LO.5, 7 Swallow Company is a large real estate construction company that has made a Subchapter S election. The company reports its income using the percentage of completion method. In 2013, the company completed a contract at a total cost of $4.8 million.

The contract price was $7.2 million. At the end of 2012, the year the contract was begun, Swallow estimated that the total cost of the contract would be $5.4 million. Total accumulated cost on the contract at the end of 2012 was $1.8 million. The relevant tax rate is 35%, and the relevant Federal interest rate is 5%. Assume that all income tax returns were filed and taxes were paid on March 15 following the end of the calendar tax year.

a. Compute the gross profit on the contract for 2012 and 2013.

b. Compute the lookback interest due or receivable with the 2013 tax return.

c. Before bidding on a contract, Swallow generally makes three estimates of total contract costs: (1) optimistic, (2) pessimistic, and (3) most likely (based on a blending of optimistic and pessimistic assumptions). The company has asked you to write a letter explaining which of these estimates should be used for percentage of completion purposes. In writing your letter, you should consider the fact that Swallow is incorporated and has made an S corporation election. Therefore, the income and deductions flow through to the shareholders who are all individuals in the 35% marginal tax bracket. The relevant Federal interest rate is 8%. Swallow’s mailing address is 400 Front Avenue, Ashland, OR 97520.