Tax Look-Back Rule for Long-Term Contracts

The tax look-back rule is an interest calculation method applied to certain long-term contracts. Its purpose is to reconcile the difference between taxes paid based on estimated profits during a project and the taxes that should have been paid based on the actual, final profit. Because projects spanning multiple years involve inherent uncertainties, initial estimates can differ from the final numbers. The rule allows either the taxpayer or the IRS to recover interest on tax underpayments or overpayments from prior years, ensuring the correct amount of interest is paid on deferred taxes or refunded for overpaid taxes.

Determining Applicability of the Look-Back Rule

The look-back rule’s applicability depends on whether a taxpayer has a “long-term contract,” defined as any agreement for manufacturing, building, installation, or construction not completed within the same taxable year it was started. This rule applies to contracts reported using the percentage-of-completion method (PCM), where income is recognized based on the percentage of costs incurred. Even if a contract is exempt from the look-back method for regular tax purposes, the method may still be required for calculating the Alternative Minimum Tax (AMT).

Several exceptions exempt certain contracts from the look-back rule. The primary exceptions are:

• Small contractor exemption: A contractor’s average annual gross receipts for the three preceding tax years must be $31 million or less for 2025, and the contract must be expected to be completed within two years.
• Home construction contracts: Contracts where at least 80% of the estimated total costs are for building or improving dwelling units in a building with four or fewer units.
• Mandatory de minimis exception: Applies to contracts completed within two years that have a gross price not exceeding the lesser of $1 million or 1% of the taxpayer’s average gross receipts for the prior three tax years.
• Elective de minimis exception: Taxpayers may elect to not apply the look-back method if, for each prior contract year, the cumulative taxable income or loss is within 10% of the cumulative look-back income or loss.

The Look-Back Calculation Explained

The look-back calculation is a multi-step process performed in the year a long-term contract is completed. It does not change the total tax paid on the contract, but calculates the interest owed on the timing differences of those tax payments. The first step involves re-applying the percentage-of-completion method for every prior year of the contract, substituting the final, actual contract price and costs for the original estimates to determine the corrected gross profit for each year.

The second step is to compare the recomputed tax liability with the tax liability that was originally reported for each prior year. This is done by preparing a hypothetical amended return for each year to see what the tax would have been with the corrected income figure. The difference reveals a hypothetical tax underpayment or overpayment for each year the contract was in progress.

The final step is to calculate the interest on these hypothetical underpayments or overpayments. This interest is computed from the original due date of the tax return for the prior year until the due date of the return for the completion year. If the net result is an underpayment, the taxpayer owes interest to the IRS; if the result is an overpayment, the IRS owes interest to the taxpayer. For example, if a contractor’s final figures show the profit for year one should have been $1.2 million instead of the estimated $1 million, interest would be owed to the IRS on the tax associated with that $200,000 understatement of income.

Required Information and Form Completion

The entire look-back calculation is reported on Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts. Filing this form is the mechanism for settling the interest amounts with the IRS.

Before beginning the form, a taxpayer must collect all relevant financial information. This includes the original estimated and final actual contract price and costs. It is also necessary to have the income tax returns as originally filed for all prior years the contract was active and the applicable IRS interest rates for the various periods.

Completing Form 8697 involves specific steps. Part I of the form is used to reallocate contract income among the prior tax years using the final, actual cost data. Part II then guides the taxpayer through calculating the difference in tax liability for each prior year and computing the resulting interest on the underpayment or overpayment.

Filing and Post-Filing Procedures

Form 8697 is not filed on its own; it is attached to and filed with the taxpayer’s income tax return for the tax year in which the long-term contract is completed. The look-back method may also need to be applied in a post-completion year if there are adjustments to the contract price or costs, such as from the settlement of a dispute.

If the form shows that interest is owed to the IRS, the amount is treated as an interest payment, not an additional tax. The taxpayer should remit this amount along with their regular tax payment for the year. This payment does not trigger estimated tax penalties.

If the calculation on Form 8697 shows that interest is due to the taxpayer, the process is different. The taxpayer does not calculate the final interest refund. Instead, the IRS reviews the filed form, verifies the computation of the hypothetical tax overpayment, and then calculates and issues the interest refund as a separate check.