FAR 31: Related-Party Rent

Key Takeaways

• FAR Limits Related-Party Rent: When common control exists, allowable rent is generally limited to the property’s normal cost of ownership.
• Know Allowable Costs: Depreciation, property taxes, insurance, maintenance, and FCCM may be included, while expressly unallowable costs cannot be claimed.
• Document Thoroughly: Lease agreements, depreciation schedules, tax bills, insurance records, maintenance documentation, and FCCM calculations can help support allowable costs during an audit.
• Review Proactively: Periodic reviews can help maximize allowable costs and reduce audit risk.

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Rent expenses are often one of the largest components of an A&E firm’s indirect cost pool. However, firms that lease office space from a related-party entity may be surprised to learn that the rent expense recorded in their accounting records is not necessarily the amount allowable under FAR. Understanding how FAR treats related-party rent is important not only for compliance purposes but also for identifying opportunities to maximize allowable costs and avoid unexpected audit adjustments.

What Is Related-Party Rent?

Related-party rent exists when a firm leases property from an entity that is under common control. In many cases, this structure exists for business purposes, such as liability protection, estate planning, or real estate ownership.

Common examples of related-party rent include:

• A shareholder owns both the business and the real estate holding company.
• Family members own the business and the property entity.
• The same individuals control the management and policies of both organizations.

While these arrangements are common within the industry, they often receive additional scrutiny during FAR overhead audits.

How FAR Treats Related-Party Rent Differently

If a lease is entered into with a related party under common control, then FAR only allows expenses up to the property’s normal cost of ownership.

• Normal cost of ownership generally includes depreciation, real estate taxes, insurance, maintenance, and Facilities Capital Cost of Money (FCCM).
• FCCM is generally calculated by applying the annually published treasury rate to the net book value of eligible facilities assets.
• Any expressly unallowable costs (such as interest) may not be included in the allowable cost calculation.
• Additionally, costs used in the related-party cost of ownership calculation cannot also be claimed elsewhere in the overhead schedule.

Ask, “what would it cost the related party to own the property?” Generally, that will be the maximum allowable amount.

Determining Allowable Costs

Most discussions surrounding related-party rent focus on disallowed costs. However, another common issue is not fully identifying or documenting all normal costs of ownership under the regulations.

Determining the appropriate amount often requires:

• An evaluation of ownership structures
• Analysis of property-related costs
• Consideration of Facilities Capital Cost of Money (FCCM)
• Coordination between the operating company and the property-holding entity
• Documentation sufficient to withstand audit scrutiny

Because every ownership structure is different, the impact on a firm’s overhead rate can vary significantly.

Documentation for an Overhead Audit

One of the biggest challenges is that much of the supporting documentation needed to support allowable related-party rent expenses may reside with the related-party property owner rather than the firm undergoing the FAR audit. Maintaining documentation for the cost of ownership calculation is essential when undergoing a FAR overhead audit.

Examples of audit documentation to maintain include:

• Property depreciation schedules
• Property tax bills
• Insurance invoices
• Maintenance records
• Lease agreements
• Ownership structures
• FCCM calculations, as applicable

Coordination with the related party in advance of the audit is essential to ensure documentation is readily available.

Common Ownership Does Not Always Mean Common Control

One area that is important to understand is the distinction between a related-party relationship under common ownership and common control. Factors such as ownership percentages, voting rights, governance provisions, decision-making authority, lease negotiations, and the ability of the operating company to influence the policies of the property-owning entity may all be relevant in evaluating whether common control exists.

It is important to perform a periodic review of leasing arrangements and ownership structures to help determine whether common control exists under applicable guidance and whether the firm’s current treatment remains appropriate.

Because these determinations are highly fact-specific, particularly when ownership is fragmented among multiple parties or governance rights are shared, an evaluation by professionals experienced with FAR overhead compliance can help firms support their position and reduce audit risk.

Opportunities for Proactive Planning

Firms that proactively evaluate their leasing arrangements can often gain a clearer understanding of how rent expenses affect their overhead rate and whether opportunities exist to strengthen support for allowable costs.

A periodic review is particularly valuable when ownership structures change, properties are refinanced, facilities are purchased or sold, or significant changes occur in rental expenses.

Conclusion

Related-party rent is one of the most common and significant FAR adjustments identified during overhead audits. While a lease payment may be reasonable from a business perspective, FAR 31.205-36 limits allowable rent between commonly controlled entities to the property’s normal cost of ownership. Understanding the common control rules and maintaining a well-supported ownership-cost calculation can help contractors to maximize allowable costs, reduce audit risk, and defend their overhead rates.

If your firm leases office space from a related-party entity, a periodic review of the arrangement can help identify potential FAR adjustments and opportunities to optimize allowable indirect costs before an audit occurs.

For more information about McKonly & Asbury’s Architecture, Engineering, and Construction (AEC) experience, visit the AEC Industry Page and don’t hesitate to contact a member of the AEC team.

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