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Construction Industry Audit Technique Guide (ATG) - Chapter 5

Publication Date - May 2009

NOTE: This document is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.


Table of Contents
Chapter 4 / Chapter 6


Chapter 5: Look-Back Interest

Introduction

Taxpayers using the percentage of completion method must generally apply the look-back method upon completion of each contract. IRC Section 460(b)(2) provides that in the taxable year in which a contract is complete, a determination is made whether the taxes paid with respect to the contract in each year of the contract were more or less than the amount that would have been paid if the actual cost and contract price, rather than estimated contract price and cost, had been used to compute gross income. This look-back computation does not result in an adjustment to tax, but instead results in interest due to or from the taxpayer, depending on the results of the computation.

Upon completion of the contract (or, with respect to any amount properly taken into account after completion of the contract, when such amount is so properly taken into account), IRC Section 460(b)(1)(B) requires the taxpayer to pay (or be entitled to receive) interest computed using the look-back method under paragraph (2).

A taxpayer must file Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts, in the tax year in which a contract subject to the look-back method is completed and pay interest (but no tax) if the look-back method reveals an underpayment with respect to a taxable year. The taxpayer will receive interest back if the look-back computation reveals an overpayment.

Look-Back Is Hypothetical

The computation of the amount of deferred or accelerated tax liability under the look-back method is hypothetical. The application of look-back does not result in an adjustment to the tax liability (i.e., the prior years’ look-back computation does not amend the tax liability of those years). The computation is only to determine the interest due to or owed by the taxpayer on the tax differential in each year due to the differences in the estimated and actual figures.

Treasury Regulation Section 1.460-6(a)(1) provides that the computation on the amount of deferred or accelerated tax liability under the look-back method is hypothetical. Application of the look-back method does not result in an adjustment to the taxpayer’s tax liability as originally reported, as reported on an amended return, or as adjusted on examination. Thus, the look-back method does not correct for differences in tax liability that result from either overestimation or underestimation of contract price and costs that are permanent because tax rates change during the term of the contract.

Example:

Job 1 commenced during Year 1 and was completed in Year 3. The taxpayer was required to report the gross receipts and expenses on Job 1 using the  pursuant to the formulas set forth below under IRC Section 460(b):

Percentage of Completion Method

Total Allocable Contract Costs Incurred To Date
Divided By
Total Estimated Allocable Contract Costs

Times

Total Estimated Contract Price Prior Years’ Reported Gross Receipts

Equals

Gross Receipts To Be Reported For The Taxable Year

In Year 3, the year of completion, the percentage of completion computation would be recomputed for Year 1 and Year 2 using the actual figures rather than the estimated amounts as follows:

Percentage of Completion Method Year 3
Return Formula Year 1 Year 2 Year 3
Job 1

Total Allocable Contract Costs Incurred to Date
Divided By
Total Estimated Allocable Contract Costs
Equals
Percentage
Times
Total Estimated Contract Price
Estimated Gross Receipts
(Prior Years’ Reported Gross Receipts)
Equals
Gross Receipts to be Reported for Taxable Year

$450,000
Divided By
$4,500,000
Equals
10.00%
Times
$5,000,000
$500,000
($0)
Equals
$500,000

$4,000,000
Divided By
$4,800,000
Equals
83.33%
Times
$5,200,000
$4,333,333
($500,000)
Equals
$3,833,333

$5,000,000
Divided By
$5,000,000
Equals
100.00%
Times
$5,500,000
$5,500,000
($4,333,333)
Equals
$1,166,667

 

Percentage of Completion Method Year 3
Look-back Formula Year 1 Year 2 Year 3
Job 1

Total Allocable Contract Costs Incurred to Date
Divided By
Total Estimated Allocable Contract Costs
Equals
Percentage
Times
Total Estimated Contract Price
Estimated Gross Receipts
(Prior Years’ Reported Gross Receipts)
Equals
Gross Receipts to be Reported for Taxable Year

$450,000
Divided By
$5,000,000
Equals
9.00%
Times
$5,500,000
$495,000
($0)
Equals
$495,000

$4,000,000
Divided By
$5,000,000
Equals
8.00%
Times
$5,500,000
$4,400,000
($495,000)
Equals
$3,905,000

Completion Year is Look-back Interest Computed on the prior Years of the contract

Difference

Gross Income Overstated or (Understated)

$5,000

($71,667)

N/A

In the above example, Year 1 and Year 2 tax returns are not amended; the tax computation of look-back is hypothetical. The interest is computed on the tax differential of the changes to income in Year 1 and Year 2, which would be shown on Form 8697 filed in Year 3, the year of completion.

Additionally, the above example only recomputed the hypothetical change to the gross income of the contract rather than the gross profit of the contract. If one were to hypothetically recalculate the gross profit each year, the look-back adjustment would still be the same because the incurred expenses (i.e. numerator) remain the same under the look-back method.

Scope of Look-back Method

The look-back method applies only to long-term contracts subject to the percentage of completion method described in IRC Section 460(b). Thus, look-back interest does not apply to construction contracts meeting the exceptions under IRC Section 460(e), such as home construction contracts and taxpayers meeting the small contractor exception. The look-back method applies to the following:

Percentage of Completion Method (PCM)

This includes any income from a long-term contract that is required to be reported under the percentage of completion method for regular income tax purposes. See Treasury Regulation Section 1.460-6(b) (1).

