Unallowable Costs for SBIR Companies: What the Government Will Not Pay

Every company spends money the government will not reimburse. For a Small Business Innovation Research (SBIR) company moving into Phase II, the question is not whether those costs exist, but whether the books keep them apart. This guide covers which costs are unallowable, the ones small companies run into most, and how to keep them out of your rates, proposals, and invoices.

The short answer

Unallowable costs are costs the federal cost rules (FAR 31.2) say the government will not pay, such as entertainment, alcohol, interest on loans, the costs of raising capital, lobbying, donations, and fines. Under the federal rule on accounting for unallowable costs (FAR 31.201-6), they have to be identified and excluded from any billing, claim, or proposal on a government contract, along with the costs directly associated with them. The same cost principles generally apply to NIH grants to for-profit companies. The practical answer is to record these costs in their own accounts from the first day, so they never land in an indirect cost pool.

The practical takeaway: you can spend money on unallowable costs. You just cannot charge it to the government. Unallowable costs left inside overhead or G&A inflate every rate you bill on.

Why unallowable costs matter in Phase II

Unallowable costs are one of the four areas where a pre-award accounting review most often finds gaps, along with separating direct from indirect costs, timekeeping, and posting costs monthly. The full picture of that review is in SBIR Phase I to Phase II: How to Get Your Accounting Ready Before the Award.

The reason is arithmetic. An indirect rate is a pool of costs divided by a base. If a team dinner with wine or the legal fees from a funding round sit inside the G&A pool, the G&A rate goes up, and every hour billed on a cost-reimbursable contract carries a piece of a cost the government never agreed to pay. That is why the problem shows up in proposals, in billing, and later in an incurred cost audit.

On larger contracts, it can also carry a penalty. The federal rules on penalties for unallowable costs (FAR 42.709) apply to contracts over $1 million, other than fixed-price contracts without cost incentives. If a final indirect cost rate proposal includes a cost that is expressly unallowable, the penalty is the disallowed amount allocated to covered contracts, plus interest on anything already paid. If the company knew the cost was unallowable before submitting, the penalty doubles. A cost-reimbursable Phase II can be well over $1 million.

Common unallowable costs

The federal rules on selected costs (FAR 31.205) cover dozens of specific types of cost. These are the ones a small research company is most likely to run into:

Cost	Examples	FAR cost principle
Entertainment	Amusement, social activities, show or sports tickets, and the meals, transportation, and tips that go with them; social, dining, and country club memberships	31.205-14
Alcohol	Alcoholic beverages, on any occasion	31.205-51
Interest and financing	Interest on borrowings, and the costs of financing or refinancing capital	31.205-20
Organization and raising capital	Incorporation fees, and fees paid to lawyers, accountants, brokers, or consultants in connection with raising capital or reorganizing the company	31.205-27
Lobbying and political activity	Influencing elections or legislation, political action committees, and related legislative liaison work	31.205-22
Contributions and donations	Cash, property, or services donated, regardless of recipient	31.205-8
Fines and penalties	Fines and penalties for violating, or failing to comply with, a federal, state, local, or foreign law or regulation	31.205-15
Gifts	Gifts, other than performance awards and recognition awards under an established plan	31.205-13
Advertising and public relations	Most advertising and promotion meant to sell products or services or build the company's image, with narrow exceptions	31.205-1

The complete list is in the federal rules on selected costs (FAR 31.205), which cover each type of cost in its own section and say whether it is allowable, unallowable, or allowable only under certain conditions. Several have exceptions worth reading in full. When a cost is unclear, ask your CPA before it is coded, not after it is billed.

Directly associated costs

A cost generated only because of an unallowable cost is unallowable too. FAR 31.201-6 calls these directly associated costs. The entertainment rule names its own examples: the tickets, the meals, the transportation, and the tips that come with an outing. Under the same rule, salary for time spent on unallowable activities is treated as a directly associated cost when it is material.

