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Crowe Horwath SPECIAL ADVERTISING SECTION Contractor Tax-Deferral Strategies: Lookback Computation Tips and Traps By Phillip McCarty , CPA, Partner, Tax Services Group, Crowe Horwath LLP and Marc McKerley , CPA, Partner, Construction Services Group, Crowe Horwath LLP Contractors often use the same percentage of completion (POC) method of recognizing revenue for both financial reporting and tax purposes. Internal Revenue Code (IRC) Section 460 requires using a POC accounting method to calculate taxable income from nonexempt contracts not completed within the tax year. But the POC method required for tax differs from the financial reporting POC method in a number of ways. Furthermore, contractors are generally required to file a lookback computation for tax purposes to address poor estimates in the tax POC calculation. Most tax law provisions related to the deduction of expenses force many deductions into a later period than they are expensed for financial reporting purposes. This distinction, coupled with the required use of the tax POC method, creates numerous opportunities to defer tax and improve working capital through tax POC accounting method alternatives, including: • The 10% election method • Retainage payables • Nondeductible expenses allocable to the job • Contract aggregation • The capitalized cost method • The simplified cost allocation method Despite the potential benefits, the POC calculation process frequently is viewed as complicated and time consuming, and, as a result, ignored by many CPAs. Contractors might mistakenly assume that this omission is inconsequential because any tax-deferral and cash flow benefits received are offset by the increase in lookback interest paid. In fact, most of the tax-deferral strategies listed above do not affect the amount of lookback interest payable. C1 | December 12/19, 2016 Lookback Computation in a Nutshell The lookback is a complex area of tax law that causes both errors in compliance and missed opportunities. The lookback is a hypothetical recalculation of a contractor’s taxable income based on the actual cost and contract price of its completed jobs to determine if it made an over-or underpayment of taxes in prior years based on estimates on long-term contracts not yet completed. significant fade on large multiyear jobs. The statute of limitations for lookback refund claims is generally six years from the due date of the tax year in which the job closed. Many contractors in this situation have received lookback refunds in the six-to seven-figure range. The lookback rules could present a refund opportunity for many contractors who have experienced significant fade on large multiyear jobs. The lookback does not result in an adjustment to the contractor’s previously reported taxable income or require an amended return. It does, however, result in the refund or payment of interest, depending on the accuracy of the contractor’s applicable job estimates. Contractors Subject to Lookback Any contractor with long-term contracts that must be reported using the POC method under IRC Section 460 is required to comply with the lookback rules when contracts are completed. The IRS devotes an entire chapter in its Construction Industry Audit Technique Guide for staff auditors to compliance with lookback. Nevertheless, it is common for contractors to give little attention, or even completely ignore, the requirements. But the lookback rules could present a refund opportunity for many contractors who have experienced The application of lookback is determined on a contract-by-contract basis. To be subject to lookback, a contract must meet the requirements for a long-term construction contract under IRC Section 460. Contracts that are started and completed during the same tax year are not considered long-term construction contracts. Such contracts are not subject to the long-term contract rules and might present deferral opportunities based on the allowable accounting method used. The tax rules for determining the completion date of a contract differ from the financial reporting rules, often resulting in an earlier completion date for tax purposes. Even if a contractor has long-term construction contracts, exemptions from lookback applicability might apply. These include: • Home construction contracts • Contracts started in a year during which the contractor qualified as a “small contractor” (generally, this includes contracts estimated to be completed within two years, started during a year in which the contractor’s average gross receipts for the three preceding tax years did not exceed $10 million) • Small contracts that have a gross contract price less than the lesser of $1 million or 1% of the contractor’s gross receipts for the prior three tax years • Contracts for which an election not to apply lookback applies (the IRC enr.com/texas-louisiana/resources/SpecialAd Jobs Subject to Lookback

Contractor Tax-Deferral Strategies: Lookback Computation Tips And Traps

Phillip McCarty, CPA, Partner, Tax Services Group, Crowe Horwath LLP and Marc McKerley, CPA, Partner, Construction Services Group, Crowe Horwath LLP

Contractors often use the same percentage of completion (POC) method of recognizing revenue for both financial reporting and tax purposes. Internal Revenue Code (IRC) Section 460 requires using a POC accounting method to calculate taxable income from nonexempt contracts not completed within the tax year. But the POC method required for tax differs from the financial reporting POC method in a number of ways. Furthermore, contractors are generally required to file a lookback computation for tax purposes to address poor estimates in the tax POC calculation.