Alternative Minimum Tax (AMT)

This includes any income from a long-term contract that is required to be reported under the percentage of completion method for alternative minimum tax purposes. These include non-home construction contracts, with average annual gross receipts for the prior 3 years that are less than $10,000,000. Although these non-home construction contracts are exempt from reporting income on the percentage of completion method for regular income tax purposes, for alternative minimum tax purposes the taxpayer must report the income on the percentage of completion method. The look-back method is applied to the recomputed the AMT. See Treasury Regulation Section 1.460-6(b) (2) (ii).

Percentage of Completion-Capitalized Cost Method (PCCM)

Residential construction contracts may be reported under PCCM in which 70% of the contract is reported under PCM and the other 30% is reported under an exempt contract method. See Treasury Regulation Section 1.460-4(e). Look-back would be computed on the 70% PCM portion of the contract. See Treasury Regulation Section 1.460-(6) (b) (1).

Related Parties

To the extent that the percentage of completion method is required to be used under Treasury Regulation Section1.460-1(g) with respect to income and expenses that are attributable to activities that benefit a related party’s long-term contract, the look-back method also applies to these amounts, even if those activities are not performed under a contract entered into directly by the taxpayer. See Treasury Regulation Section 1.460-(6) (b) (1).

Exceptions from the Application of Look-Back

Look-back does not apply to the regular taxable income from any long-term construction contract in the following situations:

Home Construction Contract

Home construction contracts are defined by IRC Section 460(e) (6) (A) and are exempt from look-back under IRC Section 460(e) (1) (A).

Small Contractor Exception

Any contract which is not a home construction contract but is estimated to be completed within a 2-year period is exempt per IRC Section 460(e) (1) (B) if the taxpayer’s average annual gross receipts for the 3 tax years preceding the tax year the contract is entered into do not exceed $10,000,000. However, the look-back may apply to the alternative minimum taxable income from a contract of this type; or

De Minimis Small Contract Exception

The look-back method does not apply to any long-term contract that is (1) completed within 2 years of the contract commencement date and (2) has a gross contract price that does not exceed the lesser of:

  1. $1,0000,000; or
  2. 1% of the average annual gross receipts of the taxpayer for the 3 tax years prior to the tax year that the contract is completed.

Exception from the look-back method is mandatory for de minimis small contracts and applies for purposes of computing both regular taxable income and alternative minimum taxable income. See IRC Section 460(b)(3)(B).

Example:

This situation illustrates the concept of de minimis small contract exception. The average annual gross receipts for the 3 preceding tax years are $55,000,000. The following non-home construction contracts were completed during the taxable year and all jobs were completed within 2 years of the contract commencement date.

De Minimis Small Contract Exceptions
Job Gross Contract Price

1

$5,000,000

2

$900,000

3

$15,000,000

4

$2,500,000

5

$400,000

Only Job 5 would be exempt from the application of look-back. The de minimus exception applies to jobs that have a gross contract price less than $550,000 (1% of $55,000,000 - average annual gross receipts), which is the lesser of $1,000,000 or 1%. However, if Job 5 was not completed within 2 years of the contract commencement date, the de minimis exception would not apply, and look-back would be required. The $1,000,000 benchmark would only apply when the average annual gross receipts of the three preceding years exceeds $100,000,000.

Election Not to Apply Look-Back

For contracts completed in tax years ending after August 5, 1997, contractors may elect not to apply the look-back method if the amount reported is within 10 percent of the cumulative taxable income or loss as determined using actual contract price and costs for each prior contract year. The 10% test must be met in each year of the contract; it is not 10% of the entire contract (i.e. a contract will not meet the de minimis exception if the entire contract is within 10% of the look-back computation but in Year 1 the contract was 11% different). See IRC Section 460(b) (6) (B).

IRC Section 460(b) (6) (B) provides that de minimis discrepancies pursuant to paragraph (1)(B) shall not apply in any case to which it would otherwise apply if the cumulative taxable income (or loss) under the contract as of the close of each prior contract year, is within 10 percent of the cumulative look-back income (or loss) under the contract as of the close of such prior contract year.

This is an election and is not mandatory as compared to the mandatory de minimis small contract exception per IRC Section 460(b) (3) (B). Once elected, the de minimis discrepancy exception applies to all long-term contracts completed during the taxable year for which the election is made and any subsequent taxable year. Revoking this election is considered a change in method of accounting, which requires the Commissioner’s consent. See IRC Section 460(b) (6) (D) and Treasury Regulation Section 1.460-6(j).

Computation of Look-Back

The computation of look-back interest involves a three-step process that is described under IRC Section 460(b) (2):

  1. Hypothetically reapply the PCM for each year of all long-term contracts that are completed or adjusted in the current year, using the actual, rather than estimated, total contract price and contract costs to determine income for each year of the contract;
  2. Compute the hypothetical overpayment or underpayment of tax for each year, which will be the difference between the amount of income reported each year, and the amount that would have been reported if actual, rather than estimated, contract price and costs had been used; and
  3. Apply the rate of interest on overpayments to the hypothetical overpayment or underpayment of tax.

