In June, the IRS issued Prop. Reg. 1.460-6 relating to the look-back method for long-term contracts. The look-back provision applies to a contract accounted for under either the percentage of completion method or the percentage of completion-capitalized cost method. Upon completion of the contract, the contractor computes the income that should have been reported in all years of the contract if actual total contract price and costs had been used instead of estimated total contract price and costs. The contractor is required to pay or is entitled to receive interest on the amount of tax liability that is deferred or accelerated as a result of overestimating or underestimating total contract price or total contract costs.

The look-back method does not apply to 1) any home construction contract or 2) any other construction contract that is estimated to be completed within a two-year period by a taxpayer whose average gross receipts for the three years preceding the year the contract is entered into do not exceed $10 million. Additionally, certain small contracts are not subject to the look-back rules. The look-back method does not apply to any long-term contract that 1) is completed within two years of the contract commencement date and 2) has a gross contract price (as of the completion of the contract), that does not exceed the lesser of $1 million or 1% of the average annual gross receipts of the taxpayer for the three tax years preceding the tax year in which the contract is completed. Form 8697 is used to calculate the interest due or to be refunded under the look-back method for completed long-term contracts entered into after February 28, 1986. The latest Form 8697 should be used to calculate the interest.

Prop. Reg. 1.460-6(d) provides a simplified method to all taxpayers for calculating look-back method interest. Some taxpayers may be required to use this new method, and for others it is elective. Under the simplified marginal impact method, the interest calculation is made at the entity level and any interest owed to or by the IRS must be paid by or to the entity. A taxpayer reapplies the percentage-of-completion method, using actual rather than estimated, total contract price and total contract costs, to all contracts that are completed in the tax year. The taxpayer then computes the increase or decrease in income from those contracts in each year affected by the contract. Then, a taxpayer calculates a "hypothetical underpayment or overpayment of tax" that is determined at the highest corporate tax rate in effect for each year. However, if more than 50% of the interests in the entity were held by individuals, the highest individual tax rate is used to compute the "hypothetical underpayment or overpayment of tax." It is also important to note that the "net hypothetical overpayment of tax" for any redetermination year is limited to the taxpayer's actual tax liability for that year. This overpayment ceiling does not apply when the simplified marginal impact method is applied at the entity level by a widely held pass-through entity.

Required Use

The simplified marginal impact method is required to be used with respect to income reported from domestic contracts by a pass-through entity that is either a partnership, an S corporation, or a trust, that is not closely held. A pass-through entity is closely held if, at any time during the redetermination year, 50% or more (by value) of the interests in the entity are held (directly or indirectly) by five or fewer persons. The constructive ownership rule of Sec. 1563(e) is used for determining whether an interest in a pass-through entity is indirectly owned by any person.

In the case of a pass-through entity (partnership, S corporation or trust) that is not closely held, the simplified marginal impact method is applied to contracts completed in tax years for which the due date of the return (including extensions) is after November 9, 1988.

Example

The following example illustrates the application of the required use by not closely held pass-through entities:

P, a partnership, began a long-term contract on March 1, 1986, and completed this contract in its tax year ending December 31, 1989. P used the percentage-of-completion-capitalized cost method for all contract income. Substantially all of the income from the contract arose from U.S. sources. At all times during all of the years for which income was required to be reported under the contract, 25% of the value of P's interest was owned by Corporation M. The remaining 75% of the value of P's interest was owned in equal shares by 15 unrelated individuals that are also unrelated to Corporation M. M's ownership of P represents less than 50% of the value of the beneficial interest in P and, therefore viewed alone, is insufficient to make P a closely-held partnership. In addition, because no four of the individual owners together own 25% or more of the remaining value of P's beneficial interest, there is no group of five owners that together own, directly or indirectly, 50% or more by value of the beneficial interests in P. Therefore, P is not a closely held pass-through entity.

Because P is not a closely held pass-through entity, and because P completed the contract in a tax year for which the due date of the return is after November 9, 1988, P is required to use the simplified marginal impact method. Any interest computed under the look-back method will be paid to, or collected from, P rather than its partners. Note: Look-back interest expense is allocated to the partners and separately stated on Schedule K-1 as personal interest.

Further assume that, for the redetermination years, Corporation M is subject to alternative minimum tax at the rate of 20% and three of the individuals who own interests in P are subject to the highest marginal tax rate of 33% in 1988. Regardless of the actual marginal tax rates of its partners, P is required to determine the underpayment or overpayment of tax for each redetermination year (1986-1989) at the entity level by applying a single rate to the increase or decrease in income resulting from the reallocation of contract income under the look-back method. Because more than 50% of the interests in P are held by individuals, P must use the highest individual tax rate for each redetermination year. Thus, the rate applied by P is 50% for 1986, 38.5% for 1987, and 28% for 1988.

Elective Use

C corporations, individuals, owners of closely held pass-through entities, owners of non-closely held pass-through entities with respect to foreign contracts, and sole proprietors, may elect the simplified marginal impact method. In the case of an electing owner in a pass- through entity, the simplified marginal impact method is applied at the owner level, instead of at the entity level, with respect to the owner's share of the long-term contract income and expense reported by the pass- through entity. The pass-through entity would have to provide the information with Schedule K-1 for its tax year in which the contracts are completed. It would be to the owner's advantage to elect the simplified method if the shareholder/ partner is entitled to receive interest from the IRS and the owner's marginal tax bracket is less than the highest tax rate in effect for that year. It should be noted that "hypothetical overpayment of tax" is limited to the taxpayer's actual tax liability for that year.

Sidney W. Leibowitz, CPA, Holtz Rubenstein & Co.