Percentage-of-completion versus completed contract
Long-term contract accounting governs how a business reports income on contracts that span more than one tax year, most commonly in construction. The default is the percentage-of-completion method, which recognizes income as the work progresses. A narrow small-contractor exception lets qualifying builders use the completed-contract method instead, deferring income until the job is finished. The choice moves income between years.
Verify annually — figures adjust
The gross-receipts threshold for the small-contractor exception is adjusted periodically; confirm the current figure before relying on the completed-contract method.
There is no capital outlay; the cost is accounting complexity. Percentage-of-completion requires reliable cost estimates and job-cost tracking, and the look-back computation adds work as contracts close. Choosing or changing methods may itself require a formal accounting-method change.
Key points
- A long-term contract is one that is not completed within the tax year in which it begins, regardless of how many months it runs.
- The default is the percentage-of-completion method, which recognizes income each year in proportion to costs incurred to date against total estimated costs.
- A small-contractor exception permits the completed-contract method, deferring income until the job is substantially complete, subject to a gross-receipts test and a duration limit.
- Contractors whose gross receipts exceed the small-contractor threshold cannot use the completed-contract deferral and must report income as the work progresses.
- Percentage-of-completion depends on reliable job-cost records, and look-back interest trues up the tax difference caused by early-year estimates once a contract closes.
What is it?
A long-term contract is one that is not completed in the tax year it begins. For these contracts the general rule is the percentage-of-completion method, under which you recognize income each year in proportion to the costs incurred to date against total estimated costs. Income tracks progress, so profit is reported steadily across the life of the job rather than all at the end.
A limited small-contractor exception allows certain builders to use the completed-contract method, which defers all income and related costs until the contract is substantially complete. This can push profit into a later year, deferring tax. The exception depends on the contractor's size, measured by a gross-receipts test, and on the expected duration of the contract, so it is available only to smaller builders on shorter jobs.
Percentage-of-completion carries a look-back mechanism. Because early-year income is based on estimates, once a contract finishes the actual results are compared to what was reported, and look-back interest is charged or refunded on the difference. Home-construction contracts follow different rules than general construction, and treating one as the other is a common error that changes which method is even allowed.
Statutory basis
Who does it apply to?
Construction contractors and similar builders whose projects begin in one tax year and finish in another.
Smaller contractors who may qualify for the completed-contract method under the gross-receipts-based small-contractor exception and want to defer income to a later year.
Businesses evaluating whether a particular contract counts as long-term and which method the rules require or permit for it.
Who does it not work for?
- Contracts that are completed within the tax year they begin, which are not long-term contracts and do not use these methods.
- Larger contractors whose gross receipts exceed the small-contractor threshold, so the completed-contract deferral is not available to them.
- Businesses that misclassify a home-construction contract as general construction, or the reverse, and apply the wrong method as a result.
- Service or product businesses with no construction-type long-term contracts, where the regime simply does not apply.
What does the IRS look at?
- Whether a contract is properly classified as long-term and, if so, whether the required method was used.
- Whether a contractor claiming the completed-contract method actually qualifies under the gross-receipts test and the contract-duration limit.
- Whether percentage-of-completion income was computed on reasonable cost estimates rather than understated to defer income.
- Whether look-back interest was correctly computed and reported once contracts closed.
- Whether home-construction and general-construction contracts were distinguished correctly, since they follow different rules.
What does it cost to fund, and when does the window close?
There is no capital outlay; the cost is accounting complexity. Percentage-of-completion requires reliable cost estimates and job-cost tracking, and the look-back computation adds work as contracts close. Choosing or changing methods may itself require a formal accounting-method change.
The professional work is a CPA experienced in construction accounting who confirms which method the contracts require or permit, applies the small-contractor exception correctly, and handles the look-back calculation. Because method choices are made with the return and can require an advance application to change, involve the CPA before year-end rather than at filing time.
Related strategies
- §446Which year income and deductions land inNo outlay
- §471LIFO, FIFO, weighted average, UNICAP, and write-downsNo outlay
- §1361–1379Choosing and changing your business entityNo outlay
Common questions
- What makes a contract long-term?
- A contract is long-term under section 460 if it is not completed within the tax year in which it starts. What matters is that a tax year-end passes before the work is finished, not the raw length of the job, so a short project that straddles a year-end is long-term while a longer one contained in a single tax year is not. A job that begins and finishes inside the same tax year uses neither percentage-of-completion nor completed-contract accounting.
- Who can use the completed-contract method?
- The completed-contract method is available mainly through the small-contractor exception, which requires the contractor's average annual gross receipts to stay under a threshold that adjusts periodically and the contract to be expected to finish within a short duration limit. Contractors above that threshold generally must report income under percentage-of-completion as the work progresses. Home-construction contracts are treated separately and follow their own rules. Qualification is tested contract by contract, so a builder can qualify on one job and not on another.
- What is look-back interest?
- Under percentage-of-completion, the income reported in each year of a contract rests on estimates of total contract cost. Once the contract is complete, the income that should have been reported using actual results is compared with what was reported, and interest is charged or refunded on the resulting tax difference. It is a true-up mechanism rather than a penalty, and it applies only to contracts reported under the percentage-of-completion method.
Mena Hemaia, CPA, CIA
Chief Executive Officer, Accountack — West Palm Beach, Florida
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