IRC Section 460(b) (2) provides that interest computed under the lookback method of this paragraph shall be determined by:

  1. Allocating income under the contract among taxable years before the year in which the contract is completed on the basis of the actual contract price and costs instead of the estimated contract price and costs.
  2. Determining (solely for purposes of computing such interest) the overpayment or underpayment of tax for each taxable year referred to in subparagraph (A) that would result solely from the application of subparagraph (A).
  3. And, then using the adjusted overpayment rate as defined in paragraph (7) (compounded daily) on the overpayment or underpayment as determined under subparagraph (B).

For purposes of the preceding sentence, any amount properly taken into account after completion of the contract shall be taken into account by discounting (using the Federal mid-term rate determined under section 1274(d) as of the time such amount was properly taken into account) such amount to its value as of the completion of the contract. The taxpayer may elect with respect to any contract to have the preceding sentence not apply to such contract.

Step 1: Reapply the PCM to all Long-Term Contracts

Using the actual contract price and contract costs under Treasury Regulation Section 1.460-6(c)(2) for each filing year, a taxpayer must reallocate total contract income among prior years using actual contract price and costs to all contracts that are completed or adjusted (e.g., post-completion revenue and expenses are discussed below) in the filing year. See Treasury Regulation Section 1.460-6(c)(2)(i). Look-back cannot be applied to a contract before it is completed. See Treasury Regulation Section 1.460-6(c) (2) (iii). The following items may be included in the “actual” contract income and costs for the look-back computation:

Treatment of Estimated Future Costs

If a taxpayer reasonably expects to incur additional allocable contract costs in a tax year subsequent to the year in which the contract is completed, the taxpayer includes these additional costs with the actual costs in the denominator of the PCM ratio. The completion year is the only filing year for which the taxpayer may include additional estimated costs in the denominator of the PCM ratio in applying the look-back method. If look-back is reapplied in any year after the completion year, only the cumulative costs incurred are includible in the denominator of the PCM ratio for look-back purposes. See Treasury Regulation Section 1.460-6(c) (2) (ii).

Amount Treated as Contract Price

All amounts that the taxpayer expects to receive from the customer are treated as part of the contract price as soon as it is reasonably estimated that they will be received even if the all-events test has not yet been met. See Treasury Regulation Section 1.460-6(c) (2) (vi) (A).

Percentage of Completion

Under the 10% Method and Application of Look-back, contractors are required by IRC Section 460 to use the percentage of completion method to report income on long-term construction contracts may elect to defer the recognition of gross income and the deduction of costs incurred on contracts until the year in which 10% of the estimated allocable contract costs have been incurred. This method of accounting is discussed in the chapter on large contractors. Contractors that elect this method must also use the 10% method to compute look-back interest. See Treasury Regulation Section 1.460-6(c) (2) (v).

Use of actual contract price and costs under the look-back method will occasionally reveal that the year that 10% of the allocable contract costs have been incurred for look-back (the 10% year) was earlier or later than the year originally reported.

When the look-back year is earlier than the year originally reported, the contract costs must be reallocated to the new 10% year and to subsequent years as incurred. When the look-back year is later than the year originally reported, the contract costs incurred before the new 10% year must be reallocated to the new 10% year. See Treasury Regulation Section1.460-6(c)(2)(v).

Example:

This situation illustrates the concept of the 10% method and application of the look-back method.

Example of 10% and Look-Back Method
Per Return Year 1 Year 2 Year 3

Cumulative Incurred Costs

$58,000

$300,000

$500,000

Estimated Total Costs

$600,000

$600,000

$500,000

Percent Complete

9.6%

50%

100%

Total Contract Price

$1,000,000

$1,000,000

$1,000,000

Income to be Reported

0

$500,000

$500,000

Expenses to be Deducted

0

$300,000

$200,000

Per Look-Back

Year 1 Year 2 Year 3

Cumulative Incurred Costs

$58,000

$300,000

$500,000

Actual Total Costs

$500,000

$500,000

$500,000

Percent Completed

11.6 %

60%

100%

Total Contract Price

$1,000,000

$1,000,000

$1,000,000

Gross Income: That should have been reported for look-back purposes.

$116,000

$600,000
($116,000)
$484,000

 

Expenses: That should have been deducted for look-back purposes.

$58,000

$300,000
($58,000)
$242,000

 

Year 1 is the new 10% year for look-back, and the income and expenses are reallocated to year 1 to determine the underpayment of tax in Year 1 under the lookback method.

Step 2: Computation of Overpayment or Underpayment of Tax

The computation of hypothetical overpayment or underpayment of tax is provided under Treasury Regulation Section 1.460-6(c)(3). This step involves the computation of a hypothetical overpayment or underpayment of tax for each year redetermination year in which the tax liability is affected by income from contracts that are completed or adjusted in the filing year. Rather than recomputing the tax liability of each redetermination year, a taxpayer may be required, or elect, to use the simplified marginal impact method (SMIM), which uses an assumed marginal tax rate. This simplified method is discussed later in this chapter. The remaining discussion of Step 2 is applicable to those taxpayers not using SMIM.

The redetermination year is any affected tax year for which a look-back computation must hypothetically be computed. The filing year is the year that contracts are completed or adjusted (e.g., post-completion revenue and expenses, discussed below).

