Which accounting method should a construction company use?

Construction accounting methods hinge on contract length and company size. Long-term contracts generally use percentage-of-completion, recognizing income as the work progresses, while the completed-contract method defers income until a job finishes. A small-contractor exception lets qualifying smaller builders use more favorable methods for shorter contracts. The right choice affects when profit is taxed, so it deserves deliberate selection.

Key points

A long-term construction contract is one that begins in one tax year and finishes in another, and section 460 defaults it to the percentage-of-completion method.
Percentage-of-completion recognizes contract profit as costs are incurred, so tax can fall due before final payment is collected.
The completed-contract method defers all income and cost on a job until it is substantially complete, bunching profit into the finishing year.
The small-contractor exception excuses builders below the average gross receipts threshold from percentage-of-completion on contracts expected to finish within two years.
Changing a construction accounting method later generally requires IRS consent on Form 3115 and a transition adjustment.

What is the percentage-of-completion method?

Construction is one of the few industries with its own tax accounting rules, set out in section 460, because a single job can span more than one tax year and involve large amounts of income and cost. The method decides when that profit is taxed, which makes method selection one of the more important decisions a contractor makes.

The default for long-term contracts, jobs that begin in one tax year and finish in another, is the percentage-of-completion method. Under it, income and cost are recognized as the job progresses, measured by the share of total expected contract costs incurred to date. If a job is judged partway complete at year end, that share of the contract's profit is reported even though the work is unfinished and final payment has not arrived. This matches income to work performed, but it can accelerate tax into years before cash is fully collected, and it demands accurate job-cost tracking and cost-to-complete estimates, because a look-back interest computation applies when the estimates prove wrong.

When can a contractor use the completed-contract method?

The completed-contract method sits at the other end. It defers all income and cost on a contract until the job is substantially complete, so the entire profit lands in the finishing year. For tax, this defers income and helps cash flow, but it can bunch a great deal of profit into a single year and push the owner into a higher bracket.

Availability is limited. The method is generally open only to home construction contracts and to contractors who qualify under the small-contractor exception for their shorter contracts. Larger commercial contractors are locked into percentage-of-completion regardless of preference.

Who qualifies for the small-contractor exception?

The pivotal rule for most closely held contractors is the small-contractor exception in section 460. A contractor whose average annual gross receipts for the prior three tax years fall under the inflation-adjusted threshold in section 448, and whose contract is expected to be completed within two years of its start date, is excused from mandatory percentage-of-completion for that contract and may use completed-contract or another permissible method.

This exception is why two builders doing similar work can properly use different methods: one is large enough to be locked into percentage-of-completion, the other qualifies for the exception. The gross receipts test aggregates the receipts of related entities under common control, so splitting a business into several companies does not avoid it.

What are the limits, and what happens when a contractor grows?

The limits follow from the size test. Because it uses average gross receipts over a look-back period, a growing contractor can cross the threshold and lose the exception, changing how new contracts are taxed from that year forward. Contracts already in progress keep their original method, but contracts entered into afterward must use percentage-of-completion. Home construction and certain residential contracts have their own treatment, and the overall method of accounting, cash or accrual, interacts with the contract method to add another layer.

Changing methods later generally requires IRS consent through Form 3115 and a transition adjustment that can accelerate previously deferred income. Because these rules determine the timing of tax rather than just the paperwork, they are worth modeling before the first long-term contract is signed. A CPA who works with contractors can review the contract mix, average gross receipts, and growth trajectory to choose the method that fits today and to plan for the point where growth changes what is allowed.