10-Percent Method Election Under IRC Section 460(b)(5)

The 10-percent method election under IRC Section 460(b)(5) lets a taxpayer who is otherwise required to use the percentage-of-completion method delay reporting income and expenses on a long-term contract until the first tax year in which cumulative costs on that contract reach 10 percent of the estimated total contract costs. It builds a front-end buffer into the standard percentage-of-completion timing, so the early mobilization phase of a project, when spending is thin and completion percentages are misleading, does not drive taxable income. Once made, the election binds every qualifying long-term contract the taxpayer enters into that year and in every year after.¹

How the Deferral Actually Works

Under standard percentage-of-completion accounting, income is recognized in proportion to costs incurred as the contract progresses. The 10-percent method changes only the starting point. No income or expenses from the contract appear on any return before the “10-percent year,” defined by the statute as the first tax year at the close of which at least 10 percent of estimated total contract costs have been incurred.¹

Anything that would have been reported in earlier years shifts into the 10-percent year. Say a contractor starts a $2 million project in Year 1 and spends $120,000 by December 31. That is 6 percent, below the threshold, so nothing from the contract appears on the Year 1 return. If cumulative costs reach $250,000 by the end of Year 2 (12.5 percent), Year 2 becomes the 10-percent year, and the contractor applies standard percentage-of-completion for Year 2 while also picking up the deferred Year 1 amounts on that same return.

The threshold is tested at the close of each tax year. A contract that crosses 10 percent mid-year has crossed it for the whole year, and taxpayers cannot time individual expenditures late in the year to push the threshold into a later period if cumulative costs already exceed 10 percent on the year-end date.

Which Contracts Qualify

Section 460(f)(1) defines a long-term contract as any contract for the manufacture, building, installation, or construction of property that is not completed within the tax year it is entered into.¹ A contract signed and finished in the same tax year is not a long-term contract, no matter the dollar amount.

Manufacturing contracts carry an added test. A manufacturing contract is long-term only if the item is either unique (designed for a specific customer’s needs and not normally carried in the taxpayer’s finished-goods inventory) or normally takes more than 12 calendar months to produce. The regulations provide safe harbors: an item is not unique if it is normally produced in 90 days or less, if customization costs are under 10 percent of total estimated contract costs, or if the taxpayer routinely stocks similar items.²

Contracts Carved Out of the Election Entirely

The election is available only for contracts that would otherwise be subject to percentage-of-completion under Section 460(b). Contracts that Congress has removed from that subsection cannot use the 10-percent method, because there is nothing for the election to modify.

Residential construction contracts are the largest carve-out. Section 460(e)(1)(A) exempts all residential construction contracts from the percentage-of-completion rules in subsection (b).¹

Non-residential construction contracts are exempt when two conditions are met: the contract is estimated to be completed within two years, and the taxpayer’s average annual gross receipts for the three prior tax years do not exceed $32 million (the inflation-adjusted threshold for tax years beginning in 2026).³ Contractors under that threshold already have their pick of simpler methods and get nothing from the election.

For sole proprietors and other non-corporate, non-partnership taxpayers, the gross receipts test is applied as though each trade or business were a separate entity, and the Secretary has authority to police related-party and pass-through structures that try to work around the rules.¹

The Election Covers Every Long-Term Contract

Once made, the election applies to every long-term contract entered into during the election year and every year after.¹ Cherry-picking is not allowed. A taxpayer cannot apply the deferral only to contracts where it helps and keep other contracts on standard percentage-of-completion timing.

Which Costs Go Into the 10-Percent Calculation

The numerator is actual cumulative costs incurred to date; the denominator is estimated total allocable contract costs. Both numbers must include all direct costs plus the indirect costs that benefit or are incurred because of the contract. The regulations spell out the major categories:

Direct materials, allocated when dedicated to the contract by purchase order, shipping instructions, or entry on the books.
Components and subassemblies, allocated as incurred if the taxpayer reasonably expects to incorporate them into the contract, or when formally dedicated to it.
Interest, for “designated property” produced under the contract, allocated the same way as capitalized interest under Section 263A(f).
Research and experimental expenses allocable to the contract, except independent research and development costs.
Mixed service costs that would otherwise be capitalizable, allocated by a reasonable method such as labor hours or total contract costs.
Jobsite overhead. If an administrative or support function operates solely at the jobsite for a specific contract, all of its direct and indirect costs go to that contract.