The taxpayer must determine what its regular and alternative minimum tax liability would have been for each redetermination year if the actual amounts of contract income allocated in Step 1 were substituted for the amounts reported on the taxpayer’s original return (or as subsequently adjusted on an amended return or an examination). See Treasury Regulation Section 1.460-6(c) (3) (ii). The hypothetical underpayment or overpayment for each affected year is the difference between the tax liability as determined under the look-back method and the amount of tax liability as originally reported, subsequently amended or adjusted, or the last previous application of look-back, whichever is latest. See Treasury Regulation Section 1.460-6(c) (3) (iii). The redetermination of tax liability resulting from previous applications of the look-back method is cumulative. See Treasury Regulation Section 1.460-6 (c) (3) (iv).

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 Treasury Regulation Section 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:

This situation illustrates the concept of how the redetermination amounts are reflected on Form 8697 for filing year 2006.

Form 8697 Adjustments
  2005 2007

Part I, Line 1 – Taxable Income

$500,000

$600,000

Part I, Line 2 – Look-back Adjustment

$100,000

 

Part I, Line 3 – Taxable Income as Adjusted

$600,000

 

2. 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 that “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 Treasury Regulation Section 1.460-6(h)(3), Example 2 (iii).

Years Affected by Look-back

A redetermination of income tax liability under Step 2 is required for every tax year for which the tax liability would have been affected by a change in the amount of income or loss for any other year for which a redetermination is required. For example, if the allocation of contract income under Step 1 changed the amount of a net operating loss that was carried back to a year prior to the year the taxpayer entered into the contract, the tax liability for the earlier year must be determined. See Treasury Regulation Section 1.460-6 (c) (3) (v).

Example:

This situation illustrates the concept of a Net Operating Loss (NOL) and Look-back. In Year 5, a contract is completed which was in process in Years 3 and 4. On the original tax return for Year 3, the taxpayer incurred a NOL, which was carried back and fully absorbed in Year 1. When computing look-back for Year 5, the completion year, the reallocation of contract income to Year 3 “hypothetically” decreases the NOL that was carried back to Year 1. The tax liability for Year 1 would be recomputed to determine the underpayment or overpayment of tax for look-back purposes. However, the look-back interest would only be computed from the NOL generating year, Year 3, and not the carry back absorption year, Year 1. See the section on Different Interest Period for Changes in Net Operating Losses (NOL’s).

Definition of Tax Liability

The income tax liability, computed in Step 2, must be determined by taking into account all applicable additions to tax, credits, and net operating loss carrybacks and carryovers. For example, if the taxpayer did not pay alternative minimum tax but would have paid it with the application of look-back, the hypothetical overpayment or underpayment of tax is determined by comparing the hypothetical tax liability (which includes alternative minimum tax) with the actual tax liability for that year. See Treasury Regulation Section 1.460-6(c) (3) (vi).

Summary of Step 2

For each affected tax redetermination year, the hypothetical overpayment or underpayment of tax is the difference between:

  1. Hypothetical Tax Liability (includes all taxes, credits, NOL’s), and
  2. Actual Tax Liability per return adjusted by amendments, examination, and previous applications of look-back.

Step 3: Calculation of Interest on Underpayment or Overpayment of Tax

The calculation of interest on underpayment or overpayment or underpayment of tax is provided under Treasury Regulation Section 1.460-6(c)(4). Once the overpayment or underpayment of tax is calculated for each redetermination year, the interest is determined by applying the overpayment rate designated under IRC Section 6621, compounded daily.

Generally, the time period over which the interest is charged begins on the due date (not including extensions) of the return for the redetermination year and ends on the earlier of:

  1. The due date (not including extensions) of the return for the filing year (i.e. year of completion or adjustment); and
  2. The date both the income tax return for the filing year is filed and the tax for that year has been paid in full. Treasury Regulation Section 1.460-6(c)(4)(i).

Example:

This situation illustrates the concept of the interest computation period. In Year 3, a corporate calendar year-end taxpayer completed contracts. Look-back is required to be computed for Years 1 and Year 2. The interest computation for Year 1 look-back would be computed from the due date of the Year 1 tax return (3/15/X2) to the due date of the Year 3 tax return (3/15/X4), if not filed before the due date of the Year 3 tax return. The interest computation for Year 2 look-back would be computed from the due date of the Year 2 tax return (3/15/X3) until the due date of the Year 3 tax return (3/15/X4).

Different Interest Period for Changes in Net Operating Losses (NOLs)

The authority for using different interest periods for changes in net operating losses (NOL’s) is Treasury Regulation Section 1.460-6(c)(4)(ii). As previously mentioned, if the allocation of contract income under Step 1 changed the amount of a net operating loss that was carried back to a year preceding the year the taxpayer entered into the contract, the tax liability for the earlier year must be determined. The interest is computed from the due date of the tax return that gives rise to the net operating loss carryback and not from the due date of the return in which the net operating loss is absorbed. However, for net operating loss carryovers, the interest is computed from the due date of tax return in which the net operating loss carryover is absorbed.

