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Examination and Closing Procedures Form 8697, Look-Back Interest

May, 2007

Jeanne M. Wierman, LB&I Construction Technical Advisor

Table of Contents

General Information Regarding Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts

Application of Look-back

Filing and Reporting Look-back Interest

Computation of Look-back Interest

Time Periods For Calculating Look-Back Interest

Look-back Applicable Interest Rates 7 Simplified Marginal Impact Method (SMIM

Common Errors

Examination Procedures for Look-Back Interest

Minimum Examination Procedures

Closing Procedures for Refunds of Look-back Interest

Closing Procedures for Look-back Interest Owed


General Information Regarding Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts

Application of Look-back

In the year of completion, income from certain long-term contracts accounted for under either the percentage of completion method or percentage of completion-capitalized cost method is allocated among the prior taxable years on the basis of actual contract price and costs instead of estimated contract price and costs.  The underpayment or overpayment of tax that results from this reallocation of income, for each affected prior taxable year, is determined and the taxpayer must either pay look-back interest if the reallocation reveals a deferral of tax liability, or is entitled to a refund of interest if the reallocation shows an acceleration of tax liability.  See IRC § 460(b)(1)(B) and Treas. Reg. § 1.460-6(a)(1).

Post-Completion Revenue and Expenses - In addition to the year of completion, look-back applies to any post-completion year for which the taxpayer must adjust the total contract price or total allocable contract costs.  See Treas. Reg.  § 1.460-6(c)(1)(ii).  However, the taxpayer may elect not to have look-back method apply in de minimis cases – See IRC § 460(b)(6)(A) and Treas. Reg. § 1.460-6(j) for additional information regarding this election.

Alternative Minimum Tax - Look-back not only applies to long term contracts reported under the percentage of completion method for regular income tax purposes but also applies to long-term contracts that must be reported under the percentage of completion method for alternative minimum tax purposes. See Treas. Reg.  § 1.460-6(b)(1) and(4).

Percentage of Completion Capitalized Cost Method - For long-term contracts reported under the percentage-of-completion-capitalized-cost method, look-back applies to the portion of the contract that is subject to percentage-of-completion.  In the case of long-term residential contracts (buildings with four or more dwelling units), the portion is 70%.  Look-back may also apply to the remaining 30% portion for alternative minimum tax purposes.  See Treas. Reg. §§ 1.460-4(e); 1.460-6(b)(1) and (4).

Exceptions from the application of look-back

  • Home construction contract - The look-back method does not apply to home construction contracts (defined in IRC § 460(e)(6)(A)).  Home construction contracts are exempt from the requirement to use percentage of completion method for both regular and alternative minimum tax purposes. See Treas. Reg. § 1.460-6(b)(2)(i) and IRC § 56(a)(3).

  • Mandatory De minimis Exception – The look-back method does not apply to any long-term contract that is completed within 2 years of the contract commencement date and has a gross contract price that does not exceed the lesser of $1,000,000 or 1% of the average annual gross receipts for the 3 tax years preceding the tax year of completion.  This exception is mandatory.  See Treas. Reg. § 1.460-6(b)(3).

  • Elective De minimis Discrepancies Exception – A taxpayer may elect not to apply look-back if the cumulative taxable income under the contract for each prior year is within 10% of the cumulative look-back income for each prior year.  See IRC § 460(b)(6)(B) and Treas. Reg. § 1.460-6(j).

Filing and Reporting Look-back Interest

Hypothetical - The computation of the amount of deferred or accelerated tax liability under the look-back method is hypothetical; it does not result in amending prior years’ tax liability. See Treas. Reg.  § 1.460-6(a)(1).

Definitions:

  • Filing Year:  The taxable year in which long-term contracts are completed or adjusted (post-completion adjustments).  See Treas. Reg.  § 1.460-6(c)(1)(i).

  • Redetermination Year:  Each prior tax year that is affected by income from contracts completed or adjusted in the filing year. See Treas. Reg.  § 1.460-6(c)(1)(i).