⁴

Cost estimates cause most of the trouble. Underestimating total costs pulls the 10-percent threshold forward and accelerates income. Overestimating stretches the deferral longer than it should last. Total cost projections should be revisited whenever scope, pricing, or subcontractor costs change materially, because the look-back method (discussed below) will eventually true everything up against actual numbers.

The Look-Back Method Still Applies

Electing the 10-percent method does not remove the look-back obligation. Section 460(b)(5)(D)(ii) requires the look-back method to take the 10-percent method into account.⁵ Look-back recalculates how income should have been allocated across the life of a completed contract using actual total costs instead of estimates, and produces an interest charge or credit for the difference.

With the 10-percent method in play, the 10-percent year for look-back purposes is set using actual total costs, not the estimates that governed reporting during the contract.⁶ If the actual 10-percent year differs from the estimated one, income shifts to a different year and the interest calculation changes with it. Look-back is reported on Form 8697, and the simplified marginal impact method can be paired with the election to reduce the computational load.⁷

De Minimis Exception

Not every completed contract triggers a look-back calculation. A long-term contract is exempt from the look-back method if it is completed within two years of the commencement date and the gross contract price at completion does not exceed the lesser of $1,000,000 or 1 percent of the taxpayer’s average annual gross receipts for the three preceding tax years.⁷

How to Make the Election

A first-time election is made by attaching an election statement to the original, timely filed federal income tax return (including extensions) for the year the election takes effect. The statement identifies the taxpayer by name and taxpayer identification number and declares that the election is being made under Section 460(b)(5).

A taxpayer already reporting long-term contracts under a different accounting method is changing methods, which requires filing Form 3115, Application for Change in Accounting Method, using the designated change number listed in the current IRS revenue procedure governing automatic accounting method changes.⁸

Filing Form 3115

Under the automatic change procedures, Form 3115 is filed in duplicate. The original attaches to the timely filed return for the year of change (the original does not need to be signed). A signed copy goes to the IRS National Office no earlier than the first day of the year of change and no later than the date the original is filed with the return.⁸ Skipping the National Office copy is a common error that can invalidate the change. An automatic six-month extension from the original due date of the return (not counting extensions) is available in certain circumstances, but a taxpayer who misses even that extended deadline will generally not get more time absent unusual and compelling circumstances.

The Section 481(a) Adjustment

A method change ordinarily carries a Section 481(a) adjustment to keep income from being duplicated or omitted in the transition.⁹ The adjustment captures the cumulative difference between income as reported under the old method and income as it would have been reported under the new one, measured at the start of the year of change. Some changes use a cut-off approach instead, where only items arising on or after the year of change are accounted for under the new method; the applicable revenue procedure spells out which is required. A positive adjustment (prior underreporting) is generally spread over four tax years; a negative adjustment (prior overreporting) is taken entirely in the year of change.

Getting Out of the Election

The election is intended to be permanent. Section 460(b)(5)(C) applies it to every long-term contract entered into during the election year and every year after, with no built-in expiration.¹ Stopping use of the method is itself a change in accounting method under Section 446(e), so it requires IRS consent through the formal procedures, meaning a new Form 3115 requesting a change away from the 10-percent method.⁸ The IRS reviews these requests to confirm the change will not significantly distort income, and a Section 481(a) adjustment will generally be required to bridge the transition. A recent election paired with a quick reversal will draw more scrutiny than a long-standing method changed for a documented business reason.

1
Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts
2
eCFR. 26 CFR 1.460-2 – Long-Term Manufacturing Contracts
3
Internal Revenue Service. Rev. Proc. 2025-32
4
GovInfo. 26 CFR 1.460-5 – Cost Allocation Rules for Long-Term Contracts
5
Office of the Law Revision Counsel. 26 U.S. Code 460 – Special Rules for Long-Term Contracts
6
Internal Revenue Service. Instructions for Form 8697
7
eCFR. 26 CFR 1.460-6 – Look-Back Method
8
Internal Revenue Service. Instructions for Form 3115
9
Internal Revenue Service. Changes in Accounting Methods