Example:

This situation illustrates the concept of interest computation period on changes in NOL’s. In Year 5, a contract is completed which was in process in Year 3 and 4. On the original tax return for Year 3, the taxpayer incurred a NOL, which was carried back and fully absorbed in Year 1. When computing look-back for Year 5, the completion year, the reallocation of contract income to Year 3 “hypothetically” decreases the NOL that was carried back to Year 1. The tax liability for Year 1 would be recomputed to determine the underpayment or overpayment of tax for look-back purposes. However, the interest computation period would be from the due date of the Year 3 tax return until the due date of the Year 5 tax return.

In the above example, if the NOL in Year 3 was not carried back but carried over and fully absorbed in Year 4, the interest computation period for look-back would be computed from the due date of the Year 4 tax return until the due date of the Year 5 tax return.

Different Interest Period for Changes in Tax Liability That Generated a Subsequent Refund

The authority for using different interest periods for changes in tax liability that generated a subsequent refund is Treasury Regulation Section 1.460-6(c)(4)(iii). If the tax liability in a redetermination year is decreased by the application of look-back and any portion was absorbed by a loss or credit carryback in a year subsequent to the redetermination year, the interest computation period would be as follows:

To the extent the amount of tax absorbed because of the carryback exceeds the total hypothetical tax liability for the year, the interest period for look-back ends on the due date (not including extensions) of the return for the year in which the carryback arose and not the due date of the filing year (i.e. completion year).

Example:

In Year 5, upon the completion of a long-term contract, the taxpayer redetermines its tax liability for Year 3 under the look-back method. This redetermination results in a hypothetical reduction of tax liability of $300 determined as follows:

Redetermination Items
Redetermination Item Year 3

Tax Per Return

$1,500

Hypothetical Tax Per Look-back

$1,200

Hypothetical Overpayment of Tax

$300

In Year 4, a NOL was incurred and carried back to Year 3. The interest computation period for look-back would depend on the amount of reported tax liability of Year 3 that was refunded:

  1. If the amount refunded because of the NOL is $1,500: interest is credited to the taxpayer on the entire hypothetical overpayment of $300 from the due date of the Year 3 return, when the hypothetical overpayment occurred, until the due date of the Year 4 return, when the taxpayer received a refund for the entire amount of the Year 3 tax, including the hypothetical overpayment. Treasury Regulation Section 1.460-6 (c) (4) (iii) (A).
  2. If the amount refunded because of the NOL is $1,000: interest is credited to the taxpayer on the entire amount of the hypothetical overpayment of $300 from the due date of the Year 3 return, when the hypothetical overpayment occurred, until the due date of the Year 5 return. In this situation interest is credited until the due date of the return for the completion year of the contract, rather than the due date of the return for the year in which the carryback arose, because the amount refunded was less than the hypothetical tax liability. Therefore, no portion of the hypothetical overpayment is treated as having been refunded to the taxpayer before the filing year. Treasury Regulation Section 1.460-6(c) (4) (iii) (B).
  3. If the amount refunded because of the NOL is $1,300: interest is credited to the taxpayer on $100 ($1,300 - $1,200) from the due date of the Year 3 return until the due date of the Year 4 return because only this portion of the total hypothetical overpayment is treated as having been refunded to the taxpayer before the filing year. However, the taxpayer did not receive a refund for the remaining $200 of the overpayment at that time and, is therefore is credited with interest on $200 from the due date of the Year 3 return to the due date of the tax return for Year 5.

Interest Rate Computation Period is Annual and not Quarterly

Generally, IRS computes interest on a quarterly basis. Prior to the Taxpayer Relief Act of 1997, the look-back interest computation was also computed quarterly. However, the Taxpayer Relief Act of 1997 added IRC Section 460(b) (7), which provided the annual rate for tax returns ending after August 5, 1997. Rather than using the rates in effect for each quarter, the look-back rate will change only once for each twelve month period. The interest rate to be used for this period is the rate in effect for the calendar quarter in which the interest rate accrual begins.

Adjusted Overpayment Rate

In General, the adjusted overpayment rate for any interest accrual period is the overpayment rate in effect under IRC Section 6621 for the calendar quarter in which such interest accrual period begins. The interest accrual period for purposes of subparagraph (A) means the period:

  1. Beginning on the day after the return due date for any taxable year of the taxpayer, and
  2. Ending on the return due date for the following taxable year.

For purposes of the preceding sentence, the term “return due date” means the date prescribed for filing the return of the tax imposed by this chapter determined without regard to extensions.

Corporate Interest Rates

For tax periods ending after 1994, corporate interest rates are different for increases or decreases of tax exceeding $10,000. Therefore, the first $10,000 of the look-back interest is computed at one interest rate with any amount over $10,000 being computed at a lower rate (i.e. 1.5% lower). See IRC Section 6621(a) (1).

Simplified Marginal Impact Method (SMIM)

The authority for the Simplified Marginal Impact Method (SMIM) is Treasury Regulation Section 1.460-6(d). The SMIM eliminates the need to refigure the tax liability based on actual contract price and actual contract costs each time the look-back method is applied. Under the simplified method, prior year hypothetical underpayments or overpayments in tax are figured using an assumed marginal tax rate, which is generally the highest statutory rate in effect for the prior year under IRC Section 1 for an individual or IRC Section 11 for a corporation.

