Among the most common challenges of any long-term construction project are fluctuating job costs. However, variations in the cost of materials and labor over time aren’t the only cause for concern. Permitting issues, economic changes and evolving regulations can all contribute to a total project cost — and, in turn, taxable profit — that differs significantly from the original estimate.

In the meantime, you’ve got to pay federal income taxes based on your estimates. The look-back method is a tax accounting technique that construction businesses and the IRS rely on to 1) adjust taxes paid on long-term contracts to reflect actual profit or loss, and 2) recover interest on income taxes that were over- or underpaid during the project.

Although executing the look-back method should be done only in consultation with your CPA, construction company owners and their leadership teams should still familiarize themselves with the technique so they know what to expect.

Basic rules

The look-back method (or just “look-back” for short) typically applies to long-term contracts accounted for under the percentage-of-completion method (PCM) or the percentage-of-completion-capitalized-cost method (PCCM). For tax purposes, long-term contracts are generally considered those started in one tax year and not completed until a later tax year.

For long-term contracts reported under the PCCM, look-back applies to the portion of the contract that’s subject to the PCM (70% for long-term residential contracts with four or more dwelling units). In addition, it applies to long-term contracts that must be reported under the PCM for alternative minimum tax (AMT) purposes, including the remaining 30% on long-term residential contracts, when applicable.

In the year of completion, the income from covered contracts is allocated among the previous tax years based on the actual contract price and costs instead of the estimated figures. In the case of an underpayment, the construction business must pay look-back interest on the shortfall.

If the reallocation reveals that the construction company paid the taxes on an accelerated basis — because it overestimated gross profits on a long-term contract in an earlier year — the business is entitled to a refund of interest on the overpayment. The amount of look-back interest received, and any additional interest received on the look-back interest (which often occurs because the IRS doesn’t immediately pay a refund due), is included in taxable interest income for the tax year it’s received or accrued.

Important: The look-back method doesn’t change the total amount of taxes paid on a long-term project. It simply accounts for timing differences through interest. Estimated tax penalties don’t apply.

The look-back method also applies to any post-completion tax year in which you must adjust the total contract price or total allocable contract costs. This might occur if, for example, you receive additional income from the settlement of a dispute regarding a contract after completion.

Examples of exemptions

An exemption from having to carry out the look-back method may be available under certain circumstances. Generally, look-back doesn’t apply to:

• Home construction contracts,
• Contracts completed within two years of the contract start date with a gross contract price that doesn’t exceed the lesser of 1) $1 million, or 2) 1% of the taxpayer’s average annual gross receipts for the three tax years preceding the tax year of completion (known as the mandatory de minimis exception), and
• Contracts under which the cumulative taxable income for each previous year is within 10% of the cumulative look-back income for each previous year if the taxpayer elects not to apply the look-back method (known as the elective de minimis exception).

Cumulative look-back income or loss is the amount of taxable income or loss a construction company would have reported if it had relied on the actual contract price and costs rather than the estimated figures.

A “non-home” construction contract that isn’t completed in the same tax year it’s entered into is generally subject to the PCM and, therefore, the look-back method — unless the construction business in question qualifies for the small contractor exemption.

To be eligible for this exemption, a construction business’s annual average gross receipts for the preceding three tax years can’t exceed $31 million. (This is known as the “annual gross receipts test,” and the revenue amount is inflation-adjusted annually.) In addition, when entering into the contract, the contractor must estimate that the project will be completed within the two-year period beginning on the contract’s commencement date.

If, however, you’re required to use the PCM for AMT purposes, you must also apply the look-back method for calculating your AMT liability.

Complex requirements

We’ve touched on only a few points regarding the look-back method and the related tax accounting methods. Additional conditions and rules may apply to your construction company’s situation. Please contact us for help with the complex requirements involved in recognizing revenue from long-term contracts.