By Albert Rinella
Large construction contractors generally recognize income by implementing the percentage of completion method (PCM) for income tax purposes. Contractors are considered large contractors in the eyes of the IRS, if their average gross receipts for the 3 preceding years were $30 million for tax year 2024 and $31 million for tax year 2025. To take this one step further, if you are a large contractor reporting income from long-term contracts on PCM, you may be subject to look-back interest. IRC Section 460 defines long-term contracts as contracts that are not completed within the same taxable year in which the contract commences.
What Is “Look-Back”
Typically, contractors recognize revenue based on estimates while the jobs are in progress and these estimates usually differ from the actual amounts reported upon completion. As a result, taxpayers need to perform a “look-back” calculation to quantify the understatement or overstatement of income in prior years. For clarity, the look-back calculation is not an adjustment of tax but an interest charge based on the timing on when the contract’s revenue is reported. It is the IRS’s way to recoup interest as a result of a taxpayer underpaying taxes prior to the contract’s completion due to underestimating the gross profit on the long-term contract. On the other hand, if a contractor overestimates it profit on a long-term contract, the IRS will owe the contractor interest on the taxes it overpaid in a prior year.
Contracts That Are Exempt From Look-Back
In general, a construction contract is subject look-back when the taxpayer recognizes revenue using the percentage of completion method or the percentage of completion-capitalized cost method.
The look-back calculation does not apply to:
- Home construction contracts – any contract where 80% or more of the costs are related to the construction or improvement of a building consisting of 4 or fewer dwelling unites
- Contract price does not exceed the lesser of $1 Million or 1% of average gross receipts for 3 prior tax years Construction contracts if both of the following conditions are met:
- The contract will be completed within two years from the date the contract begins and the taxpayer’s average gross receipts do not exceed $30 Million for the three preceding tax years for calendar year 2024 or $31 Million for calendar year 2025
Why Take A Closer Look At Your Estimating?
As mentioned above, the lookback is an interest charge on the timing of revenue recognition. Over the past two years, we have had significant increases in interest rates. The IRS’s interest rates for all 4 quarters of tax year 2024 was 8%. Although there has been a recent downtick in IRS rates for Q1 2025, which currently sits at 7%, these rates are significantly higher than what we’re used to. The IRS compounds interest daily so, any underpayment of taxes on jobs that take over 2-3 years to complete, can put a major hit on the overall profitability of these jobs.
Please consult with your tax advisor should you have any questions.
