Percentage of Completion: Section 460 for Contractors
How long-term contracts are taxed as work progresses, the exemption that lets smaller contractors use simpler methods, and the look-back interest that comes with estimates.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
A long-term contract — one spanning more than one tax year — is generally taxed under the percentage-of-completion method: each year's income is the contract price times the share of total estimated costs incurred to date, minus income already reported. Contractors below the gross receipts threshold are exempt on construction contracts expected to finish within two years.
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How does percentage of completion work?
| Element | Rule |
|---|---|
| Completion percentage | Cumulative contract costs incurred ÷ total estimated contract costs (the cost-to-cost method) |
| Income recognized to date | Completion percentage × total contract price |
| Current-year income | Cumulative income to date minus income reported in prior years |
| Costs deducted | Contract costs as incurred |
| Estimates | Revised each year; changes flow through the current year |
| Look-back | At completion, interest is computed on the tax that would have been due had actual results been known, on Form 8697 — paid to or by the taxpayer |
| 10 percent election | Defer the contract's income and costs until the year at least 10 percent of estimated total contract costs have been incurred (applies to all contracts entered into in the election year and later) |
Retainage receivable is included in the contract price; retainage payable to subcontractors is a contract cost once it is incurred under the accrual all-events and economic-performance tests, which can be before it is paid.
Who is exempt?
A contractor that meets the Section 448(c) gross receipts test — average annual gross receipts for the prior three tax years of no more than $32 million for tax years beginning in 2026 ($31 million for 2025) — for construction contracts expected, when signed, to be completed within two years of starting. Exempt contractors may use:
- Completed contract method — all income and costs recognized when the contract is complete, which defers tax on jobs spanning year-end.
- Cash or accrual method as the overall method, with contract revenue recognized under that method.
Residential construction contracts are exempt from the percentage-of-completion requirement regardless of the contractor's size. For contracts entered into in tax years beginning after July 4, 2025, that means any construction contract with 80 percent or more of estimated costs for dwelling units and related on-site improvements; before then, only home construction contracts — buildings with four or fewer dwelling units — qualified. Larger contractors may still have to capitalize costs under Section 263A.
What traps apply to exempt contractors?
For owners subject to the individual alternative minimum tax — including owners of pass-through contractors — the AMT requires percentage of completion for long-term contracts other than residential construction contracts (only home construction contracts under the pre-2025 rule) regardless of the regular-tax method, so an exempt contractor using completed contract must compute the adjustment. Growing past the gross receipts threshold requires a method change on Form 3115 to percentage of completion for new contracts, made on a cut-off basis with no Section 481(a) adjustment. And the exemption is tested contract by contract: a three-year contract must use percentage of completion even for a small contractor.
Which method is better for a small contractor?
Completed contract defers income on jobs in progress at year-end and is simplest for a cash-rich year; percentage of completion matches income to work and avoids the spike when several jobs close in one year. Many small contractors use the cash method for its simplicity and accept that progress billings are income when received.
Frequently asked questions
Is a six-month job a long-term contract?
Only if it starts in one tax year and is completed in the next; a contract started and finished within one year is not long-term.
Do service contracts fall under Section 460?
Not on their own. Section 460 applies to the manufacture, building, installation, or construction of property; design, engineering, and construction-management services are allocated to a long-term contract only when they are incident to or necessary for it.
How do change orders affect the calculation?
Approved change orders adjust the contract price and estimated costs; disputed amounts are included in the contract price when you can reasonably predict the dispute will be resolved in your favor.
What is look-back interest, in plain terms?
If estimates during the job under-reported income relative to the final result, you pay interest on the deferred tax; if they over-reported, the IRS pays you.
Official sources
The IRS explains: “Use this form to figure the interest due or to be refunded under the look-back method of section 460(b)(2) on certain long-term contracts that are accounted for under either: the percentage of completion method, or the percentage of completion-capitalized cost method.” — Internal Revenue Service, About Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts, https://www.irs.gov/forms-pubs/about-form-8697
The statute provides: “In the case of any long-term contract, the taxable income from such contract shall be determined under the percentage of completion method (as modified by subsection (b)).” — Legal Information Institute, Cornell Law School, 26 U.S. Code § 460 - Special rules for long-term contracts, https://www.law.cornell.edu/uscode/text/26/460
Next step
Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk tests each contract against the exemption and keeps the look-back schedule for contractors who have outgrown it. See pricing or book a free fit call.
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