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Look-Back Method for Long-Term Contracts

A contract has been completed, all revenue recognized, so all the hard work is done, right?  Well, not so fast.  Say hello to Form 8697 – Interest Computation Under the Look-Back Method for Completed Long-Term Contracts.

Taxpayers on the percentage of completion method report income from a long-term contract while it’s in progress. However, when the contract is completed, it’s possible these estimates were incorrect. This results in a tax liability that was either accelerated or deferred, based on whether the contract prices and costs were overestimated or underestimated. There’s no need to amend returns to correct it. Instead, Form 8697 is filed with the current year return and interest is either paid to the IRS or refunded to the taxpayer.

Who is subject to look-back?

Any contractor that has long-term contracts required to be accounted for using the percentage of completion method under IRC Section 460, is required to comply with the look-back rules.

Which contracts are subject to look-back?

Look-back is applied on an individual contract basis. In general, a contract must meet the requirements of a long-term construction contract under IRC Section 460 to be subject to look-back.

There are, however, some exceptions, where a contract is NOT subject to lookback:

  • Home construction contracts
  • Any contract completed within 2 years of the contract start date and who’s average gross receipts for the 3 previous tax years do not exceed 10 million
  • Contracts where the gross price of the contract does not exceed the smaller of $1 million or 1% of the taxpayer’s average annual gross receipts for the 3 previous tax years
  • An election is made to not apply look-back. The election is irrevocable and applies for all years going forward.

How is the look-back calculation applied?

There are 3 steps to applying look-back:

  • Reapply the percentage of completion method using actual contract prices & costs
  • Determine the hypothetical overpayment or underpayment of tax
  • Compute the interest due on the hypothetical overpayment or underpayment using either the regular method or the simplified marginal impact method.

Although the calculation can be cumbersome, look-back can have a significant impact on a taxpayer’s return, whether in the form of an additional tax liability, or a sizable refund, and shouldn’t be forgotten. For more information regarding our construction experience, be sure to visit our Construction Services page, and don’t hesitate to reach out to a member of our construction team.

About the Author

Kelly Koman

Kelly joined McKonly & Asbury in 2013 and is currently a Senior Manager with the firm. She is a member of the firm’s Tax Segment, working primarily on S-Corporation, partnership, and individual tax returns. She services clients in sev… Read more

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