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Accounting - Lookback interest

image Trey Hardy, CPA Lane Gorman Trubitt, LLC, Dallas, TX

SAN ANTONIO - With respect to certain contracts, the Internal Revenue Service (“IRS”) requires contractors to compute and pay interest using the Percentage of Completion Method (“PCM”). This article explores why and how the IRS computes this interest.

 

 

 

    The IRS obviously wants taxpayers to pay their taxes, but it also wants taxpayers to pay their taxes when the income is considered taxable. If the contractor doesn’t pay when the income is considered taxable, the IRS will impose interest. This “lookback interest” prevents contractors from trying to benefit from delaying the recognition of revenue — and therefore deferring their tax liability — until the end of the contract period.
    Understanding how contractors recognize revenue under PCM contracts helps to understand the calculation of lookback interest.  Under the PCM, contractors’ recognized revenue equals the contract price times a fraction where the numerator is actual costs and the denominator is estimated total costs. Put differently, contractors under the PCM are recognizing revenue based on the costs they incur. For example, if the contractor had no expenses related to a certain contract for a period, the contractor would recognize no revenue related to that contract for that period, and therefore would have no tax to pay related to that contract.  This is true regardless of whether the contractor has billed the customer.
    Lookback interest is computed after the project is complete by looking back at the contract’s life and determining the revenue that should have been recognized (and the tax that should have been paid) throughout the life of the contract.  Since this analysis is performed after the project is complete, the IRS bases lookback interest on actual costs per year over actual total costs for the contract.
    Because lookback interest is computed using actual costs instead of estimated costs, a difference can arise between the amount of revenue recognized by the contractor in a given year and the amount of revenue recognized under the IRS’s lookback interest calculation for that given year.  For example, if the contractor recognized less revenue in the first year of a four-year contract using estimated costs than the IRS determines should have been recognized using actual costs, the contractor will owe lookback interest on the underpayment of tax for that first year. Conversely, if the contractor recognized too much revenue for a given year, the IRS will pay the contractor interest on the overpayment of tax. The same interest rate applies to both situations.
    In conclusion, the IRS imposes lookback interest to ensure that contractors are using fair estimates for recognizing their revenue (and paying their tax). If the cost estimates for the contracts are close to actual costs, lookback interest should be minimal. If the estimated costs vary from what the actual costs total, there will be lookback interest — either in the form of lookback interest due the Government or an overpayment refundable to the contractor by the Government. As always, please consult your tax advisor in order to confirm that the contractor is subject to the lookback interest calculation and to accurately determine to what contracts the lookback interest calculation applies.
    After joining our firm, Trey has aligned himself to be an asset to not only our firm, but our tax department as well. Trey specializes his knowledge and efforts within our Construction Group, along with working with manufacturing, distribution, and real estate industries. Some of his current responsibilities include organizing and coordinating clients’ tax data for the accurate, timely completion of individual tax returns and simple-to moderately-complex corporate, partnership, S-corp, and trust tax returns. He also prepares and reviews individual, corporate, and partnership income tax returns, as well as state income and franchise tax returns. Trey’s additional duties include being a member of the tax training committee and the further training and supervision of our lower tax staff.


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