If you are looking for a way to kill a few hours to figure out if you owe the IRS just a few bucks, then lookback is for you. The lookback calculation is quite possibly the most complicated, elaborate, mind-bending thing I have ever done and the result is often either a small amount due to the IRS or small refund from the IRS, but it’s a hoop you are required to jump through, so here goes:
The IRS requires that long-term construction contracts that were done using the percentage of completion method be recalculated as part of a lookback calculation. Thankfully they exempt small contractors that average less than $25M of gross receipts over the prior 3 years. Only the bigger businesses need to do the calculation. Additionally there is a de minimus exception where all the contracts that are less than 1% of the average gross receipts are not subject to the lookback.
Once you have finished off your contracts, sometimes your original estimates were not quite right. You thought the project would cost $467k in materials, but you were efficient and it ended up being only $431k in materials when it was all said and done. That extra $36k of income from your estimates being off is recognized in the year you finish the project and discover the estimate was incorrect. If the project was done evenly over 3 years, the income recognized on a percentage of completion would have been short by $12k each of the 3 years. Obviously it is to the taxpayer’s advantage to have $36k of income in the 3rd year rather than $12k in each of the 3 years. To correct for this, the IRS came up with a sinister system called lookback.
The lookback is basically a calculation to “true up” the tax effects of that problem of the original estimates. There is interest due to the IRS in the case where you had $36k of income in the 3rd year instead of $12k in each of the 3 years. The interest is based on the tax due on the $12k from year 1 that was deferred into the 3rd year. That is added to the interest which is based on the tax due on the $12k from year 2 that was deferred into the 3rd year.
Thankfully the lookback goes both ways. If you under reported income in prior years you owe the IRS the interest, but if you over reported the income in prior years you will get a refund from the IRS. Since it goes both ways the contracts often end up offsetting each other and the amount due or refunded is rather small.
Chris Wittich, CPA