Final answer:
Lookback interest is calculated to adjust the taxes previously reported on long-term contracts using the percentage-of-completion method. To compute it, IRS Form 8697 is utilized, comparing actual progress to past forecasts, with adjustments leading to either interest due or receivable with the tax return.
Step-by-step explanation:
The concept of lookback interest relates to the tax treatment of long-term contracts, particularly in the construction industry. According to the Internal Revenue Service (IRS) regulations, companies using the percentage-of-completion method for reporting income from long-term contracts are required to calculate lookback interest at the completion of the contract. This calculation serves to adjust the income or tax previously reported, based on the actual completion rate of the project. It helps to ensure that taxpayers pay the correct amount of tax over the duration of a contract.
To compute lookback interest due or receivable with the 2018 tax return, a taxpayer must use IRS Form 8697, Income Forecast Method. Interest is calculated by comparing the actual pace of work done and income earned to the forecasted figures reported in prior tax years. If the taxpayer reported more income in the past, they might receive interest from the IRS. Conversely, if they reported less, they owe interest to the IRS. The interest rate used for the calculation is the federal short-term rate plus three percentage points.