Construction Update
Contractors Should “Look Back” Carefully
“Don’t look back,” advised Satchel Paige. “Something may be gaining on you.”
The baseball Hall of Famer might have voiced the sentiment of construction contractors who neglect a provision of the Internal Revenue Code (IRC) called the “look-back” rule.
But firms who fail to look back can place themselves at risk — and the IRS plans to gain on them. In an April 2004 memorandum, the agency’s construction director alerted his managers to an “emerging issue” in which too many firms are failing to apply the look-back rule in their tax calculations.
Long-Term Contracts
Section 460 of the IRC applies to long-term contracts, defined as those that straddle any part of two calendar years. The provision requires some contractors to estimate a long-term job’s price and costs, and use the percentage-of-completion accounting method (PCM) to recognize income and calculate tax obligations.
If the job is estimated to last less than two years, companies with less than $10 million in annual sales are generally exempt from the PCM requirement. Housing and residential projects are also at least partially exempt. For more details, see Different Rules Govern Long Term Contracts in our Fall 2004 issue.
After the completion of a long-term project, the contractor calculates tax liability using the contract’s actual price and costs. Depending on a job’s circumstances, this calculation can result in a tax obligation that’s higher or lower than what the contractor paid over the previous year or more.
Here is where the look-back rule comes into play. It essentially makes the new tax obligation retroactive. And it requires the contractor to pay interest on the difference between what it actually paid in taxes, and what it would have paid had it been able to estimate — perfectly and in advance — the job’s final profit margin.
Look-back interest is deductible only on a corporate tax return. If it flows through to an individual doing business as an S corp or limited partnership, it’s not.
Congress established the look-back rule to control gigantic defense contracts that stretched over many years and offered vast opportunities for income deferral and manipulation. Whether the lawmakers intended to police mid-size construction firms is debatable, but the IRS holds that the provision applies to them as well.
Over time, an honestly run business has little to fear from the look-back rule. After all, the calculation can also result in a lower tax bill — most contractors being optimistic by nature — and in such cases the IRS owes the firm not only a refund but interest as well (although the IRS obligation is more limited than the contractor’s). And there’s no evidence that a belated look-back calculation triggers undue IRS scrutiny.
An Unexpected Interest Debt
In some cases, however, even a company that takes care to estimate jobs and taxes accurately can be taken by surprise. For example, a heavy change order late in the game might extend a contract, or yield a substantially higher margin than the job has yielded up to that point.
With rare exceptions, the tax code prohibits the contractor from severing the contract into two smaller ones. So the longer period might trigger Section 460, or the high-profit work might increase the job’s overall margin and create a higher tax bill.
And then the look-back principle seems to be, “You enjoyed the use of this money, which rightfully belonged to the government — even if no one could have known that at the time. That enjoyment will cost you some interest.”
Since the IRS has announced its determination to enforce the look-back rule more strictly, the first step for any construction firm should be to understand its own actual exposure.
In its 2004 memorandum, the IRS acknowledged that Section 460 errors often result from “complexity in tax law.” Our firm understands complexity, and we can help you obtain the best tax position available to you.
When Hindsight Isn’t 20/20
The IRS says construction tax returns show five common errors in applying the look-back provision of Section 460:
- Calculating interest from the Net Operating Loss (NOL) carry-back year rather than the NOL generating year.
- Changing the interest rate quarterly, rather than keeping it the same for the entire annual period.
- Computing look-back interest at the entity level of a flow-through entity, when it is required to be computed at the owner level.
- Attaching forms improperly to tax returns. When Form 8697 shows a refund due, it must be filed separately.
- Improperly reporting cumulative changes to look-back taxable income and tax liability for each re-determination year.
For more information about our services to the construction industry, Contact:
Mark Lund, Parter-in-Charge of Construction Services at 713.297.6907.
The articles in this newsletter are general in nature and are not a substitute for accounting, legal, or other professional services. We assume no liability for the reader's reliance on this information. Before implementing any of the ideas contained in this publication, consult a professional advisor to determine whether they apply to your unique circumstances.