Taking a Look at the Look-back CalculationJuly 22, 2011
Crystal A. Germanese, CPA
What is the look-back rule?
The look-back calculation is a calculation of additional interest that needs to be paid to (or refunded by) the IRS on taxes paid on contract revenue that has been recognized in prior years using the percentage of completion method.
The look-back calculation, which applies to completed long-term contracts (contracts open more than 12 months), compares the percentage of gross profit that was recognized in prior years to the actual gross profit percentage once the job has been completed. The calculation determines whether or not the gross profit for that particular job was over- or under-reported in prior years based on job cost estimates at the time of the tax reporting.
For example, if gross profit was overstated in the past due to changes in estimates or job fade, then, theoretically, income was overstated and too much tax was paid in the prior year. The taxpayer is then entitled to have interest refunded to them on that excess tax. Conversely, if profit was understated in prior years due to conservative estimates or job pick-up, taxes were underpaid, and the taxpayer is required to pay interest on that difference.
Why was the look-back rule created?
Since contract revenue reported on the percentage of completion method is based on estimates, a taxpayer could defer reporting taxable income in one year by understating a contract’s percentage of completion. Essentially taxpayers could push off reporting a majority of income to the final years of the contract. For large and/or long contracts, that could mean big dollars and a long wait to the IRS. The look-back calculation is the IRS’ tool which makes that kind of “tax planning” irrelevant.
When does the look-back rule apply?
The look-back method applies to any completed long-term contract that spanned more than two tax years and/or has a gross contract price exceeding the lesser of $1,000,000 or one percent of the average annual gross receipts for the three previous years. There is an exception that can be elected when the change in cumulative taxable income (or loss) actually reported under the contract was within 10% of the cumulative look-back income (or loss).
If a contract has post-completion changes in contract income or cost, there is a re-application of the look-back rule. There is a di minimus rule which is elective and would allow a taxpayer to avoid applying the re-application to certain contracts. Another relief from the look-back is to elect to delay the re-application method for up to five years. For example a company is incurring legal fees related to a job in post completion years 1, 2, and 3 and then receives revenue from a claim in year 4. The taxpayer can delay the re-application of the look-back method to year 4 and adjust for all of the changes in one re-application. It is important to make your tax preparer aware of any costs related to post-completion adjustments in the first year the costs are incurred so they can elect to delay the re-application on the appropriate return.
How to look-back?
The look-back calculation is done annually and is reported on a company’s income tax return or, in the case of S Corporations and Partnerships, generally on the owner(s)’ income tax return. The look-back recomputations are hypothetical and are used only for purposes of determining the amount of interest owed by or due the contractor - prior years' returns are not amended.
The look-back method is calculated when a job is complete and, therefore, all facts are known (final contract revenue and total contract costs). Using these actual facts, the percentage of completion is recalculated for each open year of the contract, and the revenue that should have been recognized each year, if all facts were known, is determined. This revenue is compared to what was actually reported on a tax return(s), and the difference is the look-back income adjustment.
The taxpayer(s) carry this look-back adjustment to their tax return(s) to calculate the tax that would have been paid if this adjustment was made. That calculated tax is compared to their actual tax paid and the difference is the look-back tax adjustment. Interest is calculated on this hypothetical overpayment/underpayment of tax at prescribed rates -- this calculation is done for regular tax as well as the alternative minimum tax.
To look-back or not to look-back?
Contractors who fail to perform look-back calcuations when required may be subject to additional taxes and penalties. In 2004, the IRS declared that look-back compliance was an emerging issue and the IRS guide identifies the look-back as a very complex area of tax law which causes many errors in compliance.
This should not always be received as bad news. In today’s economy, where many jobs are not as profitable as originally expected, a look-back return could provide an unexpected and a welcome refund.