IRS Losing Patience With Noncompliance on Look-Back Rules

By Jim Jordan, director of construction services for Weaver and Tidwell LLP

At the IRS, hackles are going up over the construction industry's struggle to comply fully with "look-back'' interest rules on long-term contracts. In August, the agency's Large and Mid-Size Business Division designated look-back compliance in the construction industry as an emerging issue and formed a team to assist IRS personnel with affected cases.

Look-back rules have been a festering bone of contention within the construction industry since their enactment 18 years ago.

A growing number of officials argue that the procedure is ill defined and doesn't reflect industry contracting procedures. On the last point, contractors are correct.

Introduced in the 1986 Tax Act, look-back and percentage-of-completion requirements were intended to serve as deterrents for income deferral by large defense contractors. The purpose was to make these companies recognize income based on the costs incurred to date-and to assist large manufacturers who might incorrectly estimate costs.

Although most construction industry contracts run for less than a year or two, the IRS felt there were enough long-term contracts to put the industry under the look-back umbrella.

For construction companies, the rule means that at the end of a contract, managers must look back at the profits they actually earned each year as opposed to what they estimated at the time. If they originally underestimated profits they must pay the interest on the underpayment of taxes. If they overestimated profits, they may receive a tax refund.

A modification to look-back accounting was granted in the 1997 Taxpayer Relief Act. That provision allows a taxpayer to elect to forego the look-back method to a given contract if for each prior taxable year, estimated taxable income or loss under the contract is within 10 percent of the actual taxable income-or loss-of the contract.

Additionally, the provision allows for one interest rate to apply during each accrual period in a contract.

Despite the modification, many leaders in construction have been hoping look-back will be totally repealed. Construction industry trade associations contend that unlike other industries, the price of delivering a construction product is set through a competitive basis before work begins. There is little room for imprecise estimates, and most contracts are completed in a short time frame.

Moreover, industry leaders emphasize that strict lending and credit requirements of surety bond companies and banks, as well as potentially stiff IRS penalties, provide strong incentives not to underestimate revenue.

It is unlikely, however, that Congress will repeal the look-back rule, at least for now. Meanwhile, construction company managers and accountants need to be cognizant of problems targeted by the Large and Midsize Business Division. In its recent memorandum addressing noncompliance with look-back rules, the agency said too many construction companies are:

• Improperly computing interest from the net operating loss carry-back year rather than the NOL generating year.
• Improperly changing the interest rate quarterly rather than keeping it the same for the entire annual period.
• Improperly computing look-back interest at the entity level of a flow-through entity (partnership or S corporation) when it is required to be computed at the owner level.
• Improperly attaching Form 8697 to the tax return, reducing the current year's tax liability (Form 8697 refunds must be filed separately from the income tax return).
• Not properly reporting on Form 8697 the cumulative changes to look-back taxable income and look-back liability for each redetermination year.

For construction companies with lengthy contracts, Form 8697 can present numerous challenges because of requirements for precise documentation of annual costs and revenues, as well as prorated interest on projections that were missed.

The good news is that there aren't a lot of four- or five-year contracts. It should also be noted that the IRS permits construction businesses whose revenue during the last three years averaged less than $10 million to elect the completed contract method of accounting. These companies may defer taxes on the profits from any jobs open at year-end until they are closed. Gross profit can be deducted on open jobs at year-end from book income to arrive at taxable income.

For larger companies, however, it isn't just tedious paperwork that has kept look-back reporting in the doghouse. Many larger companies are moving from C Corporations to limited partnerships. When look-back reporting is filed at the partnership level, the IRS can look at the partners' returns. At limited partnerships, then, look-back reporting also can open the books on personal tax filings.

For companies working diligently to comply fully, look-back reporting can be arduous enough that outside assistance from professional accountants or consultants may be necessary.