Construction Accounting: Applying the Look-Back Method on Long-Term Contracts
There are many difficulties in estimating construction job costs, such as rising material and labor prices, changes in government regulations, delays in obtaining permits, and the worker shortage to name a few. When a construction project spans multiple tax years, the final profit on the contract will likely be higher or lower than the estimated profit. Look-back allows the taxpayer or IRS to recoup interest on income taxes generated by long-term contracts if taxes were overpaid or underpaid in any given year before the contract’s completion.
What is look-back?
Contractors must use the percentage of completion method ("PCM") of accounting for most long-term construction contracts. Under PCM, current year income is calculated as the gross contract price multiplied by the ratio of costs incurred to date to the estimated total contract costs. Contracts in progress recognize estimated amounts of revenue that may be significantly different from the actual amounts determined at completion of the contract. While the correct amount of income tax will be paid over the contract's life, the look-back method allows the taxpayer or IRS to "look back" and recoup interest due to an over- or underpayment of taxes prior to the contract's completion. So if you overestimated the gross profit on a long-term contract in any particular year, the IRS would owe you interest on income taxes that you'd overpaid. On the other hand, if you underestimated the gross profit on a long-term contract for any specific year, you would owe the IRS interest on income taxes for that year and would need to recalculate your taxes based on the actual final gross profit percentage.
For example, say you estimated you'd earn $1 million in profit on a contract based on your estimate for the prior year-end. However, on completion, you performed much better. If you recalculated your profit based on the actual final profit (instead of the estimate), you should have recognized $1.2 million in the prior years. The tax on the additional $200,000 in earned profit would then be subject to interest and payable to the IRS. The look-back calculation does not result in a change to the taxes paid in the prior year.
Who must comply with look-back?
Construction companies must comply with look-back if they have long-term contracts (contracts spanning more than one tax year) and report income using the percentage of completion method or the percentage of completion-capitalized cost method. Look-back also applies to construction companies that use different accounting methods for long-term contracts for alternative minimum tax ("AMT") purposes. Contractors subject to look-back may use Form 8697: Interest Computation Under the Look-Back Method for Completed Long-Term Contracts to determine their interest due or interest to be refunded based on the project's final cost. Contractors generally have six years from the due date of the tax year in which the job closed to file look-back refund claims.
Look-back method exceptions
Construction contract exemptions: The look-back method does not apply to regular taxable income from:
- Home construction contracts (as defined in section 460(e)(5)(A)) or
- Any other construction contract entered into by a taxpayer:
- Who anticipates the contract will be completed within two years from the date the contract begins, and
- Whose average gross receipts do not exceed $10 million (or $25 million for contracts entered into after 2017) for the three tax years preceding the tax year in which the contract is entered into.
Note: The look-back method does apply to the AMT income from any such contract (excluding home construction contracts) and must be accounted for using the percentage of completion method for AMT purposes.
Exemptions for small contracts: Look-back does not apply to any contract completed within two years of the contract start date if the gross price of the contract upon completion does not exceed the lesser of:
- $1 million, or
- 1% of the taxpayer's average annual gross receipts for the three tax years before the tax year of contract completion.
De minimis exemption: You can elect not to apply the look-back method for completed contracts in certain de minimis cases. If you make this election, look-back does not apply in the following situations:
- If, in the completion year, the cumulative taxable income (or loss) reported under the contract is within 10% of the cumulative look-back income (or loss) for each prior contract year. Cumulative look-back income (or loss) is the amount of taxable income (or loss) you would have reported if you'd used the actual contract price and costs instead of the estimated contract price and costs.
- If, in a post-completion year, the cumulative taxable income (or loss) under the contract is within 10% of the cumulative look-back income (or loss) under the contract as of the close of the most recent year in which the look-back method was applied to the contract (or would have been applied if the election had now been made) as of the close of the post-completion year.
Look-back is a complex area of tax law that is commonly missed, which can lead to compliance errors and missed opportunities. While its compliance requirements can be cumbersome, look-back can result in significant cashflow for construction companies with long-term contracts in certain circumstances.
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