generally accepted sound business practices
3. Arm's length bargaining
4. Federal and State laws and regulations
5. Contractor's responsibilities to the Government, other customers, the owners of the business, employees, and the public at large; and
6. Any significant deviations from the contractor's established practices.

Subject to interpretation?  Sounds like it to me.  So document your basis for any rent/lease costs.  FAR 31.201-3 reference    What costs are allowable?

1. Rental costs, under operating leases, to the extent the rates are reasonable at the time of the lease decision, after consideration of :
2. Rental costs of comparable property, if any;
3. Market conditions in the area;
4. Type, life expectancy, condition, and value of the property leased (watch out for this one);
5. Alternatives available; and
6. Other provisions of the agreement.
7. Rental costs under a sale and leaseback up to the amount the contractor would be allowed if the contractor retained title, computed based on the net book value of the asset on the date the contractor becomes a lessee of the property adjusted for any gain or loss recognized in accordance with 31.205-16(b) [Depreciation]
8. Charges in the nature of rent for property between any division, subsidiary, or organization under common control, to the extent that they do not exceed the normal costs of ownership, such as depreciation, taxes, insurance, facilities capital cost of money, and maintenance (excluding interest or other unallowable costs pursuant to Part 31), provided that no part of such costs shall duplicate any other allowed cost.

If the contractor has an established practice of leasing the same or similar property to unaffiliated lessees (those paying rent) then the cost shall be allowed in accordance with paragraph 1 above.

Do you see what is said here?  If you are charging market rents to affiliate's in any legal form, the costs are limited to normal costs of ownership as identified above.  However, if you also charge rent to unaffiliated firms you would not be limited to the cost of ownership but could use market rents base on guidance outlined in 1 above.  Remember this must be an established practice and not one that a contractor is just implementing to make the cost allowable.

Capital Leases For Capital Leases, the provisions of FAR 31.205-11 and CAS 404 (Depreciation) apply.  Although small businesses are exempt from all cost accounting standards (CAS), the provisions of CAS 404 are incorporated in FAR 31.205-11(m).  Small businesses are subject for FAR.  You can see what happened here.

Capital leases are to be treated as purchased assets.  The capitalized value of such assets should be distributed over the useful lives of the leased assets as depreciation charges, or over the leased life as amortization charges, as appropriate.

Your CPA or Tax Accountant will know how to apply and calculate this cost because the FAR and CAS guidance is based on FASB Statement 13 that applies to generally accepted accounting principles (GAAP).  Therefore, I will not go into the details of FASB Statement 13 here.  If you would like to know more details about the main requirements of FASB Statement 13 and you or your CPA do not know where to go, then contact me at paulgunn@paulgunn.com.

What about Related Party Lease Cost? You know, you own the property and want to charge the company rent or lease costs.  There is nothing wrong with this.  You just have to understand the limitations on allowability for government contract costing purposes.

First, leases between related parties are governed by FASB Statement 13, FAR 31.25-11(i)(2), Depreciation, and FAR 31.205-36(b)(3), Rental Costs as applicable.  Your CPA or Tax Accountant should review these clauses and make appropriate calculations on your behalf.

If as a small business, you own the property and are leasing/renting space to the company under an operating lease, which is usually the case, then the above discussion under Operating Leases: What costs are allowable - item 3 generally apply.  Cost would be limited those items listed.  However, do not forget to include Maintenance cost in the calculation.  I have seen many firms fail to include the maintenance and other related normal costs of ownership.

In other words, the government does not want us to make a profit on our owned property, unless this is our established practice and we also rent to other unaffiliated parties.  They will pay the reasonable cost of ownership, but that?s it.

And the beat goes on.  

So go ahead and identify your Rental and Lease Costs in your Indirect Cost Pool(s).  Just make sure the costs are reasonable as outlined above, and if it is a related party lease then limit the cost to normal cost of ownership as also outlined above.

Review the references provided to the information above to check it out for yourself and if you have any comments, experiences with this situation, or feedback please let me know.  I will share it with the colleagues in our community.