When estimating construction job costs, it can be challenging to calculate for rising material and labor prices, delays in obtaining permits, changes in government regulations, and worker shortages. If your project spans multiple tax years, the final profit on any contract will likely vary from any initial estimates due to these variables. Contractors and companies who utilize the Look-Back Method can recoup interest on the income taxes generated by their long-term contracts that were previously overpaid or settle any underpayments in any given year before the contract’s completion.
The Look-Back Method
When accounting for most long-term projects, contractors must use the percentage of completion method (PCM). With PCM, current-year income is calculated by taking the gross contract price and multiplying it by the ratio of costs incurred to date to the estimated total contract costs. However, the actual amount of revenue at the completion of the contract may significantly vary from the previously estimated amounts while the contract was in progress.
Though the correct amount of income tax will be paid over the contract’s life, the Look-Back Method allows the contractor or the IRS to recoup interest due to the over- or underpayment of taxes prior to the contract’s completion. If a contractor overestimated the gross profit in any year in a multi-year contract, the IRS would owe the contractor interest on the income taxes that were overpaid. If a contractor underestimated the gross profit for any specific year on that contract, they would owe the IRS interest on the income taxes for that year. They would need to recalculate their taxes based on the actual final gross profit percentage.
Let’s look at an example:
- A contractor estimates $2 million in profit on a contract based on the estimate for the prior year-end.
- Upon completion, the profit is higher than expected at $2.6 million.
- The contractor uses the actual final profit (not the estimate) to recalculate their profit and determines that they should have recognized the $2.6 million in the prior years of the contract. The tax on the $600,000 additional earned profit would be subject to interest and payable to the IRS.
Who Needs to Use Look-Back?
Construction companies that meet the following conditions must comply with Look-Back:
- Companies that 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.
- Companies that use different accounting methods for long-term contracts for alternative minimum tax ("AMT") purposes.
When complying with look-back requirements, contractors may use Form 8697: Interest Computation Under the Look-Back Method for Completed Long-Term Contracts to calculate their interest due or interest to be refunded based on the project’s final cost. Typically, contractors have six years from the due date of the tax year when the job closed to file any Look-Back refund claims.
Exemptions to Look-Back
There are several exceptions to consider when complying with Look-Back. First, this method does not apply to regular taxable income from home construction contracts (defined in 460(e)(5)(A)). It also does not apply to any construction contract entered by a taxpayer who anticipates the contract will be completed in two years from the start day, and the average gross receipts do not exceed $25 million for the three years preceding the tax year the contract begins in. However, the Look-Back method does apply to the AMT income from those contracts and must be accounted for with the percentage of completion method for AMT purposes (except home construction contracts).
Smaller contracts where the contract is completed within two years of its start may be exempt from Look-Back, if the gross price of the contract at completion does not exceed either $1 million or 1% of the taxpayer’s average annual gross receipts for the three tax years before the tax year of the contract completion (whichever is less). Additionally, companies may elect not to apply the Look-Back Method for completed contracts in certain de minimis cases. In that case, Look-Back does not apply when the cumulative taxable income (or loss) for the completed contract is within 10% of the cumulative look-back income (or loss) for each prior contract year, determined by comparing the actual to the prior estimated costs.
Final Thoughts
When looking to apply the Look-Back method, remember that this complex area of tax law is commonly misused, leading to compliance errors or missed opportunities. Despite the overwhelming compliance requirements, Look-Back can result in substantial cash flow for construction companies and contractors with long-term contracts. When looking to comply with regulations like Look-Back, Baldwin CPA’s extensive experience with the specific tax needs of the construction industry can help ensure your company meets all regulations and never leaves money on the table. Contact our tax professionals today for a consultation.
