Select the Right Accounting Methods for Income Tax Reporting Purposes

When financial statements are required for a contractor, the statements are must be based on generally accepted accounting principles in the U.S. (GAAP). However, the Internal Revenue Service (IRS) allows for different methods of accounting when reporting for income tax purposes for the revenues and costs associated with construction contracts. 

Learn construction firms and contractors can identify the appropriate accounting and tax method for reporting each project.

IRC 460

The Tax Reform Act of 1986 introduced Internal Revenue Code section 460 (IRC 460), Special Rules for Long-Term Contracts, which is used primarily by one industry: construction. 

Contracts that qualify as long-term must use the percentage-of-completion method (PCM) to report income tax unless they qualify for exceptions. Exceptions are available for home construction contracts as well as taxpayers qualifying for the small contractor exception. 

Here’s how to determine a contract’s eligibility for a PCM exception, which may allow the use of another method of accounting for income tax reporting. 

Home Construction Exemption

Do any of your contracts entered into in 2026 for calendar-year taxpayers qualify for the home construction contract exception (in which 80% or more of the estimated total contract costs are expected to be attributable to the building, construction, reconstruction or rehabilitation of dwelling units in apartment buildings, condominiums, student housing, long-term care facilities and other properties with multiple residential units)? If so, you may be eligible to use an alternative to PCM for income tax reporting purposes associated with that contract. 

Additionally, recent changes introduced by the One Big Beautiful Bill Act (OBBBA) expanded the types of projects eligible for the home construction exemption. Contracts entered into in tax years beginning before July 4, 2025, should assess their eligibility based on the provisions available under prior tax code, which limited the home construction exception to buildings with four or fewer dwelling units.

Small Contractor Exception

To determine your eligibility for a small contractor exception, ask: “Are both of the following true?”

• At the time the contract was entered into, it was estimated that the contract would be completed within a two-year period beginning on the commencement date of the contract.
• The contractor’s average annual gross receipts for the three taxable years preceding the year in which the contract was entered does not exceed $31 million. For the tax year 2026, the inflation adjusted average annual gross receipts threshold for the IRC Section 460 small contractor exception is $32 million.

If both of the above are true of your contract and business, you may qualify for the small contractor exception. Note that annual gross receipts are measured on revenue reported for income tax purposes, so proper tax reporting must be applied to exempt and nonexempt IRC 460 contractors to avoid overstating gross receipts. In addition, the three-year period is looked at on a current and going forward basis, and, in a year that the small contractor exception is not met, only contracts that start in subsequent years are required to be reported using PCM.

Tax Planning Opportunities Available to Large Contractors

Additional income tax reporting opportunities may exist for large contractors under IRC 460. If you qualify as a large contractor, consider your eligibility and the potential advantages of:

• 10% elective deferral — The 10% elective deferral that allows for the deferral of gross profit recognition until the job is at least 10% complete and applies to all long-term contracts entered into during and after the electing year. This deferral is not an alternative minimum tax (AMT) preference item.
• Residential contracts — Contracts that qualify as residential contracts allow taxpayers to report 70% of the contract on PCM and 30% on the contractors’ exempt method of accounting for income tax purposes. If the exempt method is the completed contract method (CCM), 30% of the associated profit is deferred, for income tax reporting purposes, until the job is complete. Crucially, this deferral is an AMT preference and will impact the contractor’s tax liability. The definition of a residential project is similar to the home construction exemption described above, except that “dwelling unit” is broadly defined as a house or apartment providing living accommodations. This provision applies to residential contracts entered into in tax years beginning before July 4, 2025.
• Retainage receivable and payable — Retainage constitutes the percentage of billings withheld by the customer until the project’s completion. Large contractors electing accrual less retainage method may benefit on short-term contracts when retainage receivables and/or retainage payables are outstanding at year-end. Those not currently deferring retainages, but interested in electing for this provision, must file Form 3115 to change accounting methods in accordance with Revenue Ruling 69-314.
• Methodologies to allocate G&A in accordance with IRC 460 — Additional costs (general, administrative and overhead [G&A]) need to be allocated to contract costs for tax reporting purposes. The formula for calculating PCM for income tax purposes dictates that allocating current G&A costs to date also requires the consideration of estimated future G&A costs to be incurred on that contract in progress. Therefore, complying with IRC 460 requires developing a methodology to estimate future G&A costs to be incurred and will result in a different gross profit on contracts for income tax. 

Closing the Reporting GAAP

While alternatives to PCM reporting are available for income tax purposes, GAAP standards are a near universal requirement based on their utility to banks and sureties. Financial statements should be based on PCM for all long-term contracts and disclosures should include:

• Detailed notes to the financial statements
• Contracts receivable aging
• A breakout of contracts and retention receivables by contracts in progress, jobs completed and unbilled receivables
• Earnings from contracts schedule that reconcile the contracts in progress and contracts completed during the year to the statement of income
• A contract in progress schedule and completed contracts schedule that illustrate the contract revenues, costs and gross profits by project for the accounting period
• Explanation of significant contract gross profit changes
• Collections on accounts receivable subsequent to the reporting period (not required by GAAP but a best practice)
• Disclosure of retention accounts payable
• Contract backlog disclosure

Because applicable methods of accounting for income tax purposes are determined on a contract-by-contract basis, contractors can report revenue from construction contracts under several methods of accounting. Determining the most efficient method of accounting requires an understanding of IRC 460, GAAP and the language within contracts that lend themselves to
deferral opportunities. 

Work-in-progress (WIP) schedules for open and closed jobs represent a great starting point. Consulting with an experienced CPA to review WIP and contracts is an important first step to designing a strategy that best meets the contractor’s financial and income tax reporting needs.