Required Use of SMIM by Certain Pass-Through Entities

The Simplified Marginal Impact Method (SMIM) is required by certain pass-through entities under Treasury Regulation Section 1.460-6(d) (4). The simplified marginal impact method is required with respect to income reported from domestic contracts by a pass-through entity that is a partnership, an S-Corporation, or a trust, and that is not closely held. With respect to contracts described in the preceding sentence, the simplified marginal impact method is applied by the pass-through entity at the entity level. See Treasury Regulation Section 1.460-6(d) (4) (i).

The assumed marginal rate to be used at the entity level is determined by the ownership of the entity. For determining the amount of any hypothetical underpayment or overpayment, the applicable regular and alternative minimum tax rates, respectively, are generally the highest rates of tax in effect for corporations under section 11 and section 55(b)(1). However, the applicable regular and alternative minimum tax rates are the highest rates of tax imposed on individuals under section 1 and section 55(b) (1) if, at all times during the redetermination year involved (i.e., the year in which the hypothetical increase or decrease in income arises), more than 50 percent of the interests in the entity were held by individuals directly or through 1 or more pass through entities. See Treasury Regulation Section 1.460-6(d) (4) (i) (A).

A pass-through entity is closely held if, at any time during any redetermination year, 50 percent or more (by value) of the beneficial interests in that entity are held (directly or indirectly) by or for 5 or fewer persons. For this purpose, the term “person” has the same meaning as in IRC Section 7701(a) (1), except that a pass-through entity is not treated as a person. In addition, the constructive ownership rules of IRC Section 1563(e) apply by substituting the term “beneficial interest” for the term “stock” and by substituting the term “pass-through entity” for the term “corporation” used in that section, as appropriate, for purposes of determining whether a beneficial interest in a pass-through entity is indirectly owned by any person. See Treasury Regulation Section 1.460-6(d) (4) (i) (B).

A domestic contract is any contract in which substantially all of the income is from sources in the United States. For this purpose, “substantially all” of the income from a long-term contract is considered to be from United States sources if 95 percent or more of the gross income from the contract is from sources within the United States as determined under the rules in IRC Sections 861 through 865. See Treasury Regulation Section 1.460-6 (d) (4) (i) (D).

If a widely held pass-through entity has some foreign contracts and some domestic contracts, the owners of the pass-through entity each apply the look-back method (using, if they elect, the simplified marginal impact method) to their respective share of the income and expense from foreign contracts. Moreover, in applying the look-back method to foreign contracts at the owner level, the owners do not take into account their share of increases or decreases in contract income resulting from the application of the simplified marginal impact method with respect to domestic contracts at the entity level. See Treasury Regulation Section 1.460-6(d) (4) (i) (E).

Elective Use of SMIM

C corporations, individuals, and owners of closely held pass-through entities that are not required to use the SMIM may elect to use this simplified marginal impact method. In the case of an electing owner in a pass-through entity, the simplified marginal impact method is applied at the owner level, instead of at the entity level, with respect to the owner’s share of the long-term contract income and expenses reported by the pass-through entity. See Treasury Regulation Section 1.460-6(d) (4) (ii) (A).

A taxpayer elects the simplified marginal impact method by stating that the election is being made on a timely filed income tax return (determined with regard to extensions) for the first tax year the election is to apply. An election to use the simplified marginal impact method applies to all applications of the look-back method to all eligible long-term contracts for the tax year for which the election is made and for any subsequent tax year. The election may not be revoked without the consent of the Commissioner. See Treasury Regulation Section 1.460-6(d) (4) (ii) (B).

In the case of a consolidated group of corporations, as defined in Treasury Regulation Section1.1502-1 (h), an election to use the simplified marginal impact method is made by the common parent of the group. The election is binding on all other affected members of the group (including members that join the group after the election is made with respect to all applications of the look-back method after joining). If a member subsequently leaves the group, the election remains binding as to that member unless the Commissioner consents to a revocation of the election. If a corporation using the simplified marginal impact method joins a group that does not use the method, the election is automatically revoked with respect to all applications of the look-back method after it joins the group. See Treasury Regulation Section 1.460-6(d) (4) (ii) (C).

Operation of SMIM

Under the simplified marginal impact method, income from those contracts that are completed or adjusted in the filing year is first reallocated in accordance with the procedures of Step 1 above.

Then, the increase or decrease in taxable income in the redetermination year due to the reallocation of contract income determined in Step 1 is multiplied by the applicable tax rate (highest rate of tax in effect for the redetermination year). This rate is determined without regard to the taxpayer’s actual rate bracket. The amount of any overpayment determined in this step may be limited to the taxpayer’s actual tax liability (see below). See Treasury Regulation Section 1.460-6(d) (2) (i).

Overpayment Ceiling on Refunds

The net hypothetical overpayment of tax for any redetermination year is limited to the taxpayer’s total federal income tax liability for the redetermination year reduced by the cumulative amount of net hypothetical overpayments of tax for that redetermination year resulting from earlier applications of the look-back method. If the reallocation of contract income results in a net overpayment of tax and this amount exceeds the actual tax liability (as of the filing year) for the redetermination year, as adjusted for past applications of the look-back method and taking into account net operating loss, capital loss, or credit carry over and carry back to that year, the actual tax so adjusted is treated as the overpayment for the redetermination year. This overpayment ceiling does not apply when the simplified marginal impact method is applied at the entity level by a widely held pass-through entity. See Treasury Regulation Section 1.460-6(d) (2) (iii).

