Industry Insights

Congress enacted the Tax Reform Act of 1986 (TRA) mandating the percentage completion method (PCM) for certain long-term contracts. Computing PCM involves estimating the total contract price as well as the total cost of the contract. Drafters of the TRA were concerned taxpayers may manipulate the estimated amounts as compared to the actual and derive a tax-deferred benefit. Congress created the look-back rule to true up estimates made in the PCM computations.

After 23 years, taxpayers struggle with the complicated computations involved in the look-back rule, and the IRS has indicated that many taxpayers continue to make errors in their calculations. Often errors are made simply because of misunderstanding the unique nature of this particular rule. You can find the rule in Internal Revenue Code Section 460 and related regulations.

What exactly is the look-back rule? In general, after a particular contract is completed and accepted, a contractor must hypothetically recalculate the prior year’s income using actual price and total contract costs rather than estimates. This results in two scenarios.

The first scenario would be that the contractor overreported income in the prior year and is entitled to interest on overreported tax. The second is that the contractor underreported income in a prior year and owes interest on the underreported tax. The look-back method does not require a contractor to amend prior years’ tax returns. The hypothetical recalculations are made on IRS Form 8697. For pass-through entity taxpayers such as an S corporation, partnership or trust, the look-back calculation is made at the owner level rather than at the entity level.

When does the look-back rule apply? The rule applies to all long-term contracts where PCM is mandated. If PCM is mandated for Alternative Minimum Tax (AMT) purposes, the rule applies to PCM computation for AMT. However, PCM does not apply to small construction contractors who estimate their contract will be completed within two years and whose average annual gross receipts for three years do not exceed $10 million. In computing the three-year test, be sure to take into account all related entities. PCM also does not apply to home construction contracts. The small long-term contract exception is applicable when the gross price of the contract at completion does not exceed the lesser of $1 million or 1 percent of average gross receipts for three taxable years before the contract is completed. The contract exception also applies when the contract is competed within two years of the contract commencement date. This exception for contracts applies to both the regular tax and AMT. It is important to note the exception is mandatory and not elective.

The look-back rule does not apply in the completion year of a contract if, for each prior contract year, cumulative taxable income or loss actually reported under contract is within 10 percent of the cumulative look-back income or loss. In this case, you must elect not to use the look-back method and must calculate on an individual contract basis. At first glance, this may seem to make the calculation simpler, but does it really?

Just when you thought you were finished, you still must consider post-completion changes. If a contract has post-completion changes in contract income or cost, there is a re-application of the look-back rule. The amount of any post-completion adjustment to total contract price or contract costs taken into account after contract is completed is discounted to their value at time of completion. You can elect not to discount such amounts if you meet certain de minimis rules or if you elect to delay the re-application method.

Despite Congress enacting the rule more than 23 years ago, the IRS finds many errors in the computation of look-back interest. The service is focusing its attention on the application of the look-back method and has singled out this method through a correspondence audit. The IRS has developed several issues involving the look-back rule. In August 2004, the service issued a memorandum that identified compliance with look-back provisions as an emerging issue in the construction industry. Common mistakes are as follows:

• The form is missed altogether
• Improperly computing interest from net operating loss (NOL) carryback year rather than NOL generating year
• Using incorrect interest rates
• Improperly computing entity level versus owner level
• Improperly attaching Form 8697 refunds to income tax return and applying refund to tax due
• Improperly reporting cumulative changes as opposed to annual changes
• Electing an improper method for calculating the look-back

There are other issues involving the look-back rule. You should not automatically choose simplified marginal impact method; it may not be so simplified. In years of NOL, the carry forward simplified method will compute tax even if it's not paid. Look-back interest is tax deductible by corporations but treated as personal interest if it’s owed by an individual.

Although you may have been computing the look-back method for many years, you may want to re-evaluate your current process. Take into consideration the common mistakes many taxpayers have made. Have you made the proper elections, and are you using the most advantageous method?

For more information on this issue or related matters, please consult your BKD advisor.