Construction companies face a tax accounting question that most other businesses do not: when is income from a multi-year project recognized? The answer determines not just timing but the company's effective tax rate for the life of each contract. The general rule under IRC §460 is the percentage of completion method (PCM) - income is recognized ratably as the contract is completed based on costs incurred. But significant exceptions allow smaller contractors to use the completed contract method (CCM), under which no income is recognized until the contract is substantially complete. The choice has major cash flow implications.
Percentage of Completion (PCM): Income recognized each year based on percentage of contract costs incurred to date vs. total estimated costs. If 40% of costs are incurred in Year 1, 40% of contract revenue is recognized in Year 1. Tax is paid as the project progresses. Required for most long-term contracts.
Completed Contract Method (CCM): No income or expense recognized until the contract is substantially complete (generally when the contractor can use the property for its intended purpose or the owner accepts it). All income and deductions bunched into the completion year. Available only for qualifying small contractors and home construction contracts.
A "long-term contract" under IRC §460 is any contract for the manufacture, building, installation, or construction of property that is not completed within the taxable year in which it is entered into. A contract signed and completed in the same calendar year is not a long-term contract and is not subject to §460. The vast majority of commercial and residential construction contracts spanning two or more tax years are long-term contracts subject to §460.
Under IRC §460(e), a contractor may use the CCM (or any other permissible method) for a long-term construction contract if: (1) the contract is estimated to be completed within two years of the contract commencement date, and (2) the contractor's average annual gross receipts for the three preceding tax years do not exceed $30 million (the "small contractor" gross receipts test, indexed - verify current amount). This exception applies only to construction contracts, not manufacturing contracts.
For contractors required to use PCM, the most common method is cost-to-cost: the completion percentage equals total costs incurred to date divided by total estimated contract costs. Revenue recognized in each period equals (cumulative completion percentage x total contract price) minus revenue recognized in prior periods. The key variable is the total estimated contract cost - if that estimate changes, the completion percentage and revenue recognition change retroactively through a cumulative catch-up adjustment in the year of the estimate change.
Costs that enter the PCM denominator include all direct costs (labor, materials, subcontractors) and allocable indirect costs (equipment depreciation, supervisory salaries, insurance). Front-loaded costs (heavy material purchases early in the project) accelerate PCM income recognition even when economic performance is more evenly spread.
IRC §460(b) imposes a look-back interest charge when a PCM contract is completed if the actual profit percentage differed from the estimated profit percentage used during the contract. If the contractor underestimated profits during the contract (income recognized was less than it should have been based on actual results), interest is owed to the IRS on the tax deferral. If the contractor overestimated profits (income recognized was more than actual), the IRS pays interest back to the contractor. The look-back is computed on Form 8697 and filed in the year the contract is completed.
A "home construction contract" - a contract for the construction or improvement of a dwelling unit (up to four units) where 80% or more of the estimated contract costs are for the dwelling - is exempt from PCM regardless of the contractor's size. Home builders of any size may use CCM, the cash method, or the accrual method for home construction contracts. This is why residential homebuilders are taxed differently from commercial contractors: their primary contracts qualify for the home construction exception.