The Wrap Podcast | Episode 065 | Navigating Opportunities, Challenges and Compliance for Government Contractors | Warren Averett

Commentators (0:02): You’re listening to The Wrap, a Warren Averett podcast for businesses designed to help you access vital business information and trends when you need it. So, you can listen, learn and then get on with your day. Now, let’s get down to business.

Paul Perry (0:17): Well, hello, and welcome to another episode of The Wrap podcast. Glad to be back with you today for episode 65. Today, we’re going to be talking to some of our experts in the government contracting space. Look forward to having their expertise come through on the discussion and look forward to what that’s going to be. Today, my cohost for this podcast is Jessica Juliano. Jessica, glad to have you back with us today.

Jessica Juliano (0:44): Happy to be here. We’ve got Amber Stout, who’s a Senior Manager. We’ve got Todd McAdams, who’s a Member in our Huntsville office, and Jared Sharp. You guys, we’d love to hear just a little bit about what y’all do and your career with the firm. Tell us a little bit about yourselves.

Amber Stout (1:03): So, my name is Amber Stout, and I work with government contractors. We really focus on consulting and keeping them out of trouble with the DCAA. That’s very important and just all the different accounting and year-end needs that they have.

Todd McAdams (1:19): My name is Todd McAdams. I’m a member here in our Huntsville, Alabama office, and I help lead our Government Contractors Practice Group. I have worked with government contractors since 2001, so a little over 20 years at this point. In public accounting, but also in industry on that side of the fence. So, I understand all the nuances of what our contractors are going through daily, and as Amber mentioned, help our clients navigate the complexities of working with the United States’ largest customers.

Jared Sharp (2:05): I’m Jared Sharp in the Huntsville office. I’m a Member. I’ve been with the firm since 2005 and focus my practice on tax, mainly with technology, GovCon and spend a lot of time with the R&D tax credit, which we’re going to get into here in a little bit.

Paul Perry (2:24): Good deal. It’s good to have all of you all with us today. In this series of episodes, we have been talking to some experts within different industries. Obviously, the GovCon industry has a lot of unique challenges and opportunities that others aren’t facing. So, Todd, do you want to start us off with: what are some of those challenges or opportunities that this industry faces?

Todd McAdams (2:51): Sure. Thanks, Paul. As I mentioned previously, there are a lot of complexities doing business with the U.S. government. Number one is the compliance requirements that are inherent to doing business with the government. That’s one of our specializations, as Amber mentioned, helping contractors navigate those and make sure they are ready to do business with the government. I would say that’s one of the number one items that we get calls about: “Are we ready to take on this contract to work with the government? Is our accounting system ready? Do we have policies and procedures in place?” Those types of things, I would also say that political climate is always changing, and it does affect the defense industry. That is a concern on our clients’ minds. Then from an opportunity standpoint, they’re obviously in the defense industry. War overall is not good, but in the industry, which does heighten the need for what our clients are providing to the warfighters in the world, that’s certainly an opportunity.

Jessica Juliano (4:15): Thank you, Todd. That was a great summary. We have some topics we’d like to just hone in on. Jared, you mentioned the R&D credit: R&D 174. Do you want to give us a little insight into how that affects your clients?

Jared Sharp (4:35): Yes, certainly. The government contracting industry is unique in that they have some challenges with the way their contracts are structured and who’s actually on the hook for the R&D that’s being done. R&D 174 references an IRS Code Section that has been in the Code for a long time, but it got new life in 2017 with the Tax Cuts and Jobs Act that was introduced under the Trump administration. It did not take effect until 2022, and so it didn’t get a lot of publicity at the time when the Tax Cuts and Jobs Act came about. This Code Section that dealt with the research and development expenses was not highly publicized.

It was a revenue generator for the tax side. A lot of the Tax Cuts and Jobs Act were tax cuts, and this was one way they had to balance the budget, to put in some revenue generators that are right for the tax side. This didn’t get the headlines, because it made people may pay more in taxes and that was not something they talked about back in 2017 when that bill was introduced. Here we are, obviously, through the year of 2023. We’ve gone through one round of filing tax returns with this being the law for 2022. It was very clear that there were not a lot of people that were ready for this, including most practitioners, right?

I mean, we run to the assumption most of the time that it was going to be overturned and that this bill would not see the light of day. That was all the talk you heard in 2022. 2022 came and went. That didn’t happen. Even in early 2023, we heard, “Well, it’s going to still be overturned.” People weren’t really giving it the attention that I think it needed, even though it had been out there. Now here we are at the end of October. We’re sitting here with a law that’s on the books that’s still being discussed in Congress and being overturned, but we’ve got one tax filing dealt with that had to have this in it.

