by Brandon Cook, CPA | Partner, Tax Services Group and Member of the Construction Services Group
In all businesses everyone knows that cash is king. This is especially true in the construction industry. In the new reality of tight margins, high retainage percentages, and slow-paying contracts, every bit of cash a contractor can get their hands on can be vital to a company’s operations. The look-back calculation, which is required for many contractors, could put more cash into your pocket.
Who Must File a Look-back Calculation?
If a contractor is required by the IRS to report their long-term contracts under the “Percentage of Completion” method, then those contracts are subject to the look-back calculation.
What is the Look-back Calculation?
In simple terms, the look-back calculation is a calculation of additional interest that needs to be paid to (or refunded by) the IRS on taxes paid on contract revenue that has been recognized in prior years. It is calculated on a job-by-job basis, and then all over/under reporting is netted to determine if you are entitled to an interest refund or owe the IRS interest.
The look-back calculation compares the percentage of gross profit that was recognized in prior years to the actual gross profit percentage realized upon completion of the job. Based on that analysis, the calculation determines whether or not the gross profit for that particular job was “over” or “under” reported in prior years based on job cost estimates at the time of the tax filings. If gross profit was overstated in the past due to changes in estimates or job fade, then theoretically, income was overstated and too much tax was paid in the prior year and the taxpayer is entitled to have interest refunded to them on that excess tax.
In our experiences, we tend to see job fade as a contract progresses through its various life stages. Overly optimistic expectations, unexpected costs or ineffective management of jobs can occur, and that once gross profit estimate of 12% shrinks down to maybe 10%. Anytime you have job fade on a long-term contract, more than likely you will be entitled to an interest refund from the IRS. However, the opposite holds true as well. If you experience job gain and had under-reported profit in prior tax years, you may have to write a check to the IRS for the interest on that under-reporting.
As always with tax law, there are exceptions and various elections that relate to the look-back calculation. If you have any questions regarding “percentage of completion” or the look-back calculation, please do not hesitate to contact me.