What is look-back? Look-back is essentially a revisit under the premise of: If I knew then what I know now, how would interim measures of final gross profit on a multi-year job be different? You are looking back to see. It is a hypothetical calculation, and that is because you are not amending returns to correct prior estimates of gross profit; it is just a hypothetical calculation of tax that generates an interest charge or credit on the difference. You look back to see if the estimated gross profit was “over-” or “under-” reported, given the final results of the job. Those annual variances are then taxed in a hypothetical nature, and the interest (emphasis: it’s the interest) is then owed by the taxpayer or due to the taxpayer. The interest rate is per §6621, and the hypothetical calculation is cumulative.
With that as a backdrop, here’s why it exists. Taxpayers must estimate taxable income from certain long-term (LT) contracts during each tax year, even though such LT contracts are incomplete. To do this, percentage of completion (PCM) is an allowable method – and for many – a required method of accounting for LT contracts. IRC §460 is dedicated to PCM. PCM is based upon estimates: job-to-date job costs / total estimated job costs. Sometimes the PCM results change because of the nature of estimating, sometimes they change due to changes in the scope of the work, and sometimes they stay the same, but the Total Contract amount changes. All of these factors impact the gross profit reported each year. The result is that gross profit can, and very often does, change once you have finalized components that are known at the end of the job.
For example, let’s say there is an LT contract that, in year one, is estimated to be 37% complete. At the close of the job, using actual and not estimated amounts, year one was 44% complete. For look-back purposes, you then perform a hypothetical calculation using 44% of the gross profit (up from 37%) and then calculate interest on that additional 7%.
There are, of course, exceptions and exemptions.
An eligible small contractor who does not report LT contracts on PCM is exempt from look-back interest for regular income tax purposes. That contractor must, however, still calculate it for AMT purposes. Small contractor status generally is determined by reference to its three-year average amount of gross receipts (subject to aggregation rules when the contractor is a member of a controlled group).
There is also a “small contract” exception. Note the language difference here; the contract or job itself is potentially excepted from the calculation. This is also referred to as the de minimis exception, not to be confused with the election for de minimis discrepancies (to be discussed). See §1.460-6(b)(3).
A job is a small contract if the gross contract price does not exceed the lesser of a) $1 million (at the time of writing this article, this amount is not adjusted for inflation) or b) 1% of the average annual gross receipts for the three years before completion. There is a second requirement: the job must be completed within two years of the contract commencement date. Whether favorable or unfavorable, when this exception is met, a taxpayer is prohibited from calculating look-back interest on those jobs.
There are also elections that can be made. One such election is the simplified marginal impact method; see §460(b)(4). This method is required for certain pass-through entities that are not "closely held”; otherwise, it is elective. A pass-through entity is closely held when five or fewer persons own 50% or more of the entity’s value (subject to attribution rules). Under this method, the hypothetical tax is calculated at the highest rates under either Section 11 for corporations or Section 1 for individuals.
The “simplicity” of this election comes from a fixed tax calculation at the highest rate in lieu of an exercise to determine the actual tax impact from the underlying returns. The highest rate for individuals is used if (at all times during the redetermination year) more than 50% of the entity’s interests are held (directly or indirectly) by individuals. The redetermination year is the year you are looking back in your hypothetical tax calculation. Under this method, there is also a requirement that substantially all income is from the United States.
Another election is available for “de minimis discrepancies” (again, this is different than the de minimis exception noted earlier). This election involves an analysis of the differences in gross profit percentage for each of the prior years. If the actual results using the final PCM and contract amount produce a result within 10% of the reported gross profit percentage, then the differences (discrepancies) are deemed de minimis. See § 460(b)(6)(B).
If these conditions are met, the taxpayer can elect to have look-back interest not apply. The election is Irrevocable, and it applies to all LT contracts completed during and after the taxable year for which the election is effective. See §1.460-(6)(j).
The following items also add a degree of complexity: post-completion costs; credits; PCCM method; “10% election;” net operating losses (NOLs); and changes in ownership. Let’s discuss a few of those here.
PCCM is the method contractors use to report taxable income for residential construction contracts. It uses a 70/30 split, with 70% reported under PCM and 30% under an “exempt method.” Look-back interest needs to be considered on the PCM portion for regular tax purposes and on the full amount for AMT purposes (as AMT requires the use of PCM).
The 10% election is available when contractors wish to defer gross profit until the job is 10% or more complete. Because you are looking back when performing the interest calculation, the year the job reaches 10% could be different when you perform the hypothetical look-back calculation. It could be earlier or later than the year that the 10% threshold was previously reported.
When an NOL carryback would change on a hypothetical calculation for look-back interest purposes, the interest is calculated in the redetermination year. The hypothetical calculation of tax goes all the way back to the year the NOL carryback was absorbed, but the interest only references the year that generated the NOL.
Look-back interest is calculated after the job is complete or deemed complete. It is filed using Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts. When the hypothetical tax results in an interest charge, it is added to the return. When the hypothetical tax results in an interest refund, the form must be filed separately; if married filed jointly, the form must be signed by both taxpayer and spouse. At the time of writing this article, this form could not be separately e-filed for a refund and must be paper-filed with the IRS at the address in the instructions.
There are several factors that make the look-back interest calculation a fairly involved process. A methodical approach is recommended. Chart it out, starting at the beginning: is this job to be reported using PCM for tax purposes? Which exceptions and elections are available and/or required? Then look, job by job by job.
This article originally appeared in the April 2023 Tax Stringer, copyright 2023, and is reprinted with permission from the New York State Society of Certified Public Accountants.
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