Form 8697 is used to compute and report look-back interest due or to be refunded.  For each filing year, the taxpayer will either owe look-back interest or be entitled to a refund as the “net” result of computing look-back interest on one or more redetermination years. Thus, a current filing year may contain both hypothetical overpayments and underpayments for prior years, but the net result determines whether look-back interest is owed by the taxpayer or should be refunded. See Treas. Reg.  § 1.460-6(f)(1) and (2).

The Form 8697 consists of two methods, represented as Part I & II, for computing look-back interest. 

            Form 8697, Part I – Regular Method

            Form 8697, Part II – Simplified Marginal Impact Method

Different Procedures For Filing And Reporting Look-Back Interest

The taxpayer will file look-back interest one of two ways depending on whether look-back interest is owed or look-back interest is to be received.

1.  Balance Due - Look-back Interest Owed by the Taxpayer

  • Form 8697 is attached to and filed with the taxpayer’s income tax return.  These forms are processed as integral parts of the return. 

  • The amount of interest required to be paid by the taxpayer is treated as an income tax liability, but only for purposes of subtitle F which addresses tax procedures and administration.  Thus the interest owed is included as an “additional” tax on the reporting taxpayer’s tax return for the filing year.

  • The amount of look-back interest paid is also treated as interest expense for computing taxable income.  However, for individuals, the interest paid is personal interest and, therefore, is disallowed in accordance with Treas. Reg. §  1.163-9T(b)(2).  

  • Failure to pay the amount of interest due is subject to any applicable penalties (for example, the underpayment penalty). 

  • Estimated tax penalties do not apply.

See Treas. Reg. § 1.460-6(f)(1) and (2).

2.  Refund - Look-back Interest Due to Taxpayer

  • Unlike look-back interest owed, look-back interest that is to be received by the taxpayer is not treated as a reduction in the tax liability or a tax refund. Therefore, it is not reported as part of the tax return for the filing year.

  • However, the amount of look-back interest received and any additional interest received on the look-back interest is included in taxable interest income in the tax year in which it is received or accrued.  See Treas. Reg. § 1.460-6(f)(1) and (2).

  • A Form 8697 claiming a refund is filed separately from the tax return in one of two campuses (previously known as Service Centers) depending on the type of taxpayer.

    • Individual taxpayers: Form 8697 is filed with the Philadelphia Campus.

    • All other taxpayers, Form 8697 is filed with the Cincinnati Campus.

Computation of Look-back Interest

The computation of look-back interest is a 3-step process:

  1. Hypothetical Reallocation Of Income Among Prior Tax Years - For each filing year, a taxpayer must allocate total contract income among prior tax years, by hypothetically applying the percentage-of-completion method on the basis of actual, rather than estimated, contract price and costs.  See Treas. Reg. § 1.460-6(c)(2). The result of Step 1 should be reflected on Form 8697, Part I (Regular Method),  Line 2 or Part II (Simplified Marginal Impact Method), Line 1 for each prior taxable year.

  2. Computation of Hypothetical Overpayment or Underpayment of Tax -Determine the overpayment or underpayment of tax for each tax year that is affected by the reallocation of income in Step 1.  See Treas. Reg. § 1.460-6(c)(3). The result of Step 2 should be reflected on Form 8697, Part I (Regular Method), Line 6.
    If the taxpayer is required or elects to use the simplified marginal impact method (SMIM), which is explained later, an assumed tax rate is used to compute step 2.  The result of Step 2 should be reflected on Form 8697, Part II (Simplified Marginal Impact Method), Line 2.

  3. Calculate Interest on the Hypothetical Overpayment or Underpayment of Tax - Compute the interest, using the applicable overpayment rate under IRC § 6621, for each redetermination year. See Treas. Reg. § 1.460-6(c)(4). The result of Step 3 for each redetermination year should be reflected on Form 8697, Part I – Line 7 or 8 with the “net” result being reflected on Line 9 or 10.  Alternatively, if SMIM is used, Step 3 for each redetermination year would be reflected on Form 8697, Part II – Line 8 or 9 with the “net” result being reflected on Line 10 or 11.