What it is: If you have research and development expenses, you’re required now to capitalize those for tax purposes and amortize them over a five-year period if they’re U.S. based or a 15-year period if they’re foreign based. There’s a lot of confusion, because we’ve had the R&D tax credit up there for a long time. This does piggyback off the R&D tax credit. But it’s not mutually exclusive in that if I take an R&D tax credit, this provision clearly applies. Even if I don’t take an R&D tax credit, this provision may still apply. It’s a game changer. In the past, all these expenses can be deducted. So, there were immediate 100% deductions. Now, we’re looking at a five-year amortization, or 15-year amortization. It’s a big deal for taxpayers to have to pick up that in their reduction of their expenses and amortize those over a period versus being able to have immediate deduction. We’re seeing a lot of increased tax bills because a lot of people are paying more taxes because of this provision. Your government contractors are no different. The only nuance there is—and it’s still a little bit unclear because we’re still waiting on IRS guidance—but do contracts, or R&D done under contract, do those apply to this provision or not?

From what we’ve done in the past on R&D tax credits, it’s pretty clear that you can take an R&D tax credit related to firm fixed-price work that’s being done under contract. But if it’s T&M or cost-plus type work, it’s not allowed for the R&D tax credit. Well, under these 174 provisions, it’s a little bit unclear. Does that same guidance follow here or not? While I definitely think it follows to your firm fixed-price efforts and your internal R&D efforts, there’s still some question on: Do I have to pick this up in my 174 cost if I’m doing T&M work or cost-plus work, where I’m not really at risk for the financial piece of this, but I’m doing R&D under those contracts and I’m being paid for it?

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Jared Sharp (8:57): So, on the 174 provisions, the 2022 tax returns have come and gone. That was part of those filings. There was not a lot of guidance from the IRS on how to even treat some of these expenses for these 174 provisions. We have gotten some guidance that they released in September, although it’s a notice—not a regulation. The notice is the first thing that they’re going to put out there. It’s got some detail, but not a lot. We’ve got a little bit of initial guidance from the IRS; we do expect more guidance to come early in 2024. That’s the latest we saw. Those are going to be in the form of regulations, which will be a little bit more formal than what they introduced in September. But, you know, my thoughts are on just seeing what the IRS released in the notice.

There’s going to be a lot more detail that goes into these calculations than what I think we’ve done in 2022. For 2022, it was a reasonable method because there was no guidance. I think for 2023 forward, we’re going to have a little bit more emphasis on what actual expenses need to be done and how the allocations work for some of the overhead type items that are part of this whole calculation. I do expect there to be a little bit more heavy lifting in 2023 for some of these 174 calculations.

Paul Perry (10:10): I guess we should note that this was recorded on October 30, 2023. So, any changes to anything from a political landscape perspective may change some of the conversation we have today. But just wanted to make that note for the presentation. Jared?

Jared Sharp (10:25): That’s a good point, Paul, because this has been something that we thought Congress is going to overturn, even before it saw the light of day in 2022. That has not happened. There is currently a bill sitting in Congress that was introduced in June, which wouldn’t repeal this completely, but it would push it back to 2025. That has not been voted on. So, it still has a way to go to even become an actual law. But they are still pushing this in Congress to get this overturned. So, before the end of the year or even in 2024, there might be some political changes to this law that either change the way we’re dealing with it or completely do away with it.

Paul Perry (11:09): Todd, I want to go back to something you talked about. At the opener, when you said that the government people call you and say, “Are we ready to work with the government?” In my very limited financial statement auditor years, in dealing with maybe one or two, I do remember reporting was always a big issue: what they’re reporting and how they’re reporting to the government. Can you break down why that’s unique within this industry that maybe other industries don’t see? Todd and Amber, I’d love to hear both of your opinions on that.

Todd McAdams (11:42): Thanks, Paul. Yeah, there’s many compliance requirements to do business with the government. You know, from a reporting standpoint, if you have certain types of contracts annually, you must submit an incurred cost submission, which is due six months after your calendar year end or fiscal year end. That’s a pretty complex filing that that’s required. We help with those and help contractors complete and file those. But backing up, there’s a lot of information you have to capture to populate those types of filing requirements. That’s where the accounting systems come into play to make sure you’re tracking costs in direct buckets and indirect buckets—segregating those—and allowable versus unallowable expenses. One of the misconceptions with a lot of our contractors is that, “Okay, well, I’ve got this certain accounting system, and it’s DCA approved.” That’s not necessarily the case. If you have a certain product that’s commonly used in the GovCon industry, that’s great. But the system must be set up and operate in a proper manner.