Anti-Abuse Rule

The IRS may compute the interest on the contract (including domestic contracts of widely held pass-through entities) under the look-back method by using the actual method if the simplified marginal impact method is used with respect to any long-term contract (including a contract of a widely held pass-through entity). See Treasury Regulation Section 1.460-6(d) (3) for additional information on the anti-abuse rule.

Post-Completion Revenue and Expenses

Guidance on post-competition revenue and expenses is provided under Treasury Regulation Section 1.460-6(c) (1) (ii). When a contractor incurs post-completion year costs or receives post-completion year revenues, additional look-back computations are necessary. Any year in which the look-back method must be applied is treated as a filing year. See Treasury Regulation Section 1.460- 6 (c) (1) (ii) (A). The amount of any post-completion adjustment to the total contract price or contract costs is discounted, solely for purposes of applying the look-back method, from its value at the time the amount is taken into account in computing taxable income to its value at the completion of the contract. See Treasury Regulation Section 1.460-6(c) (1) (ii) (C) (1).

The following items should be considered with post-completion revenue and expenses are:

  1. Taxpayers have the option not to discount post-completion year revenues and costs. Treasury Regulation Section 1.460-6(c) (1) (ii) (C) (2).
  2. For purposes of reapplying the look-back method after the year of contract completion, a taxpayer may elect the “delayed reapplication method” to minimize the number of required reapplications of the look-back method. See Treasury Regulation Section 1.460-6(e).
  3. A taxpayer may elect not to apply the look-back method in de minimis cases. IRC Section 460(b) (6); Treasury Regulation Section 1.460-6(j).

Revenue Acceleration Rule

Treasury Regulation Section 1.460-6(c) (1) (ii) (D) and IRC Section 460(b) (1) requires a taxpayer to include in gross income, for the tax year immediately following the year of completion, any unreported portion of the total contract price not previously required to be included in income (including amounts that the taxpayer expects to receive in the future) determined as of that year. This treatment is required even if the percentage of completion ratio is less than 100 percent because the taxpayer expects to incur additional allocable contract costs in a later year. At the time any remaining portion of the contract price is includible in income under this rule, no offset against this income is permitted for estimated future contract costs. To achieve the requirement to report all remaining contract revenue without regard to additional estimated costs, a taxpayer must include only costs actually incurred through the end of the tax year in the denominator of the percentage of completion ratio in applying the percentage of completion method for any tax years after the year of completion. See Treasury Regulation Section 1.460-6(c) (1) (ii) (D).

Reporting Look-Back - Form 8697

The reporting of look-back is provided for under Treasury Regulation Section 1.460-6(f). Form 8697 is used for the Look-Back Computation. Each contract year is computed in a separate column on Form 8697, with the totals being netted to determine whether an overall refund or additional tax is due for the filing year (the completion year or a post-completion year). If a taxpayer owes interest under the look-back method, the Form 8697 is attached to the tax return and is considered an additional tax. See Treasury Regulation Section 1.460-6(f) (2) (i), and the Instructions to Form 8697.

If the taxpayer is due a refund, the Form 8697 is not attached to the taxpayer’s tax return, but instead is filed separately. See the Instructions to Form 8697.

If the taxpayer was an owner of an interest in a partnership or an S-Corporation during any year in which long-term contracts were being accounted, Form 8697 must be filed for the tax year that ends with or includes the end of the entity’s tax year in which the contract was completed. See Instructions to Form 8697.

Interest required to be paid on Form 8697 will be added to the tax on the income tax return and the Form 8697 will be attached to the income tax return. For a corporation the interest due would still be an interest deduction even though it is added to the total tax on the return. See Treasury Regulation Section 1.460-6(f) (2) (i).

For an individual, the interest is nondeductible personal interest. A taxpayer that fails to pay the amount of interest due is subject to any applicable penalties and interest. See Treasury Regulation Section 1.460-6(f) (2) (i).

If a taxpayer owes interest on Form 8697, the Form 8697 is a form within the tax return, and the statute of limitations on the return under IRC Sections 6501 and 6502 is controlling. See Treasury Regulation Section 1.460-6(f) (3).

In cases where the taxpayer is entitled to receive a refund of interest, the Form 8697 must be filed separately; it is not attached to the tax return. The amount of interest received is treated as taxable interest income and is not treated as a reduction in tax liability or a tax refund. See Treasury Regulation Section 1.460-6(f) (2) (i).

The amount is includible in gross income as interest income in the tax year it is properly taken into account under the taxpayer’s method of accounting for interest income. When the taxpayer is entitled to a look-back refund, the taxpayer has a 6-year period in which to file a claim. See Revenue Ruling 56-506, 1956-2 C.B. 959, and Revenue Ruling 57-242, 1957-1 C.B. 452.