Most tax law provisions related to the deduction of expenses force many deductions into a later period than they are expensed for financial reporting purposes. This distinction, coupled with the required use of the tax POC method, creates numerous opportunities to defer tax and improve working capital through tax POC accounting method alternatives, including:

• The 10% election method

• Retainage payables

• Nondeductible expenses allocable to the job

• Contract aggregation

• The capitalized cost method

• The simplified cost allocation method

Despite the potential benefits, the POC calculation process frequently is viewed as complicated and time consuming, and, as a result, ignored by many CPAs. Contractors might mistakenly assume that this omission is inconsequential because any taxdeferral and cash flow benefits received are offset by the increase in lookback interest paid. In fact, most of the taxdeferral strategies listed above do not affect the amount of lookback interest payable.

Lookback Computation in a Nutshell

The lookback is a complex area of tax law that causes both errors in compliance and missed opportunities. The lookback is a hypothetical recalculation of a contractor’s taxable income based on the actual cost and contract price of its completed jobs to determine if it made an over- or underpayment of taxes in prior years based on estimates on long-term contracts not yet completed.

The lookback does not result in an adjustment to the contractor’s previously reported taxable income or require an amended return. It does, however, result in the refund or payment of interest, depending on the accuracy of the contractor’s applicable job estimates.

Contractors Subject to Lookback

Any contractor with long-term contracts that must be reported using the POC method under IRC Section 460 is required to comply with the lookback rules when contracts are completed. The IRS devotes an entire chapter in its Construction Industry Audit Technique Guide for staff auditors to compliance with lookback. Nevertheless, it is common for contractors to give little attention, or even completely ignore, the requirements.

But the lookback rules could present a refund opportunity for many contractors who have experienced significant fade on large multiyear jobs. The statute of limitations for lookback refund claims is generally six years from the due date of the tax year in which the job closed. Many contractors in this situation have received lookback refunds in the six- to seven-figure range.

Jobs Subject to Lookback

The application of lookback is determined on a contract-by-contract basis. To be subject to lookback, a contract must meet the requirements for a long-term construction contract under IRC Section 460. Contracts that are started and completed during the same tax year are not considered long-term construction contracts. Such contracts are not subject to the long-term contract rules and might present deferral opportunities based on the allowable accounting method used. The tax rules for determining the completion date of a contract differ from the financial reporting rules, often resulting in an earlier completion date for tax purposes.

Even if a contractor has long-term construction contracts, exemptions from lookback applicability might apply. These include:

• Home construction contracts

• Contracts started in a year during which the contractor qualified as a “small contractor” (generally, this includes contracts estimated to be completed within two years, started during a year in which the contractor’s average gross receipts for the three preceding tax years did not exceed $10 million)

• Small contracts that have a gross contract price less than the lesser of $1 million or 1% of the contractor’s gross receipts for the prior three tax years

• Contracts for which an election not to apply lookback applies (the IRC provides a permanent and binding election not to apply lookback on contracts whose gross profit does not vary more than 10% from the gross profit estimated in each of the prior tax years; the election might be valuable for large contractors who typically experience slight pickup on their jobs, but it increases the compliance costs of lookback requirements)

Additional Lookback Opportunities and Pitfalls

Contractors should be aware of several other potential opportunities and pitfalls related to the lookback rules. For example, contractors sometimes use an incorrect interest rate. The applicable interest rate is required to be redetermined on the anniversary of the tax return due dates rather than being recalculated quarterly. Also, a different interest rate applies to C corporations on recalculated income amounts exceeding $10,000.

The election of the simplified margin impact method to calculate interest does not require the taxpayer to recalculate its hypothetical taxable income for previous tax years. Rather, the highest assumed marginal (C corporation) tax rate is applied to the calculated change. This method is required and only allowed for use by non-closely held S corporations and partnerships, and it simplifies reporting requirements.

Incorrect treatment of change orders is another consideration. The inappropriate treatment as a change order rather than a new job can cause a disparate impact on the lookback calculation.

In addition, the impact of postcompletion additional income or expenses on previously reported lookback filings sometimes has not been properly addressed in the lookback computation. Large refunds could result for contractors with significant rework requirements, claims paid or change orders denied.

Time for a Tax Checkup

Contractors would be wise to undergo a “tax physical” to explore if they are taking full advantage of the tax-deferral opportunities provided under current law. The alternative is to risk leaving money on the table.

Marc McKerley, CPA, is a partner in the construction services group of Crowe Horwath LLP. He has more than 34 years of experience providing consulting services to the construction industry. For more information, call 214-777-5209 or email marc.mckerley@crowehorwath.com.

Phillip McCarty, CPA, is a partner in the tax services group of Crowe Horwath LLP He has been working with contractors for 24 years. For more information, call 865-539-5602 or email phillip.mccarty@crowehorwath.com.

The Crowe POC Manager® solution streamlines the POC and lookback processes.

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