Sometimes it pays for a contractor to "look-back".

Contractors who fail to perform look-back calculations when required, or make the calculations incorrectly, may be subject to additional taxes and penalties. That's the result of closer scrutiny that is being paid to the look-back issue following a recent declaration by the Internal Revenue Service that look-back compliance was an "emerging issue."

But this should not be received as "bad news" by the construction community. Because the truth of the matter is contractors who fail to perform look-back interest claims may be leaving money on the table.

Here's a "true life" situation that is not uncommon: A New York general contractor had never filed look-hack interest claims. Upon close examination of the company's prior year returns, it was determined that several jobs had not performed as originally estimated and that the client could be owed as much as $100,000 from the IRS. We assisted the contractor with preparing and filing look-back claims with the IRS and the IRS reviewed these claims. The result? The contractor received a refund in excess of $100,000.

What made this process more difficult than necessary was the fact that the contractor was playing catch-up. The look-back process can be relatively seamless, if maintained or tracked on an annual basis, but can be more complicated, if done on a "catch-up" basis as in this situation. But whether the process is simple or complex, it is often in the contractor's best interest to file look-back interest claims.

Contractors can expect the IRS to scrutinize their look-back calculations, so it's important to be sure these calculations are done correctly. According to the IRS, common errors include:

* Treating net operating losses (NOLs) incorrectly. If the look-back method increases or decreases an NOL that was carried back to a previous year, interest should be computed beginning with the NOL generating year, not the NOL carry-back year.

* Using the wrong interest rates. For look-back purposes, interest rates are adjusted annually, not quarterly.

* Improperly computing look-back interest at the pass-through entity level when it's required to be computed at the owner level.

* Making filing errors. Contractors should pay interest owed by attaching Form 8697 to their tax returns. Form 8697 refund requests should be filed separately.

* Failing to report cumulative changes to look-back taxable income and look-back tax liability properly for each redetermination year.

Why Look Back?

Under the percentage-of-completion (PCM) method, a contractor reports its taxable income or loss on jobs in progress based on estimated costs and contract prices. Contractors who use PCM to account for long-term contracts generally must apply the look-back method upon completion of each contract.

Once a job is complete and the actual costs and contract price become known, the contractor "looks back" at each prior tax year the project was in process and calculates the amount of tax he would have owed had he used actual figures rather than estimates. If the look-back method reveals an underpayment of taxes in a previous tax year, the contractor owes interest on that amount. If the contractor overpaid, as was the case with the general contractor described above, he is entitled to receive interest on the overpayment.

The look-back method doesn't require a contractor to amend tax liability on prior year returns. Any previous underpayments or overpayments are reconciled in the year the contract is completed. But since the use of estimates during the life of the contract results in acceleration or deferral of the contractor's tax liability, the look-back interest compensates the contractor or the IRS for these timing differences.

When to Look Back?

The look-back method applies only to long-term contracts--that is, contracts that straddle two or more tax years--subject to PCM. It doesn't apply, therefore, to contracts that are exempt from PCM, such as qualifying home construction contracts and contracts expected to be completed within two years by a "small contractor." (A small contractor is one whose average annual gross receipts for the three tax years preceding the contract year are $10 million or less.)

There's also a "de minimis small contract exception," which exempts a long-term contract from the look-back rules if it (1) is completed within two years and (2) has a gross contract price that doesn't exceed the lesser of $1 million or 1% of the contractor's average annual gross receipts for the preceding three tax years.

Finally, contractors can elect not to apply the look-back method if, for each contract year, the amount reported is within 10% of the cumulative taxable income or loss determined using the actual contract price and costs.

Is There an Easier Way?

Calculating look-back interest can be a painstaking, time-consuming process, so the tax regulations provide an alternative called the simplified marginal impact method (SMIM). Rather than recalculate tax liability for each tax year subject to the look-back method, the contractor determines underpayments or overpayments for prior years using an assumed marginal tax rate (generally, the highest rate in effect for the relevant year).

Pass-through entities--such as S corporations, partnerships, and LLCs--are required to use SMIM if they're not closely held. C Corporations, individuals and owners of closely held pass-through entities may elect to use SMIM. Electing pass-through entities apply SMIM at the owner level rather than at the entity level.

Although SMIM can ease a contractor's administrative burden, contractors considering an SMIM election should be sure to understand its implications. For one thing, once the election is made, it's irrevocable without IRS consent. Also, while there's no limit on the amount of interest a contractor must pay, SMIM places a ceiling on a contractor's overpayment refunds.

Looking Ahead

The look-back rules are complex. Contractors who are uncertain about whether they're required to calculate look-back interest or whether they're doing it correctly should consult their certified public accountant. Though the process may seen arduous, the result can indeed be beneficial to the contractor.

BY MARC NEWMAN, CPA 

ANCHIN, BLOCK & ANCHIN LLP