Look-back method for long-term contract reporting.

Taxpayers who report long-term contract income under the percentage-of-completion method (PCM) of accounting are generally subject to detailed look-back reporting regulations if they entered into long-term contracts after Feb. 28, 1986. The look-back method of Sec. 460(b) applies to long-term contract income reported under the PCM for regular tax or alternative minimum tax (AMT) purposes. Regs. Sec. 1.460-6 is highly complex and contains several elective methods that taxpayers may use to calculate hypothetical contract underpayments and over-payments.

Although all long-term contractors must comply with the substantial recordkeeping and reporting requirements, the regulations may be burdensome to small and mid-sized contractors. Because Regs. Sec. 1.460-6(f)(2) defines look-back method interest owed as a tax for the purposes of Subtitle F, taxpayers who fail to comply with the regulations may be liable for failure to file and failure to pay penalties.

Under the look-back method for long-term contracts reported under the PCM, the taxpayer pays or receives interest under Sec. 460(b) on the amount of tax liability deferred or accelerated as a result of overestimating or underestimating total contract price or contract costs. The computation of the amount of deferred or accelerated tax liability under the look-back method is hypothetical and does not result in an adjustment to the taxpayer's tax for any year.

Taxpayers subject to the look-back method

In general, the look-back method applies to any income from a post-Feb. 28, 1986 long-term contract that is reported under the PCM for regular tax or AMT purposes. There are exceptions to look-back reporting for regular tax and AMT purposes for home construction contracts within the meaning of Sec. 460(e)(1)(A) or as defined in Sec. 460(e)(6) and, for regular tax purposes, for small contractors meeting the definition of Sec. 460(e)(1)(B) (Regs. Sec. 1.460-6(b)(2)). Finally, a mandatory de minimis exception exists for any long-term contract (1) completed within two years of the contract commencement date and (2) with a gross contract price (as of contract completion) that does not exceed the lesser of $1 million or 1% of the taxpayer's average annual gross receipts for the three tax years preceding the tax year in which the contract is completed. The de minimis exception applies to both regular and AMT income (Regs. Sec. 1.460-6(b)(3)).

Operation of the look-back method

The amount of interest charged or credited to a taxpayer under the look-back method is computed in three steps. The first step is to hypothetically reapply the PCM to all long-term contracts completed or adjusted in the current year using actual (rather than estimated) total contract price and contract costs (Regs. Sec. 1.460-6(c)(2)). Based on this reapplication, the taxpayer determines the amount of taxable income (and AMT income) that would have been reported for each year prior to the filing year if the PCM had been applied on the basis of actual (rather than estimated) total contract price and costs in reporting income from contracts completed or adjusted in the filing year and in any preceding year. If the PCM applies only to AMT income for contracts completed or adjusted in the filing year, only AMT income is recomputed in the first step.

The second step is to compare (1) what the tax liability would have been under the PCM (as reapplied in the first step) for each tax year for which the tax liability is affected by income from contracts completed or adjusted in the filing year with (2) the most recent determination of tax liability for that year, to produce a hypothetical underpayment or overpayment of tax (Regs. Sec. 1.460-6(c)(3)).

The third step is to apply the overpayment rate of interest designated under Sec. 6621, compounded daily, to the hypothetical underpayment or overpayment of tax for each redetermination year (see Regs. Sec. 1.460-6(c)(4)). Interest computed under this method generally runs from the return's due date (determined without regard to extensions) for the redetermination year to the return's due date (determined without regard to extensions) for the filing year.

Contract completion and postcompletion items

Regs. Sec. 1.460-6(c) defines contract completion and provides special rules and elective methods for postcompletion adjustments. Delayed reapplication method: The look-back method must be applied in the year in which a long-term contract is completed and in subsequent years for which adjustments in contract price and cost occur. As an alternative to applying the look-back method in each subsequent year in which postcompletion adjustments occur, a taxpayer may elect the "delayed reapplication method."

This allows taxpayers to wait until cumulative adjustments to either the contract price or contract costs reach the lesser of 10% of those amounts before adjustment, or $1 million. A taxpayer electing this method must reapply the look-back method no later than five years after completion. This election, if made, is binding on all the taxpayer's contracts that are subject to the look-back rules. A taxpayer should consider whether the election of the delayed reapplication method will ease the burden of look-back reporting. Discounting postcompletion adjustments: Adjustments in price and cost occurring in postcompletion years must generally be discounted back to the year of contract completion using the federal mid-term rate under Sec. 1274. Under Regs. Sec. 1.460-6(c)(1)(ii)(C), taxpayers may elect on a contract-by-contract basis not to discount postcompletion adjustments. Simplified marginal impact method: Regs. Sec. 1.460-6(d) provides for a "simplified marginal-impact method" to calculate the hypothetical tax adjustment for the look-back method. This method is required to be applied by nonclosely held passthrough entities at the entity level on their domestic contracts for tax years for which a return's due date (including extensions) is after Nov. 9, 1988. This method is elective for all other taxpayers. The election and reporting for taxpayers opting for this method are made at the owner level for passthrough entities.

Under the simplified marginal impact method, the taxpayer reapplies the PCM using actual costs to all contracts completed or adjusted in a year. The taxpayer computes the aggregate marginal increase or decrease in income for each year affected by those contracts. Hypothetical overpayments and underpayments are calculated by using the highest regular tax and AMT rates in effect for the redetermination year in lieu of actual facts and circumstances. This method also limits hypothetical overpayments to the taxpayer's federal income tax liability for the year reduced for prior look-back overpayment applications.

Elective 10% method

Under Regs. Sec. 1.460-6(c)(2)(v), taxpayers reporting income from long-term contracts under the elective 10% method of Sec. 460(b)(5) must also use the 10% method in applying the look-back method. In applying this method, it is possible that the taxpayer's initial recognition year could change, based on the use of actual costs in determining the "10% year." If a change in the recognition year occurs, the taxpayer is required to reallocate costs to the applicable year for purposes of look-back reporting.

Change orders

In applying the look-back method, a change order on a contract is not treated as a separate contract unless the change order would be treated as a separate contract under the rules for severing and aggregating contracts provided in Regs. Sec. 1.451-3(e). Thus, if a change order is not treated as a separate contract, the contract price and contract costs attributable to the change order must be taken into account in allocating contract income to all tax years affected by the underlying contract.

Tax treatment of look-back interest

Under Regs. Sec. 1.460-6(f), net interest refunded to a taxpayer under the look-back method is includible in gross income as interest income. Net interest paid under the look-back method is interest expense arising from an underpayment of tax. Therefore, look-back interest required to be paid by an individual (or by a passthrough entity on behalf of an individual owner) under the simplified marginal impact method is treated as personal interest, subject to disallowance under Temp. Regs. Sec. 1.163-9T(b)(2).

The amount of interest due or to be refunded as a result of applying the look-back method is computed and reported on Form 8697, Interest Computation Under the Look-Back Method For Completed Long-Term Contracts, for any tax year in which a long-term contract is completed. Form 8697 is due no later than the return's due date (including extensions) for the year in which income is reported from a contract completion or adjustment. Form 8697 is filed with the same IRS Service Center at which the taxpayer files an income tax return.