Long-Term Contracts Under IRC 460: PCM, Exemptions, and Look-Back

IRC Section 460 governs how contractors and manufacturers report income on long-term contracts, and its default rule is that you cannot wait until the job is finished to pay tax on it. Instead, income is recognized year by year under the percentage-of-completion method, with a final reconciliation (the look-back) once the contract closes. Small contractors, home builders, and certain short-cycle manufacturers can step outside this regime, and for tax years beginning in 2026 the small-contractor gross receipts threshold is $32 million.¹

Which Contracts Fall Under Section 460

A long-term contract is any agreement to build, install, construct, or manufacture property that isn’t finished within the same tax year it begins.² Calendar length is beside the point. A job that starts in October and wraps in February counts as long-term because it spans two tax years, even though the work took only five months.

Manufacturing contracts have a tighter test. A manufacturing agreement only falls under Section 460 if the item is either unique (designed for a specific customer’s needs) or normally takes more than 12 calendar months to build.² Ordinary production runs headed for finished-goods inventory don’t qualify, even if a particular order crosses a year-end.

Manufacturing Safe Harbors

The regulations give manufacturers three ways to treat an item as not unique, and any one of them is enough:³

The item normally takes 90 days or less to complete. For multi-unit contracts, every unit must fit inside the 90-day window.
Customizing activities (design, engineering, retooling) cost no more than 10 percent of total estimated costs for the item.
The manufacturer already carries similar items in its finished-goods inventory.

Clearing any of these means you can use a simpler accounting method instead of Section 460’s machinery.

How the Percentage-of-Completion Method Works

The default treatment under Section 460 is the percentage-of-completion method, or PCM. Each year, you report a share of the contract’s total expected income equal to the share of work completed.² Progress is usually measured cost-to-cost: costs incurred to date divided by total estimated costs.

A quick example. On a $5 million contract with $4 million in estimated costs, spending $1 million in year one puts the job at 25 percent complete, so you report $1.25 million of gross income. If you spend another $2 million in year two, cumulative costs of $3 million against $4 million estimated put the job at 75 percent complete. Cumulative income should be $3.75 million, and after subtracting the $1.25 million already reported, year two picks up $2.5 million.

You must update cost estimates every year to reflect changes in material prices, labor, and scope. Rising estimated costs push some income into later years; falling estimates pull it forward. That annual recalculation is what prevents companies from bunching expenses into a single year to distort the timing.

The 10-Percent Election

You can elect to defer all income recognition on a long-term contract until at least 10 percent of estimated total costs have been incurred. Income that would otherwise show up earlier gets pushed into the year the threshold is crossed.² This is useful for projects with heavy mobilization costs but little production early on.

Once made, the election applies to every long-term contract you enter into that year and thereafter. It cannot be used with the simplified cost allocation procedure under Section 460(b)(3)(A). The look-back still runs at the end of the contract, so the election shifts timing without erasing the final reconciliation.

Allocating Costs to a Contract

Cost allocation is where most of the complexity lives. For contracts under PCM, costs must be allocated using the framework Section 263A uses for produced property: direct costs plus indirect costs that benefit or result from performing the contract.⁴

A simplified cost-to-cost method is available. It limits the calculation to three buckets: direct materials, direct labor, and depreciation on equipment and facilities used directly on the contract, with subcontractor costs falling into either the material or labor category. The simplified method reduces bookkeeping but can materially shift your completion percentage, since it leaves out much of the indirect overhead a full allocation would sweep in.⁴

One important interaction with the broader capitalization rules: UNICAP under Section 263A generally does not apply to property produced under a long-term contract subject to Section 460. Home construction contracts are the exception and remain under UNICAP.⁵ Whatever allocation approach you use, costs that are nondeductible elsewhere in the code (illegal payments, for instance) cannot be allocated to a contract.⁴

Exemptions from PCM

Section 460(e) carves out two categories of contracts that don’t have to use the percentage-of-completion method: small-contractor construction contracts and home construction contracts.²

Small-Contractor Exemption

A construction contract qualifies if two conditions are both met. Your average annual gross receipts for the three preceding tax years cannot exceed the inflation-adjusted threshold, which is $32 million for tax years beginning in 2026.¹ And at the time you enter into the contract, you must estimate the project will finish within two years of the commencement date.² Qualifying contractors can use the completed-contract method or another permissible method instead of PCM.

Both conditions apply per contract. A contractor with $20 million in average receipts who signs a three-year highway job cannot use the exemption for that job because the two-year estimate fails. The exemption is also unavailable to tax shelters prohibited from using the cash method under Section 448(a)(3).