Look-back is Cumulative for Step 1 and Step 2

The “hypothetical” reallocation of contract income as a result of applying look-back does not increase or decrease the amount of contract income; it only changes the amounts that should have been reported each year.  Therefore, the application of look-back is cumulative to ensure look-back taxable income and regular taxable income is the same over the life of a contract.  See Treas. Reg. § 1.460-6(c)(3)(iv).

There are two important practical points regarding this regulation.

  1. If a redetermination year was previously adjusted by look-back, then the adjusted amounts are the starting points for the current Form 8697.  The taxable income from Form 8697, Part I (Regular Method), Line 3 of the previous Form 8697 becomes Line 1 on the current Form 8697.  Similarly, Line 4 of the previous Form 8697 becomes Line 5 of the current year Form 8697.

Example:  Filing Year 2006       

                                                                                                  2005

Form 8697, Part I, Line 1 – Taxable Income                               500,000
Form 8697, Part I, Line 2 – Lookback Adjustment                     100,000
Form 8697, Part I, Line 3 – Taxable Income as Adjusted            600,000
In the subsequent Filing Year, 2007, for the 2005 redetermination year:
Form 8697, Part I, Line 1 – Taxable Income                               600,000

  1. The filing year is adjusted by the current year look-back adjustment even though it is not shown on the Form 8697 and does not affect the current year look-back computation.  However, it can affect subsequent year look-back computations.  Because income is reallocated (without an increase or decrease in overall taxable income), the current year adjustment for the filing year must be reflected in future years’ look-back taxable income to prevent omission or duplication of income.  Using the previous example, in the filing year 2006, the lookback adjustment to 2005 is an increase of $100,000 which “hypothetically” is a reallocation of income from 2006 to 2005.  In the subsequent filing year (2007), Line 1 of the 2006 redetermination year should reflect the $100,000 decrease in taxable income.  This is demonstrated in Regulation 1.460-6(h)(3) Example 2 (iii).

Time Periods For Calculating Look-Back Interest

Interest due or to be refunded must be computed from the due date (not including extension) of the redetermination tax year return until the earlier of:

  1. The due date (not including extension) of the return for the filing year or

  2. The date the return for the filing year is filed and any income tax due for that year is fully paid.

See Treas. Reg. § 1.460-6(c)(4)(i).

Exceptions for the time periods of calculating Look-back Interest

  • Net Operating Loss (NOL) carrybacks that are hypothetically increased or decreased as a result of applying the look-back method, the interest is computed from the due date (not including extensions) of the redetermination year that generated the NOL and not the due date of the return in which the carryback is absorbed. See Treas. Reg. § 1.460-6(c)(4)(ii).
    Example:
      In the filing year 2006, the look-back adjustment increases a net operating loss in the 2004 redetermination year.  The original net operating loss was carried back and fully absorbed in the 2002 tax year.  The tax differential caused by the look-back adjustment is computed in the 2002 tax year; however the look-back interest is computed from the 2004 year, the net operating loss generating year and not 2002, the carry back year.

  • For NOL carryforwards that are hypothetically increased or decreased as a result of applying the look-back method, interest is computed from the due date of the return for the tax year in which the carryover is absorbed. See Treas. Reg. § 1.460-6(c)(4)(ii).

  • See Treas. Reg. § 1.460-6(c)(4)(iii) for additional time period exceptions for look-back refunds in redetermination years that the tax liability was subsequently refunded due to loss or credit carryback.

Additional Interest

Add-on interest, the compounding of interest on interest when the Service does not immediately pay a refund, is computed from the original return due date of the filing year to the date of scheduled payment.   See Treas. Reg. § 1.460-6(f)(3). 

