Look Back Calculation: Construction Financial Picture May Look Good in Rear View Mirror

With fierce competition for available work, deteriorated profit margins, and difficulty finding banks willing to looking back
extend credit for construction projects, contractors know that every dollar counts. As a result, it is appealing to contractors to look back and reminisce the good old days, but there are additional reasons to “look back” that include enhancing cash flow. If you are like many contractors and have suffered profit fades in the last few years, one bright spot in comparing the past performance of jobs that have recently closed potentially uncovers a fully-collectible receivable from “Uncle Sam” of which some contractors are unaware. Don’t you enjoy the thought of the government paying for that Calcutta reel or Ford F-150 4×4 King’s Ranch truck (no offense Chevy fans!)? So how do you collect these funds? The key is performing a look back calculation by filing Form 8697.

Look Back Calculation Background

The IRS has prescribed that large contractors, defined as those contractors having three year average gross receipts exceeding $10 million, report income using the percentage of completion method. The percentage of completion method requires contractors to estimate the overall total cost and related gross profits for jobs, so there is typically a variance between the originally estimated cost/profits and final results. The IRS established a provision that protects the government from underestimates of gross profits for in-progress jobs. Upon job completion, the provision requires a look back calculation to capture the interest that the government could have earned had the taxpayer paid taxes based on the higher actual job gross profit results. Conversely, if the final gross profits are lower than the original estimates, then the taxpayer is due an interest refund.

Look Back Calculation

The look back calculation utilizes Form 8697. The contractor takes the final contract values and final gross profits for each job that requires a look back calculation and re-computes the gross profit/loss for each of the previous years. These are compared to the estimated gross profits/losses reported for each of the previous years, and the annual taxes are re-computed. Finally, interest is calculated on the tax overpayment or underpayment, and a resulting refund or payment is due from/to the IRS.

Look Back Calculation Exception

Look back calculations do not apply to the regular taxable income from any long-term construction contract in situations including home construction contracts and two exceptions:

  • Small Contractor Exception.
    • Any contract which is not a home construction contract but is estimated to be completed within a two year period is exempt. However, the look back may apply to the alternative minimum taxable (AMT) income.
  • Small Contract Exception.
    • The look back method does not apply to any long-term contract that is (1) completed within two years of the contract commencement date, and (2) has a gross contract price that does not exceed the lesser of $1,000,000 or 1% of the average annual gross receipts of the taxpayer for the three tax years preceding the tax year that the contract is completed.

In summary, contractors should be aware that if they have suffered profit fades on their jobs, potential refunds may be available as a result of performing look back calculations. They should also always be aware of possible conflicts between the financial statement objectives and tax consequences in underestimating gross profits on jobs in-progress.

Do you have questions about your construction company’s look-back calculations? These calculations are often complicated and vary widely, so be sure to check with your CRI construction CPA.  Speaking of looking back, Mac Davis, a country music singer/songwriter wrote some great lyrics: “I thought happiness was Lubbock, Texas in my rear view mirror.” Who knows, you might even have enough change leftover from that look back refund to download Mac’s tune!

 

2018-11-12T15:48:41+00:00April 18th, 2016|CONSTRUCTION|