Amber Stout (13:02): To add to that: For many of our clients, each of their contracts are unique in the requirements. Some contracts don’t require incurred costs, some require more. They require different areas to be tracked, along with the ability to propose on future legs of the contract. It’s really important to review each contract. The Department of Homeland Security might have different requirements. So, it’s just really important for them to read and understand each contract.

Jessica Juliano (13:39): As Warren Averett, we serve over 250 government contractors. Another important area we’d like to have y’all discuss is how you serve our clients in regard to DCAA compliance and the agreed-upon procedures that are currently part of your support and advice to our clients. Let’s talk about that a little bit.

Todd McAdams (14:04): Yeah, I can cover that. Thanks, Jessica. With the compliance with DCAA, they will want to come in and approve your accounting system. You can’t just knock on their door and say, “Hey, I’m ready for an audit. Come talk to me and approve my accounting system.” A lot of contractors think that’s the way it happens. But once you get educated a little bit and understand what DCAA does and who they work for, those pre-award accounting system audits or reviews, those are going to be requested by the contracting officer. If you’re proposing on a contract that’s cost-type in nature, that contracting officer is going to require DCAA to come and look at your system, because they want to make sure that you’re tracking costs adequately in the proper areas and that you’re going to be able to build the government in those cost buckets in the proper manner. It’s a little bit the chicken or the egg.

To get an approved accounting system, you must have a cost-type contract. You can’t get one until you have the cost-type contract. So, it’s a catch 22. What Jessica is mentioning, the agreed-upon procedures, we as an audit firm with the GovCon specialization, we can come in and do a mock DCAA audit. We take their programs that are public, the SF 1408, which is the system requirement checklist that they go through. We have worked with DCAA through actual accounting system audits with clients, so we’re very familiar with the process. We can come in a safe environment ahead of time, run through those checklists, run through the system, advise the client on setup, policy, policies and procedures, and recommend any corrections that need to be made. Then, we can opine on the system and provide the client an audit report that states what the DCAA’s report would. That can be used in proposal situations. It can be used if you’re a subcontractor that’s being awarded a large cost-type contract to give them comfort with your system. Because we get calls on this frequently as well, where a large prime contractor will call a small business, “Hey, we want to come look at your system to make sure it’s adequate.” It’s a very competitive thing. You don’t want to open your books to other contractors in most cases. A lot of times, they’ll accept an audit report from a CPA firm covering that adequacy.

Amber Stout (17:06): We’ve even had clients come to us, “Are we ready to go for a cost-plus?” They want to know that before they ever step foot in that door, “Can we do this? Are we prepared? What do we need to do? What infrastructure do we need to change to be competitive?” Sometimes, it’s just a comfort letter for the Board or ownership.

Todd McAdams (17:29): Yeah, and the sooner that you start thinking about an accounting system and having it approved, the better. We can do these agreed-upon procedures on the design of the system. So, it doesn’t even have to be operational yet. We can help on the very front end, structure the system, the policies and issue that design adequacy report. Then, we can always follow it up with an operational test if needed.

Paul Perry (18:04): Amber, I want to go back to when you’ve worked with some of those clients. I know y’all work with a lot of clients throughout the year. What are the top two things that you usually see that they must correct before they’re ready to jump into it?

Amber Stout (18:25): Top two things? Policies and procedures. Everybody in your company, your 1020-person company, knows what you do when XYZ occurs, but you must have it written down. DCAA is going to want to audit you on that policy. They don’t care if everybody knows it by memory, they want to see that. So that is something that a lot of when we come in, a lot of them don’t have written policies, and we help them. The other thing is internal controls. Everyone has access to the checkbook, and everyone can write a check. DCAA really wants to see that control. You know, the person who’s writing the checks also reconciles the bank account, just those simple things as a small business. Everybody’s wearing a thousand hats, and it’s easy to forget that as you grow, you’ve got control, and they want to see that you’re capable of being fiscally responsible.

Paul Perry (19:24): You just put some minds at ease. Because if there are 100 people listening to this, I bet you half of them said, “Oh, that’s me.” So, they need to know they’re all in a similar boat.

Amber Stout (19:34): Absolutely. Yeah. When you get your first contract, it might be just you or you and one employee. It’s not necessary at that time. Then, they love what you do. They love the service you provide. They’re like, “Bring me another employee and build me another widget.” Suddenly, you’re 1,015 people and you haven’t had time to slow down and even think about infrastructure. So, reaching out and talking to your consultant, “Hey, what can I do to be prepared for growth?” That’s a good first step.