Look-back Applicable Interest Rates

The overpayment rate under IRC § 6621, compounded daily, is used for both hypothetical overpayments and underpayments of tax.   For tax years ending after August 5, 1997, interest rates are determined for each interest accrual period (a year-long period), rather than changing quarterly. See Treas. Reg. § 1.460-6(c)(4)(i) and IRC § 460(b)(7).

Interest Accrual Period – Begins the day after the return due date (not including extensions) of each prior year and ends on the return due date for the following year.  Therefore, the interest rate stays the same the entire year-long interest accrual period, rather than changing quarterly.

Simplified Marginal Impact Method (SMIM)

This method provides a simplified method of calculating the hypothetical underpayment or overpayment of tax liability for each redetermination year based on an assumed marginal tax rate (Step 2 of the look-back computation).   Generally it is the highest rate of tax in effect for the redetermination year – IRC § 1 in the case of an individual and IRC § 11 in the case of a corporation.  For non-closely held flow-through entities that are required to compute SMIM at the entity level, the highest corporate tax rate in effect is used unless at all times during the redetermination year more than 50 percent of the interests in the entity were held by individuals directly or through 1 or more pass through entities.  See Treas. Reg. § 1.460-6(d)(2)(ii). 

Required use of SMIM 

For domestic contracts, SMIM is required to be applied at the entity level of pass-through entities (partnership, S corporation, or trust) that are not closely held.  A pass-through entity is a closely held entity if, at any time during any redetermination year, 50% or more of the beneficial interests in that entity are held (directly or indirectly) by or for 5 or fewer persons.  See Treas. Reg. § 1.460-6(d)(1) and (4)(i).  

Example:  A partnership has 20 unrelated partners, each owning 5% of the partnership.  The partnership is not closely held; therefore, look-back interest is computed at the partnership level using SMIM for its domestic contracts.  If the same partnership also has foreign contracts, look-back would be computed at the partner level for these contracts.

Elective Use of SMIM

Any taxpayer not required to use SMIM, may elect to use SMIM.  However, for flow-through entities, this election is made at the owner level, not at the entity level.  See Treas. Reg. § 1.460-6(d)(4)(ii).

Overpayment Ceiling 

For taxpayers electing SMIM, the net hypothetical overpayment of tax for any redetermination year is limited to the taxpayer’s total federal income tax liability reduced by earlier applications of the look-back method to that redetermination year.  This limit should be reflected on Form 8697, Part II – Line 6.  The overpayment ceiling does not apply to widely held pass-through entities that are required to apply SMIM at the entity level.  See Treas. Reg. § 1.460-6(d)(2)(iii). 

Example: In 2006, an individual elects to compute look-back interest using SMIM.  The hypothetical overpayment of tax for the 2005 redetermination year is $200,000.  However, the individual’s total tax liability on their 2005 return is $150,000.  Look-back interest would be computed on $150,000 because the overpayment ceiling is applicable.

Common Errors

  • For refunds requested by individuals, failure to include both signatures on the Form 8697.  If the related income tax return (Form 1040) is a joint return, both signatures are required on the Form 8697.

  • Improperly computing interest from the Net Operating Loss (NOL) carryback year.  The tax liability is hypothetically redetermined in the tax year the NOL carryback is absorbed, but interest to be computed for that carryback year is only from the due date (not including extensions) of the tax year that generated the NOL to the due date of the filing year (not including extensions).  See Treas. Reg.  § 1.460-6(c)(4)(ii).

  • Simplified Marginal Impact Method (SMIM) incorrectly applied at the flow-through entity level for those taxpayers electing this method.  There are only two instances in which look-back interest is applied at the entity level of a flow-thru entity (Form 1120-S or Form 1065): 

    • The pass-through entity is widely held and required to use SMIM.

    • Following the conversion of a C corporation into an S corporation the look-back method is applied at the entity level with respect to contracts entered into prior to the conversion.  See Treas. Reg. § 1.460-6(g)(3)((iv).