Home Construction Contracts

Home construction contracts are exempt from PCM regardless of contractor size or expected duration. A home construction contract is one where at least 80 percent of estimated total costs are attributable to dwellings in buildings with four or fewer units, along with directly related site improvements.² Watch the 80-percent line carefully, because crossing it in either direction changes both regular tax and AMT treatment.

The AMT Trap for Exempt Contractors

This is where exempt contractors get caught. Section 56(a)(3) requires the percentage-of-completion method when computing alternative minimum taxable income for any long-term contract entered into on or after March 1, 1986.⁶ If you use the completed-contract method for regular tax, you must still run a parallel PCM calculation for AMT.

Home construction contracts (the 80-percent, four-unit test above) are the one exception; they are exempt from the AMT adjustment as well. Every other long-term contract, including non-home residential contracts and small-contractor-exempt commercial jobs, creates an AMT timing difference. That can produce unexpected liability for pass-through owners who are individually subject to AMT. The higher AMT exemptions from the Tax Cuts and Jobs Act cut down how many taxpayers actually owe AMT, but they don’t remove the reporting obligation. If income differs materially between PCM and the completed-contract method, the preference item still has to be computed and disclosed.

The Look-Back Rule

Because PCM depends on cost estimates that will always differ from final actual figures, Section 460(b)(2) requires a look-back when the contract is done. You recompute what your tax would have been in each prior year using actual costs and the actual final contract price, and compare that to what you actually paid.²

Interest on any difference is calculated at the overpayment rate in Section 6621, running from the original due date of each affected return. Underestimate costs early (and overreport income), and the IRS owes you interest. Overestimate them, and you owe interest. Separately, accuracy-related penalties under Section 6662 can add 20 percent of any underpayment if the position lacks substantial authority.⁷

Simplified Marginal Impact Method

A full look-back requires original return data from every year of the contract, recomputed at each year’s rates. For pass-through entities, that gets punishing because every owner has a different marginal rate. The simplified marginal impact method (SMIM) does the calculation at the entity level instead of flowing it through to each owner.⁸

A pass-through that is not closely held must use the entity-level look-back for any contract generating at least 95 percent of its gross income from U.S. sources. To elect SMIM otherwise, attach a statement to a timely filed return referencing Regulations section 1.460-6(d). The election is permanent absent IRS consent to revoke it.⁸

De Minimis Exception

Section 460(b)(6) offers an elective de minimis exception. If the difference between reported and recomputed income falls within the statutory threshold, you can skip the look-back computation entirely. It’s worth checking on contracts where your cost estimates held up well, because the paperwork cost of a full look-back can easily exceed the interest at stake.

Reporting, Method Changes, and Early Termination

Form 8697 is the vehicle for calculating and reporting look-back interest on completed long-term contracts. Part I handles the regular computation; Part II is for SMIM and entity-level filers.⁹ You list previously reported and recomputed income for each contract year, applying the rates in effect during each of those years. The form is normally filed with the income tax return for the year the contract ends, but if the calculation shows the IRS owes you interest, a separate filing can accelerate the refund. To complete it, you need the total contract price, total actual costs, the years work was performed, and the original returns from those years.⁸

Switching methods (for example, moving from completed-contract to PCM after outgrowing the small-contractor exemption) requires the Commissioner’s consent under Section 446(e). The change is cut-off: it applies to contracts entered into on or after the year of change, with no Section 481(a) adjustment for prior contracts.¹⁰ Form 3115 is the standard filing, and some long-term contract changes qualify for automatic consent.

When a contract is terminated early and you keep the property, the tax treatment reverses your prior reporting: you recognize a loss (or gain) equal to cumulative costs previously reported minus cumulative gross receipts previously reported under the contract. Your basis in the retained property then equals the cumulative costs previously reported. Any compensation you keep from the customer reduces that basis, and if it exceeds the adjusted basis, the excess is taxable in the year of termination. One useful consequence: the look-back method does not apply to contracts terminated under these rules, so no interest reconciliation is required.¹¹

1
Internal Revenue Service. Revenue Procedure 2025-32
2
Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts
3
eCFR. 26 CFR 1.460-2 – Long-Term Manufacturing Contracts
4
eCFR. 26 CFR 1.460-5 – Cost Allocation Rules
5
eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs
6
Office of the Law Revision Counsel. 26 USC 56 – Adjustments in Computing Alternative Minimum Taxable Income
7
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
8
Internal Revenue Service. Instructions for Form 8697 – Interest Computation Under the Look-Back Method for Completed Long-Term Contracts
9
Internal Revenue Service. About Form 8697 – Interest Computation Under the Look-Back Method for Completed Long-Term Contracts
10
eCFR. 26 CFR 1.460-4 – Methods of Accounting for Long-Term Contracts
11
Federal Register. Accounting for Long-Term Contracts