Todd McAdams (20:04): Amber, I’ll add on to that as a great point. The opposite side of that, I’ve seen where a new contractor or small business will have googled policies and procedures for GovCon, and they have put something in place. It’s expansive policy and procedure. You can have the greatest policy procedure on paper, but if it’s not what’s happening in your daily operations, that’s not good. So DCAA certainly wants to see the policy and procedure, but also, as Amber mentioned, those being lived out each day.

Paul Perry (20:46): Jared, from a tax side, the same question. When people are getting into this, what are some of the pitfalls that they find themselves in from a tax perspective?

Jared Sharp (20:58): I think just making sure that you’re having conversations early, similar to the accounting system in that you understand: How am I going to be taxed? Especially if it’s their first venture into entrepreneurship and doing that, they’re not a hundred percent clear on the tax. How am I going to be taxed? Is it on my personal return? Is it a corporate tax expense? Just planning on that aspect of it, you know. Type of entity can matter. Having those conversations early on about what type of entity structure it is. Todd and Amber, there are certain reasons why a lot of our GovCon companies are S corps versus LLCs and partnerships.

Those types of things can matter, when it comes to not just the tax, but also making sure you’re setting up properly for DCAA, contract rate purposes and all that. The other thing is even if you’re established business and you’ve been doing this for a while: the planning aspect of it. Just having the conversations throughout the year with your tax advisor on: What am I doing that can reduce taxes or am I doing something that can increase what I’m going to pay in April?

As an example, Amber and I have a client that is cash basis, and they just picked up a big contract. It’s going to be some money up front that might cause some tax burden now versus next year. Having those conversations just so they’re prepared, right? So, they don’t assume that this is not going to be taxable income to me, because I’ve not started the expense side of that contract. Those are the things that we obviously want to talk to our clients about throughout the year, not just when it comes time to file the tax return.

Todd McAdams (22:41): From a political standpoint, one of the largest challenges at this exact moment is that we’re under continuing resolution. So, there’s not been the annual appropriations bill passed. We don’t have a budget for fiscal year 2024. That continued resolution expires November 17. Hopefully, we’ll have everything worked out by then. But if not, there could be an additional continuing resolution and the president will sign the appropriations bill before the end of the calendar year.

Amber Stout (23:31): I wanted to add back to the opportunities. As Todd said, none of us wants to see a war. But when this happens, it does create opportunities. One of my clients won a contract to produce something they were producing in Ukraine, and the government couldn’t live without it. It was an opportunity we weren’t expecting. Of course, and fortunately, it came to us, and we were able to take advantage of it. As a small contractor, they had prepared with their budget forecasting, and were ready to take on unforeseen projects.

Todd McAdams (24:08): To tie in with that, Amber, with Jared’s comments on R&D, a lot of times and uncertainty with wartime efforts and support to other nations, the U.S. must reallocate or shift funds from R&D expenditure to those types of support efforts. Depending on the type of contractor and what they do, whether it’s heavy R&D, support, missile defense or things of that nature, we hear success stories in certain cases. Then, we hear, “Well, our funding’s on hold or it’s on the chopping block.” So yeah, a lot of opportunity. I love working with the GovCon industry. We support those who support the warfighter. That’s our motto within our GovCon Industry Group, and we strive to live that out each day to support them.

Jessica Juliano (25:09): Here on The Wrap, we’d like to wrap everything up in 60 seconds or less. What’s the one piece of advice you want to leave with business leaders today?

Todd McAdams (25:19): Don’t wait until you have to have one of these compliance requirements solved. The sooner that you can reach out to your advisor, the better. It’s much easier to put a system in place when there is no system. From scratch, it’s honestly easier to stand it up on the right footing. That would be my advice if you’re getting into the GovCon industry. Reach out to your advisor, and just surround yourself with those that have been through this before and can help you succeed.

Paul Perry (25:59): Amber?

Amber Stout (26:01): Going to echo Todd a little bit. You must be prepared because opportunities arise quickly. You can’t be looking back and going, “Wait, what am I doing?” You’ve got to have most of your ducks in a row. Also remember, your business is unique. Just because Jane or John next door is doing XYZ doesn’t mean you can’t do something else.

Jessica Juliano (26:28): Jared, how about you?

Jared Sharp (26:30): Yeah, Jessica, I would say as it relates to the 174 R&D tax credits, if you’ve not dealt with that and you’re doing R&D or thinking about doing R&D, whether it’s internally funded or under contract, we need to have a conversation and talk about what that entails. Do you have a tax credit out there? Do you have implications that fall under this 174 provision? Just plan on making sure that we handle it correctly on the tax returns.

Paul Perry (27:01): Ladies and gentlemen, this has been a wonderful conversation. Thank y’all for lending your expertise to this discussion. We appreciate having you here on The Wrap. We look forward to hearing from y’all soon.

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