  • For taxpayers electing SMIM, the overpayment ceiling is not being applied – the net hypothetical overpayment of tax should be limited to the taxpayer’s total federal income tax liability as adjusted (i.e. prior applications of look-back, NOL carrybacks, etc.).  The overpayment ceiling does not apply to widely-held pass-through entities; taxpayers who are required to use SMIM.  See Treas. Reg. § 1.460-6(d)(2)(iii).

  • Members of a consolidated group erroneously file Form 8697 - The consolidated entity must file the Form 8697 using the consolidated entity’s EIN.

  • The interest rate for computing look-back interest is incorrectly being changed as the quarterly rates change - The quarterly rate that is in effect on the day after the due date of a taxpayer’s return should be applied to the entire “interest accrual period” (an annual period), and it does not change quarterly during the year.  See IRC § 460(b)(7)(B).

  • Forms 8697 claiming refunds are improperly attached to the tax return reducing the current year’s tax liability – Forms 8697 refunds must be filed separately from the income tax return.

  • Schedules of contract income reallocation are not attached to the Form 8697 – only owners of pass-through entities are exempt from this requirement.

  • The cumulative changes to look-back taxable income and look-back tax liability for each redetermination year are not being properly reported on the Form 8697.

Examination Procedures for Look-Back Interest

  1. Determine whether the taxpayer is subject to look-back provisions of IRC § 460. 
    Generally, any taxpayer required to compute income on its long-term contracts under the percentage-of-completion method (PCM) per IRC § 460 is required to compute look-back upon completion of those contracts.
  • Any non-home construction contract not completed within the same taxable year entered into is subject to PCM and look-back, unless the average annual gross receipts for the prior 3 years is less than $10,000,000 and the job is expected to be completed within 2 years.
  • Any long-term contract that is not required to be computed under PCM for regular income tax purposes, but required to use PCM for alternative minimum tax purposes, is also subject to the provisions of look-back.
  • Home construction contracts are exempt from PCM and look-back for both regular income tax and AMT.
  • Residential construction (more than 4 dwelling units in a building) contracts that are computed on the elective percentage-of-completion-capitalized cost method (PCCM) – 70% of the contract is PCM and thus subject to look-back.  Additionally, the remaining 30% would be subject to PCM for alternative minimum tax purposes (AMT), and look-back may also need to be applied to the AMT portion. 
  1. Determine whether the taxpayer computed look-back. 
  • Look-back Interest Owed – The Form 8697 is treated as an additional tax on the income tax return and must be attached to the return as any other form or schedule.  Any  amount owed will be reflected as an additional tax on the tax return (i.e. Schedule J, Line 9, for Form 1120).  For Form 1120, a BMFOL will also show an Alpha Condition Code – “K” if Form 8697 was filed with the return.
  • Look-back Interest Paid to the taxpayer - The Form 8697 is filed separately from the related income tax return and can be either non-masterfile (MFT 69) or masterfile.  Prior to 2005, Form 8697 was processed as non-masterfile.  However, since then, Form 8697 is now processed on masterfile, unless there is not a corresponding income tax return filed. 

Look-back refunds that have been paid have the following transaction codes on the masterfile transcript:

           TC 766 - This amount represents the look-back interest paid
           TC 770 - This amount represents the add-on interest
           TC 840 - This amount represents the total refund paid

Look-back refunds are filed at one of two processing campuses:

Individuals (IMF) - Philadelphia
All Others (BMF) - Cincinnati

  1. For taxpayers that have not computed look-back, issue an Information Document Request (IDR) requesting:
  • Detailed schedule of all construction contracts subject to percentage-of-completion or percentage-of-completion-capitalized-cost method that were completed during the tax year.  See the instructions to the Form 8697, Line 2, for the information that is to be included on the detailed schedule being requested.

  • Include any contracts that were previously completed but adjusted (post completion income or expenses) during the current year. 

  • Owners of flow-through entities are not required to provide the detailed schedule but should have been provided the information with the Schedule K-1 or on a separate statement.

  1. Exclude any contracts that are not subject to look-back:
  • Contracts that have a contract price that does not exceed the lesser of 1% of the average annual gross receipts for the three tax years preceding the year of completion or  $1,000,000 are not subject to look-back interest. 