Treasury Regulation Section 1.460-6(f) (2) provides for the treatment of interest on return. The general rule is that the amount of interest required to be paid by a taxpayer is treated as an income tax under subtitle A but only for purposes of subtitle F of the Code (other than sections 6654 and 6655) which addresses tax procedures and administration. Thus, a taxpayer that fails to pay the amount of interest due is subject to any applicable penalties under subtitle F, including, for example, an underpayment penalty under section 6651, and the taxpayer also is liable for underpayment interest under section 6601. However, interest required to be paid under the look-back method is treated as interest expense for purposes of computing taxable income under subtitle A even though it is treated as income tax liability for subtitle F purposes. Interest received under the look-back method is treated as taxable interest income for all purposes, and is not treated as a reduction in tax liability or a tax refund.

The determination of whether or not interest computed under the look-back method is treated, as tax is determined on a “net” basis for each filing year. Thus, if a taxpayer computes for the current filing year both hypothetical overpayments and hypothetical underpayments for prior years, the taxpayer has an increase in tax only if the interest computed on the underpayments for all those prior years exceeds the interest computed on the overpayments for all those prior years, for all contracts completed or adjusted for the year.

In general, the taxpayer that reports the income from a long-term contract applies the look-back method. See Treasury Regulation Section 1.460-6(g) for rules regarding who is responsible for applying the look-back method when, prior to the completion of a long-term contract, there is a transaction that changes the taxpayer that reports income from the contract (also known as mid-contract change in taxpayer).

Mid-Contract Change in Taxpayer and Look-back Interest

Guidance for mid-contract change in taxpayer is provided under Treasury Regulation Section 1.460-6(g). If there is a transaction, prior to the completion of a long-term contract accounted for using the PCM or the PCCM by a taxpayer (old taxpayer), that makes another taxpayer (new taxpayer) responsible for accounting for the income from the same contract, a mid-contract change in taxpayer has occurred. See Treasury Regulation Section 1.460-4(k) for additional information regarding mid-contract change in taxpayer.

Constructive Completion Transactions

On the date of the transaction, the old taxpayer constructively completes the contract and the old taxpayer applies the look-back method at the date of the transaction for the pre-transaction years. If the new taxpayer uses PCM or PCCM to account for the contract, the new taxpayer applies look-back to the post-transaction years upon completion of the contract. See Treasury Regulation Section 1.460-6(g) (2).

Step-in-the-Shoes Transactions

The look-back method is not applied at the time of the transaction, but is instead applied for the first time when the contract is completed by the new taxpayer. The new taxpayer applies look-back to both the pre- and post-transaction years as though it had been the reporting taxpayer since the inception of the contract. The new taxpayer is liable for filing the Form 8697 and for paying the look-back interest. The new taxpayer is also entitled to receive look-back interest with respect to the hypothetical overpayments of tax. The old taxpayer will be secondarily liable for any interest that must be paid with respect to the pre-transaction years.

  1. The new taxpayer may apply the look-back method to each pre-transaction year that is a redetermination year using the simplified marginal impact method (SMIM) regardless of whether of not the old taxpayer would have used that method and without regard to the tax liability ceiling. See Treasury Regulation Section 1.460-6(g) (3) (ii) (B).
  2. For the pre-transaction years, the interest accrues from the due date of the old taxpayer’s tax return (not including extensions) until the due date of the new taxpayer’s tax return (not including extensions). See Treasury Regulation Section 1.460-6(g) (3) (ii) (C).
  3. For post-transaction years, the new taxpayer must use the same look-back method it uses for other contracts. For example if the taxpayer normally does not use SMIM for its contracts, the taxpayer would have to use the regular computation of look-back interest for the post-transaction years even though it may choose to use SMIM for the pre-transaction years. See Treasury Regulation Section 1.460-6(g) (3) (iii).
  4. Following the conversion of a C corporation into an S corporation, the look-back method is applied at the entity level with respect to the contracts entered into prior to the conversion. See Treasury Regulation Section 1.460-6(g) (3) (iv).

Common Errors

  1. 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.
  2. Improperly computing interest from the Net Operating Loss (NOL) carryback year. The tax liability is hypothetically determined 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 Treasury Regulation Section 1.460-6(c) (4) (ii).
  3. 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):
  4. The pass-through entity is widely held and required to use SMIM.
  5. 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 Treasury Regulation Section 1.460-6(g) (3) (iv).
  6. 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 that are required to use SMIM. See Treasury Regulation Section 1.460-6(d) (2) (iii).
  7. Members of a consolidated group erroneously file Form 8697 - The consolidated entity must file the Form 8697 using the consolidated entity’s EIN.
  8. 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 Section 460(b) (7) (B).
  9. Forms 8697 claiming refunds are improperly attached to the tax return reducing the current year’s tax liability – Forms 8697 claiming refunds must be filed separately from the income tax return.
  10. Schedules of contract income reallocation are not attached to the Form 8697 – only owners of pass-through entities are exempt from this requirement.
  11. 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.

Conclusion

Look-back is hypothetical and does not result in an adjustment to the taxpayer’s tax liability as originally reported or amended. It does result, however, in payment of interest from or to the taxpayer upon completion of the contract, depending on the accuracy of the estimated numbers used by the taxpayer in its PCM computations. Due to the hypothetical nature of look-back, a separate tax system is necessary to account for look-back, similar to that of alternative minimum tax. Look-back is a very complex area of the tax law which causes many errors in compliance.

Page Last Reviewed or Updated: 02-Dec-2013