If you are a construction contractor reporting revenue from long-term contracts on the percentage-of-completion method (PCM), you may be required to file Form 8697 – Interest Computation Under the Look-Back Method for Completed Long-Term Contracts.

Taxpayers reporting on the percentage of completion method report estimated income while the contract is still in progress. At the end of the job, when the contract is completed, it’s likely they will find that these estimates were not 100% accurate throughout the duration of the job. This is where the look-back method may be needed.

What is “Look-Back”?

As mentioned above, contractors generally must use PCM for long-term construction contracts under Internal Revenue Code (IRC) Section 460 (home and residential construction contracts are exempt from PCM). Contracts in progress likely recognize estimated amounts of revenue that are different than the actual amounts reported upon completion of the contract. Therefore, taxpayers are required to perform a “look-back” calculation to account for any understatement or overstatement of previously reported income. For example, if you overestimate the gross profit on a long-term contract in a previous year, the IRS would owe you interest on the income taxes you overpaid in the previous year. On the other hand, if you happened to understate your gross profit while the contract was in progress, you would owe the IRS interest on income taxes underpaid in the previous year. Note that this is not a recalculation of income taxes but rather a receipt or payment of interest. Total taxes paid over the life of the contract do not change, but the timing of the collection of those taxes was based on estimated numbers during years in which the contract was ongoing, which is why the look-back method is used to determine the amount of interest owed.

The taxpayer generally applies the look-back method to any long-term contract in the year it was completed and in any year post-completion where there was an adjustment made to the total contract price or total contract costs.

What Types of Contracts are Exempt?

The look-back method generally applies to any income from a long-term contract that is required to be reported under PCM, minus a few exceptions:

• Home construction contracts defined as any contract where 80% or more of the costs are attributable to the construction or improvement of a dwelling unit in a building consisting of four or fewer dwelling units.
• Contracts where the price does not exceed the lesser of $1 million or 1% of average gross receipts for three previous tax years in which the contract was completed.
• Taxpayers that meet the small contractor exception and do not use PCM (construction-type contracts where the contract is expected to be completed within two years of the start date AND the taxpayer’s average annual gross receipts do not exceed $29 million for the three previous tax years (adjusted for inflation annually – see Section 448(c)).
  • Please note that if the taxpayer chooses to use PCM despite being considered a “small contractor” per the exception above, the look-back method is still required as long as PCM is used to account for long-term contracts. Also important to note is that small contractors are still required to use PCM for AMT purposes and thus would be required to compute look-back interest for AMT.

In addition to the three exceptions above, a de minimis election is also available. The contractor can choose to not apply the look-back method if, in the completion year, for each prior contract year, the cumulative estimated income generated from the individual contract is within 10% of the cumulative actual income. All of the calculations to determine the look-back adjustment would still need to be performed, but if the contract falls under the de minimis threshold, the net adjustments for each year can be excluded from the overall amount reported on Form 8697.

Reporting

It is important to emphasize that, despite the look-back calculation affecting multiple tax years, you do not need to amend previous returns. Look-back adjustments will be calculated at the shareholder or partner level for pass-through entities and at the entity level for C Corporations. The interest due to or receivable from the IRS is calculated and reported on Form 8697. If interest is due from the taxpayer, Form 8697 is included with the tax return, and payment is included with any other balances owed. If interest is to be refunded to the taxpayer, Form 8697 is filed separately from the return and mailed to the appropriate address.

It is no secret that many CPAs consider the taxation of construction contractors to be one of the most complex areas of the IRC. We want to ensure that you are familiar with these provisions so that you are reporting appropriately. Accurate estimating throughout the life of a contract can help minimize look-back adjustments. Although the look-back calculation can be quite involved, it helps to true-up the timing of prior-year tax payments with the potential of a refund of interest to the taxpayer.