  • Any home construction contracts are exempt from the look-back computation.

  • Elective De minimis Exception:  Verify that the difference between the look-back gross income and the amount reported on the tax return are within 10% for every prior year.

Minimum Examination Procedures

  1. Determine if the refund has been paid (Research both masterfile and non-masterfile databases).  The closing procedures, provided later in this document, are different for refunds that have been paid versus those that have not been paid.
  2. Line Items to be checked – Form 8697, Part I Regular Method.
    • Line 2 - Verify that amounts are brought forward correctly from attached schedules.  If the taxpayer is the owner of a flow-through entity, the amounts on line 2 should be reported on the taxpayer’s Schedule K-1 (Line 20 and code “J” identifies it as look-back interest for completed long-term contracts).
    • Line 6 - If negative amount (overpayment of tax), line 2 should also be negative.  If positive amount, line 2 should also be positive.
    • Line 6 - for the “negative” years, verify (by IDRS research) that the corresponding income tax return has sufficient tax liability for the hypothetical decrease in tax.  For example, if Line 6 is ($150,000) and the TC 150 code (and any other tax codes 290 – 300) for that year is $90,000 – the taxpayer should not be refunded look-back interest on “nonexistent” tax.  NOLs, amended returns, and prior applications of look-back interest may account for the difference.  Further reconciliation of the tax module to the look-back taxable income and tax liability may be necessary. 
    • Estimate the tax differential reflected on Line 6 compared to the adjustment on Line 2.  Line 2 represents the adjustment to income for look-back purposes.  Line 6 basically represents the tax differential caused by the look-back adjustment reported on Line 2.   For example, if the adjustment to income on Line 2 is ($2,000,000) and the taxpayer’s tax bracket is 34% - the tax liability decrease should be approximately ($680,000) upon which the look-back interest is to be computed.
    • Lines 7 and 8 – use the Look-back Interest Computation [Computation of LB Interest version 7.6(a)] to compute the interest on the “corrected” amount on line 6.  Print out if different from the taxpayer’s computation and close case according to procedures listed later in this document.
    • If the adjustment on Line 2 creates or changes an NOL carryback – the interest computation is from the due date of the tax year that created the NOL and not the carryback absorption year.
  3. Line Items to be checked – Form 8697, Part II Simplified Marginal Impact Method.
    • If a flow-through entity, 1120S or 1065, has filed the Form 8697, verify that the entity is not closely held (50% or more of the interest is owned by 5 or fewer persons).  If it is closely held, the Form 8697 must be filed at the owner level and not the entity level.  
    • Line 1 - Verify that amounts are brought forward correctly from attached schedule of contracts.  If the taxpayer is the owner of a flow-through entity, the amounts on line 2 should be reported on the taxpayer’s Schedule K-1 (Line 20 and code “J” identifies it as look-back interest for completed long-term contracts).
    • Line 2 – Multiply the amount on Line 1 by the highest applicable tax rate in effect for individuals or corporations for each prior year.  For non-closely held flow-through entities that are required to compute SMIM at the entity level, the highest corporate tax rate in effect is used unless at all times during the redetermination year more than 50 percent of the interests in the entity  was held by individuals directly or through 1 or more pass through entities.
    • Line 5 - If negative (overpayment of tax), line 1 should also be negative.  If positive, line 1 should also be positive.
    • Line 6 – Overpayment Ceiling – Applies to individuals and C Corporations.  For the “negative” years, verify (by IDRS research) that the corresponding income tax return has sufficient tax liability for the hypothetical decrease in tax.  For example, if Line 6 is ($150,000) and the TC 150 code (and any other tax codes 290 – 300) for that year is $90,000 – the taxpayer should not be refunded look-back interest on “nonexistent” tax.  NOLs, amended returns, and prior applications of look-back interest may account for the difference.  Further reconciliation of the tax module to the look-back taxable income and tax liability may be necessary. 
    • Line 8 and 9 – use the Look-back Interest Computation [Computation of LB Interest version 7.6(a)] to compute the interest on the “corrected” amount on line 7.  Print out if different from the taxpayer’s computation and close case according to procedures listed later in this document.

