What Is the Lookback Method for Long-Term Contracts?

The look-back method is an accounting process used for projects that span multiple years. During a long-term project, income taxes are paid based on estimated profits, which can differ significantly from the final, actual profit. The look-back method acts as a true-up mechanism after the project is finished to reconcile the taxes paid based on estimates with what should have been paid based on the actual outcome.

This is accomplished by calculating interest on the difference between the tax liability from estimated profits and the liability based on the final profit. If profits were underestimated, interest is owed to the IRS; if they were overestimated, a refund of the interest is due to the taxpayer. The method does not change the total tax paid on the contract, but addresses timing differences in those payments through an interest charge.

Determining Applicability of the Lookback Method

The look-back method’s application applies to a “long-term contract” as defined by the tax code. A contract is considered long-term if it begins in one tax year and is not completed until a subsequent tax year. For manufacturing, a contract qualifies as long-term only if it involves unique items not typically held in inventory or if the production of each item normally exceeds 12 months.

The primary trigger for the look-back method is the use of the Percentage-of-Completion Method (PCM) for tax reporting. Taxpayers using PCM for their long-term contracts must perform the look-back calculation upon the contract’s completion, as PCM relies on estimates that will differ from the final numbers.

Certain exceptions exist that allow taxpayers to avoid the look-back method. A significant exemption is for small contractors, available if the contractor’s average annual gross receipts for the three preceding tax years fall below an inflation-adjusted threshold ($30 million for recent years), and the contract is estimated to be completed within two years.

Another major exemption applies to home construction contracts, where at least 80% of the estimated total contract costs are for the construction or improvement of dwelling units in a building with four or fewer units. A de minimis exception also exists for contracts completed within a two-year period with a gross price that does not exceed the lesser of $1 million or 1% of the taxpayer’s average annual gross receipts for the three prior tax years.

Information Required for the Lookback Calculation

Before beginning the look-back calculation, a taxpayer must gather several specific pieces of financial data for the completed long-term contract. This information includes:

• The final, actual total contract price. This is the total revenue realized from the contract, which may include adjustments, settlements, or bonuses that were not known in the initial project estimates.
• The final, actual total of all costs allocable to the contract. This includes all direct and indirect costs that were incurred over the entire life of the project and have been properly assigned to it.
• A year-by-year breakdown of the total costs that were allocated to the contract and the precise amount of income that was reported on tax returns for each of those prior years under the Percentage-of-Completion Method.
• The applicable federal tax rates that were in effect for each of the prior years during which the contract was in progress. These correct historical rates must be used to re-determine the tax liability for each of those years accurately.

The Lookback Calculation Process

The look-back calculation begins by hypothetically re-applying the Percentage-of-Completion Method (PCM) for each prior year the contract was active, using the final contract price and total costs. For each prior year, the percentage of completion is recalculated by dividing the cumulative costs incurred as of that year’s end by the final total contract costs. This new percentage is then multiplied by the final total contract price to determine the cumulative revenue that should have been recognized.

After re-determining the revenue, the next step is to calculate the revised taxable income for each prior year. The taxpayer subtracts the cumulative revenue calculated through the end of the preceding year from the cumulative revenue calculated through the end of the current year. This finds the corrected gross income for that specific year, which is then compared with the income that was originally reported.

This comparison reveals a hypothetical underpayment or overpayment of tax for each year the contract was underway. For instance, a contractor who initially estimated a $2 million profit but realized an actual profit of $2.6 million would use the higher figure to recompute the income that should have been reported annually.

The final step involves calculating interest on these hypothetical tax differences. The interest is computed on the underpayment or overpayment for each year from the original due date of that year’s tax return until the due date of the return for the year the contract was completed. The interest rate used is the federal overpayment rate, compounded daily.

Filing and Reporting Requirements

Once the look-back calculation is complete, the result must be reported to the IRS using Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts. The timing for submitting Form 8697 is tied to the income tax return for the year the contract is completed, but it is filed separately. It should be mailed to the appropriate IRS service center by the due date, including extensions, of the income tax return for the completion year.

If look-back interest is due to the IRS, this amount is treated as an increase in tax and is included on the tax return for the completion year. However, if the calculation results in a refund, the interest is not treated as a reduction in tax on the return. Instead, the taxpayer must file Form 8697 separately from their tax return to claim the refund.

The look-back method can also apply in years after the contract is completed. If there are adjustments to the total contract price or costs after the completion year, such as from a settlement, the taxpayer must file a new Form 8697 for the tax year in which the adjustment occurs.

The Simplified Marginal Impact Method

As an alternative to the standard look-back calculation, certain taxpayers can use the Simplified Marginal Impact Method (SMIM) to reduce the administrative burden of the process. Eligibility to use SMIM is restricted to C corporations and, in certain situations, owners of pass-through entities like S corporations and partnerships.

The simplification offered by SMIM is the use of an assumed marginal tax rate. Instead of determining the precise change in tax liability for each prior year, taxpayers using SMIM apply the highest statutory federal tax rate for corporations or individuals for that year to the change in income.

The process under SMIM involves determining the change in long-term contract income for each prior year using the actual contract price and costs. This change in income is then multiplied by the highest applicable tax rate for that year to produce the hypothetical tax underpayment or overpayment, on which interest is then calculated.

A taxpayer must make a formal election to use the Simplified Marginal Impact Method on a timely filed tax return for the first year the election is to be effective. Once made, the election to use SMIM is binding and applies to all eligible completed long-term contracts for that year and all subsequent years, unless the IRS consents to a revocation.