Eyeing the look-back method for tax savings

By Randy Bonnecaze

Estimating revenue from long-term construction projects is difficult, not only for financial reporting purposes but also for filing your federal income taxes. In nearly every long-term contract situation, you must report income based heavily on estimates and assumptions.

The "look-back" method allows either you or the federal government to recoup any interest lost when more accurate information on contract costs and revenues becomes available.

Learning the requirements. The procedure to calculate and report the look-back method is in IRS Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts. You account for by using either the percentage-of-completion or percentage-of-completion-capitalized-cost method.

You also need to report look-back data in any year you adjust the contract price or contract costs for one or more long-term contracts from those of a previous year. The method, however, does not apply in every situation. Some exceptions include:

• Home construction contracts
  

• Some contracts that are estimated to be completed, or are actually completed, within two years of commencement
  
• Some contracts in which the cumulative taxable income or loss that was actually reported is within 10 percent of the cumulative look-back income or loss

The look-back method will normally affect larger contractors for regular income tax purposes. But any taxpayer subject to the alternative minimum tax must apply look-back as well.

There are two methods for reporting look-back interest: the regular method and the simplified marginal impact method. Any taxpayer may elect the simplified method, though nonclosely held pass-through entities - such as partnerships, S corporations and trusts - are required to use it.

Anticipating the impact. Under the look-back method, a contractor must pay, or is entitled to receive, interest on the tax liability that is deferred or accelerated because of over- or underestimating total contract price or costs. To do this, you (or, more specifically, your financial advisor) must calculate a hypothetical tax that would have been applied according to the percentage-of-completion method using the actual contract price and actual costs - once you know them - instead of the original estimates.

Based on this calculation, you pay or receive the interest on the difference between the taxes actually accounted for each year and the hypothetical tax. In many cases, the impact will trigger an income tax refund. Namely, when you're optimistic in your financial projections, reported gross profits from current projects will exceed those actually realized on completion.

These higher profits mean higher tax liability for you in the originally reported years. Thus, your company and its owners then qualify - and indeed are required - to report these differences and receive interest on the previous years' overpaid taxes.

You need to report any interest you receive under the look-back rule as interest income, while accounting for any you pay as interest expense arising from underpayment of income tax. Individuals or pass-through entities acting on behalf of an individual must report interest payments as personal interest, which is generally ineligible for an interest deduction.

Pass-through entity owners should allocate look-back interest among themselves in the same manner as they do for interest income and interest expense, applying the appropriate partnership and S corporation rules.

Facing the implications. The look-back rules were designed to protect the federal government from contractors that underestimate gross profits. But the rules also protect you from overpaying taxes in the opposite circumstance. Before reporting any of your upcoming long-term contracts, prepare carefully for whatever tax implications you may face.

Editor's Note: Randy J. Bonnecaze is a Certified Public Accountant (CPA) with Hannis T. Bourgeois LLP, Baton Rouge.