Closing Procedures for Refunds of Look-back Interest

Joint Committee procedures do not apply to refunds of look-back interest in excess of $2,000,000.00 unless the refund is a claim for previously assessed look-back interest.  The payment of look-back interest is a payment of statutory interest not subject to review by the Joint Committee.

For all non-Joint Committee refunds, the Form 8697 is closed separately from any related income tax returns, whether or not that return is under examination.  (Note: For Joint Committee refunds follow the Joint Committee procedures in IRM 4.36). 

Currently, the Form 8697 is a document which does not have an Examination Returns Control System (ERCS) tracking code.  Therefore the time applied to the examination of a look-back claims should be charged to Activity Code 575.  The Form 8697 case package should be sent to the appropriate campus listed below via Form 3210, Document Transmittal, in order to track the Form 8697.  This paragraph only applies to Look-back interest refunds.  Look-back interest owed is a part of the related tax return.  See the Closing Procedures for Look-back Interest Owed later in this document.

  1. Send the Form 8697 “refund” case package and route as follows:
  • BMF----
    Internal Revenue Service
    Operations 2; Dept 2; Team 203: Stop 6222G
    PO Box 45999
    Cincinnati, OH 45999

For UPS or FEDEX:
Internal Revenue Service
Operations 2; Dept 2; Team 203: Stop 6222G
201 West Rivercenter Blvd.
Covington, KY  41011

  • IMF----
    Internal Revenue Service
    Drop Pt. 441N
    PO Box 245
    Bensalem, PA 19020
  1. Form 8697 Refund Case Package should include the following:

  • Original Form 8697 w/valid signature(s)

  • Schedule of contracts that is required to be attached to the Form 8697.  (Note: not required by the owner of an interest in a pass-through entity.  The entity should have provided the line 2 amounts with Schedule K-1 or on a separate statement)

  • Look-back interest computation – from excel spreadsheet.

  • Work papers/ documentation of the examination procedures.

  • Explanation of any adjustments or discrepancies. Cite any applicable IRC or Treasury Regulations.

  1. Form 3198 – Other Section: Include one of the following statements in the other section based on the applicable situation.

Situation 1 - Refund Has Not Previously Been Paid - Accepted As Filed
Accept as Filed - Form 8697 has been verified and the look-back interest computed by the taxpayer is correct.  Accept and pay the interest per the Form 8697 plus additional add-on interest.”

Situation 2 - Refund Has Been Paid - Accepted As Filed
Accept as Filed - Form 8697 was processed and the taxpayer was issued a refund of $XX. This amount has been determined to be correct. No additional interest to be paid “

Situation 3 - Refund Has Not Previously Been Paid – Partial Disallowance
“Partial Disallowance - Form 8697 has been verified and the look-back interest was computed to be $XX instead of $XXX as computed by TP.  Pay the taxpayer $XX, plus additional add-on interest, and issue Letter 106C for the partial disallowance”

Situation 4 - Refund Has Been Paid – Refund Less Than Amount Paid
Partial Abatement - Form 8697 was processed and the taxpayer was issued a refund of $XXX.  As the result of an examination, the refund should have been $XX.  Abate a portion of the previous refund in the amount of $Y (XXX – XX). “

Situation 5 - Refund Has Not Previously Been Paid – Disallowed In Full
Full Disallowance - Form 8697 has been examined and is to be fully disallowed.  Issue Letter 105C and include the following explanation for the disallowance:  [Give a brief statement for the disallowance and cite any applicable IRC or Treasury Regulations – letters are limited to 385 characters.  If more space is needed include a statement to be attached to the letter].

