The look-back method; an enforcement mechanism with long arms.

• Author: Deviney, Stephen F.

The construction industry has been faced with numerous changes to the accounting methods available for long-term contracts since the enactment of the Tax Reform Act of 1986 (TRA). As a result of these changes, long-term contractors are generally required to use the percentage-of-completion method (PCM),(1) or a variation thereof, for recognizing taxable income from long-term contracts.

Although Congress determined that the PCM was the best method to report taxable income for long-term contracts, it also recognized the inherent drawbacks. Because of the many variables in a construction contract, it is impossible to pinpoint precisely the income from a particular contract in advance of the contract's completion. Because of the inability of any method of accounting to accurately report taxable income, Congress implemented the look-back method (LBM) in 1986.

According to the General Explanation of the Tax Reform Act of 1986,(2) the LBM was developed to enhance the PCM. The LBM is intended to prevent manipulation of the estimate of gross profit from contracts and to provide relief to taxpayers who inaccurately estimate profits under the PCM. The IRS acknowledges that the LBM was not "intended to raise revenue but to ensure accurate reporting by long-term contractors."(3) As this article will show, the LBM is a statutory "watchdog" over the construction industry that has caught many contractors in its far-reaching grasp.

The Look-Back Concept

Because the PCM requires contractors to use estimates of total contract price and total costs before contract completion, variances result in reporting contract income. These variances cause the resultant tax to be either higher or lower than the tax that would have occurred if all the facts had been known from the outset of the contract.

The look-back concept requires taxpayers to pay interest on the underreported taxable income from long-term contracts and, conversely, receive interest if taxable income is accelerated. At the completion of a contract the LBM is applied and the taxpayer recalculates each affected year's PCM income using actual, rather than estimated, contract price and costs. Hypothetical tax effects are calculated on the recalculated income and the corresponding look-back interest is computed.

* Scope of the LBM The LBM generally applies to all contracts that are required to be reported under the PCM for regular and/or alternative minimum tax (AMT) purposes.(4) All contracts entered into after Feb. 28, 1986 are subject to the LBM.(5) A de minimis exception allows certain long-term contracts to be exempted from the LBM for both regular and AMT purposes, if the contract --is completed within two years of commencement; and --has a gross contract price at completion that is the lesser of either a. $1 million; or b. 1% of the taxpayer's average annual gross receipts(6) for the three years preceding the year in which the contract is completed.(7)

The regulations clarify that the de minimis rule is mandatory and that all contracts meeting its definition must be excluded from the LBM.(8) Taxpayers may need to amend prior tax returns because the de minimis exception was enacted in the Technical and Miscellaneous Revenue Act of 1988 (TAMRA),(9) with a retroactive effective date. Taxpayers are permitted to amend prior look-back filings to reverse the effects of subjecting excepted contracts to the LBM.(10) However, the economic costs of recomputing, processing and paying additional professional fees must be weighed in light of these opportunities.

* The look-back computation The regulations break down the LBM into three steps, each with its own significant complications.

* Step One: Recalculate the PCM income using the actual (not estimated) contract price and costs. Income from the completed contract is redistributed among the prior contract year(s) and the hypothetical underreported or overreported amount of taxable income is determined.(11) * Step Two: Compare the hypothetical tax liability for each affected year, based on the income reallocated under Step One, with the actual tax liability previously reported.(12) * Step Three: Apply the quarterly overpayment interest rate to the hypothetical overpayment or underpayment of tax, as determined under Step Two.(13)

Step One: Income Recalculation

The recalculation of income under the LBM is performed in the year of completion of the long-term contract. The year a contract is completed is determined by the final completion and acceptance of the contract as outlined in Regs. Sec. 1.451-3(b)(2).(14) The LBM computation may also be required in years subsequent to the contract completion if there are postcompletion revenue and expenses.(15) If subsequent year LBM computations are required, all postcompletion adjustments must be discounted from the original amount taken into taxable income to the value at the time of the completion of the contract.(16) This discounting is required exclusively for purposes of the hypothetical LBM and, accordingly, does not affect how the items are recognized for other tax purposes. To avoid the complexities of discounting post-completion revenue and expenses, a taxpayer can elect, with respect to any contract, not to discount. This election is made on a contract-by-contract basis and must be made with the taxpayer's timely filed return, including extensions.(17)

Sec. 460(b)(1) adds an additional measure of complexity to the PCM and LBM calculations. This section requires that all remaining gross income that has not been reported on each completed contract at the time of completion must be reported in the tax year following the year of completion. This complicates the analysis of the appropriate timing of contract revenue and costs for LBM purposes. The regulations further explain that future costs should not be considered in this computation.(18)

* 10% election Sec. 460(b)(5) permits long-term contractors to elect to defer income under the PCM until the first year in which 10% of the total estimated costs has been incurred. This 10% rule also applies to the LBM(19) and, therefore, will have an impact on the computations under Step One of the LBM if the estimate is inaccurate. Example 1: A contractor incurred $80 of costs in 1990 of total estimated contract costs of $900. Because $80 is less than 10% of the total estimated costs, no income needs to be recognized in 1990 under the PCM if the 10% election is made. The contract is completed in 1991 and the total contract costs are $700, rather than the estimated $900. When the LBM is applied to this contract, it is determined that in 1990 the contract was actually 11.4% complete...