Costs that look like normal business spending

Most of these rules are intuitive. Here is how a few of them apply to everyday spending:

• The funding round. Legal and accounting fees for raising capital fall under the organization costs principle. A company closing a seed round while running a Phase II should keep those fees in their own unallowable account.
• Interest. Interest on a line of credit, a business credit card balance, or a loan from a founder is unallowable, however necessary the financing was.
• Team celebrations. A launch party, a holiday dinner, or tickets to a game are entertainment, and any alcohol is unallowable on its own.
• Commercial marketing. SBIR companies are expected to commercialize, but advertising to sell a product is generally unallowable, so marketing spend belongs in its own accounts.
• Gifts and donations. Gifts to customers or partners, and donations to a university lab or a local cause, are unallowable.
• Late filing penalties. Tax and regulatory penalties are fines and penalties, not overhead.

Not everything that feels like a perk is unallowable. Costs of activities designed to improve working conditions, such as employee counseling or health and fitness programs, can be allowable under FAR 31.205-13, subject to its limits.

Grants follow the same rules

An SBIR grant does not mean a looser rule book. NIH's Grants Policy Statement says the same federal cost rules (FAR 31.2) generally apply to NIH grants to for-profit companies. A cost that is unallowable on a Department of Defense contract is generally unallowable on an NIH grant too. How the rules differ by agency is covered in SBIR Grants vs. SBIR Contracts.

The fee is the one exception worth knowing. NIH describes the SBIR fee as not a cost, usable for any purpose, so the cost principles do not limit how it is spent. If the company wants to pay for a team celebration, the fee is where that money can come from.

How to keep unallowable costs out

1. Open unallowable accounts in your chart of accounts, separate from overhead and G&A. A common approach is a dedicated series, such as the 90000s described in How to Classify Indirect Costs (Fringe, Overhead, and G&A).
2. Code each expense when it is recorded, not at year end. A receipt with the business purpose and attendees noted is much easier to classify the day it comes in.
3. Split mixed receipts. A meal on a business trip is allowable up to the federal per diem rates (FAR 31.205-46), but a glass of wine with it is not. Record the meal and the alcohol as two entries, with the alcohol in the unallowable account.
4. Set a short written policy for company cards and expense reports that names the common unallowable costs.
5. Review the unallowable accounts monthly, and check overhead and G&A for anything that should have landed there.
6. Exclude them before any rate is calculated, so proposals, provisional billing rates, and the year-end final indirect cost rate proposal all start from clean pools.

Sarah Sun, CPA, Sr Manager at Wendroff & Associates, CPA, names mixed cost categories as one of the four gaps she sees most often in practice. Separating direct, indirect, and unallowable costs in the chart of accounts from day one is the fix:

How WiseCost fits

Which costs are unallowable is a judgment for you and your CPA. What WiseCost provides is a structure that applies that judgment the same way every time.

In WiseCost, each account in your QuickBooks Online chart of accounts is marked by type, and unallowable is one of the types. Costs in those accounts are left out when WiseCost calculates your fringe, overhead, and G&A rates. The Indirect Rate report shows the transactions behind each rate, so you can check that nothing unallowable slipped in. The rates are only as clean as the coding, so the monthly review still matters.

FAQ

The Bottom Line

Unallowable costs are a normal part of running a company. The problem starts only when they mix with the costs you charge the government. Learn the short list that catches small companies, from funding-round fees to team celebrations, give those costs their own accounts, code them when they happen, and calculate every rate from pools that leave them out. On a cost-reimbursable Phase II, that habit protects your rates, your invoices, and your year-end proposal.

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You can run our free DCAA Readiness Self-Assessment to check whether your chart of accounts keeps unallowable costs apart.

Official Sources

• Identifying and excluding unallowable costs: FAR 31.201-6
• Selected cost principles: FAR 31.205-14, 31.205-51, 31.205-20, 31.205-27, 31.205-22, 31.205-8, 31.205-15, 31.205-13, 31.205-1
• Penalties for unallowable costs: FAR 42.709-1 and 42.709-2
• Cost principles for NIH grants to for-profit organizations: NIH Grants Policy Statement 18.3.1
• Accounting system review areas: SBA, Accounting and Finance Tutorial 2