Situation 6 - Refund Has Been Paid – Disallowed In Full
Full Abatement – Form 8697 was processed and the taxpayer was issued a refund of $XXX.  As the result of an examination, the entire amount should not have been paid for the following reason:   [Give a brief statement for the disallowance and cite any applicable IRC or Treasury Regulations – letters are limited to 385 characters.  If more space is needed include a statement to be attached to the letter].  Abate the previous refund of $XXX.”

Situation 7 - Refund Has Not Previously Been Paid – Additional Interest Owed To the Taxpayer
Accept & Pay additional Interest - Form 8697 has been verified and the look-back interest was computed to be $XXX instead of $XX as computed by the TP.  Pay the taxpayer $XXX plus additional add-on interest.”

Situation 8 - Refund Has Been Paid – Additional Interest Owed To the Taxpayer
Pay additional Interest - Form 8697 was processed and the taxpayer was issued a refund of $XX.  As the result of an examination, the refund should have been $XXX.  Pay the additional amount of $Y (XXX-XX) plus additional add-on interest.”

Situation 9 – Refund Has Not Previously Been Paid – Interest Is Due (Balance Due) Rather Than A Refund – Related Income Tax Return Not Under Examination
Full Disallowance and Assessment on MF – Form 8697 was filed by the taxpayer requesting a refund.  As the result of an examination, the taxpayer owes look-back interest.  Disallow the entire refund requested on Form 8697 and assess the MF for $XX.”

Situation 10 – Refund Has Not Previously Been Paid – Interest Is Due (Balance Due) Rather Than A Refund – Related Income Tax Return Is Under Examination
Same explanation as situation 5 plus the following statement:
“The amount of look-back interest that is owed by the taxpayer will be assessed by the Revenue Agent examining the related income tax return”

Situation 11 – Refund Has Been Paid – Look-back Interest Is Owed (Balance Due) Rather than a Refund – Related Income Tax Return Not Under Examination
“Form 8697 was processed and the taxpayer was issued a refund of $XX.  As the result of an examination, the refund should not have been issued.  Abate the previous refund of $XX and assess MF for $YY, the amount of look-back interest the taxpayer owes.

Situation 12 – Refund Has Been Paid – Look-back Interest is Owed (Balance Due) Rather than a Refund – Related Income Tax Return Is Under Examination
“Form 8697 was processed and the taxpayer was issued a refund of $XX.  As the result of an examination, the refund should not have been issued.  Abate the previous refund of $XX. Look-back interest that is owed by the taxpayer will be assessed by the Revenue Agent examining the related income tax return.”

Closing Procedures for Look-back Interest Owed

Any change to look-back interest owed by the taxpayer is to be reflected in the examiner’s report (RAR) and would follow normal closing procedures.

Situation 1: Examination results in additional look-back interest owed – The additional amount is classified as an additional tax on the RAR and would generally result in an additional interest expense deduction (except for individuals, for whom the interest expense is personal, nondeductible interest).  Any additional interest expense that would be deductible by the taxpayer is normally taken into account during the tax year the liability becomes fixed and determinable.

Situation 2: Examination results in an amount less than what was originally reported but the corrected look-back interest still results in Interest Owed – The additional tax related to look-back interest on the income tax return is credited for the difference and would generally include a disallowance of any corresponding interest expense deduction.

Situation 3: Examination results in an overall refund of look-back interest – the total amount of look-back interest treated as an additional tax would be credited and disallow any amount deducted as interest expense.   Instruct the taxpayer to prepare a Form 8697, and use the closing procedure for Situation 1 under Closing Procedures for Refunds of Look-back Interest.

Example:  The Form 8697, filed with the Form 1120, reflected look-back interest owed of $500,000.  The taxpayer properly included the amount as an additional tax and deducted $500,000 as interest expense.  As a result of the examination, the corrected look-back interest results in a refund of $200,000.  The Revenue Agent Report (RAR) would include adjustments to disallow the $500,000 interest expense and credit the additional tax for $500,000.  The taxpayer would file Form 8697 with the Cincinnati Campus requesting a $200,000 refund. 

Page Last Reviewed or Updated: 05-Mar-2014