Percentage of Completion Method for Long-Term Contracts

The percentage of completion method for long-term contracts spreads a contract’s revenue and costs across every tax year the work is in progress rather than bunching them into the year the job finishes. Under IRC Section 460, this method is the default for any contract that will not be completed within the same tax year it was signed.¹ The mechanics are straightforward, but the exemptions, the price and cost inputs, and the after-the-fact look-back reconciliation are where contractors and their accountants get into trouble.

What Counts as a Long-Term Contract

Section 460 defines a long-term contract as any agreement for the building, installation, construction, or manufacture of property that is not completed in the tax year it begins.¹ A two-month paving job that starts in November and finishes in February qualifies. What matters is crossing the tax-year boundary, not the total length of the project.

Manufacturing contracts are treated more narrowly. A manufacturing agreement is long-term only if the item is either uniquely designed for a specific customer or normally takes more than 12 calendar months to produce. Two safe harbors keep ordinary items out: work that can be finished in 90 days or less, or customization costs under 10 percent of total contract costs, does not count as unique.² Standard goods produced under a multi-year supply agreement generally sit outside Section 460.

Who Must Use PCM and Who Is Exempt

Section 460(a) makes PCM the default. The statute then carves out important exceptions, mostly for construction, and the One Big Beautiful Bill Act (P.L. 119-21) widened them in 2025.

The Small Contractor Exemption

A construction contractor can avoid PCM if two conditions are met at signing: the contractor estimates the project will be finished within two years, and the contractor’s average annual gross receipts for the prior three tax years do not exceed the Section 448(c) threshold. For tax years beginning in 2025 that threshold is $31 million, adjusted annually for inflation.³ Contractors who qualify may use the completed contract method (CCM), deferring income and cost recognition until the project is finished.⁴ The cash-flow value of that deferral is substantial, so tracking the three-year gross receipts figure year over year is worthwhile.

Residential Construction Under the One Big Beautiful Bill Act

Before the OBBBA, only home construction contracts, meaning projects where at least 80 percent of costs related to buildings with four or fewer dwelling units, were exempt from PCM on the residential side. For contracts entered into after July 4, 2025, the exemption expands to all residential construction contracts, including apartment buildings and large condominium projects, regardless of unit count.¹ A 200-unit apartment complex contracted in 2026 can use CCM. The same project signed in early 2025 would have required PCM.

Residential contractors relying on this expanded exemption still have to capitalize certain additional costs under Section 263A even though they are not applying PCM.

Manufacturing Has No Small-Business Escape

There is no parallel small-contractor exemption for manufacturing. If a manufacturing contract meets the uniqueness or 12-month test, PCM applies regardless of the manufacturer’s size.²

How the Calculation Works

The Treasury Regulations require the cost-to-cost method for tax purposes. You divide cumulative costs incurred through the end of the tax year by estimated total costs for the entire contract. The result is your completion percentage, and multiplying it by the total contract price gives cumulative revenue recognized to date. Subtract what you reported in prior periods, and the remainder is this year’s revenue.⁴

A worked example. You have spent $400,000 on a project you estimate will cost $1,000,000 in total, so your completion factor is 40 percent. On a $1,500,000 contract, cumulative revenue is $600,000. If you already reported $250,000 in prior years, the current period’s revenue is $350,000. Actual costs incurred during the period are recorded against that revenue.

Which Costs Go Into the Ratio

“Allocable contract costs” is tightly defined. You must include both direct costs and certain indirect costs, capitalized in the same manner as costs for property produced under Section 263A.⁵ Equipment depreciation, indirect labor, quality control, insurance, and officer compensation all belong in the cost pool. Leaving required indirect costs out of the denominator understates your completion percentage and, by extension, your taxable income. That is exactly the pattern IRS examiners look for.

The 10-Percent Method Election

Contracts with heavy front-loaded spending, like mobilization, site preparation, or engineering, can distort early-year percentages. The 10-percent method defers all income recognition until the tax year in which you have incurred at least 10 percent of estimated total costs. Once you cross the threshold, you catch up by recognizing all cumulative income to date.⁴ This is a method-of-accounting election. Once made, it applies to every long-term contract going forward and also changes how the look-back method runs.

Setting the Contract Price

The number you plug in as total contract price is rarely the figure on page one of the signed agreement. Performance bonuses, penalty clauses, incentive fees, and unpriced change orders all create variable consideration that has to be estimated and folded in.

Two approaches are permitted, and you pick the one that better predicts the outcome for that contract. The expected-value method probability-weights a range of scenarios and works well when you have many similar contracts. The most-likely-amount method takes the single most probable result and fits situations with a binary outcome, such as hitting a bonus target or missing it. Either way, you can include the estimate only to the extent that a significant reversal of cumulative revenue is unlikely once the uncertainty resolves. Factors that push toward constraining the estimate include outcomes driven by weather, third-party decisions, or volatile material prices, and limited experience with similar work.

Unpriced change orders do not automatically block recognition. If the scope is approved, the work is enforceable, and you expect to be paid, treat the unsettled price as variable consideration and estimate it under the same rules. Reassess at the end of every reporting period.

When a Contract Turns Unprofitable

The gradual recognition rule flips when your current estimates show total costs will exceed total consideration. The entire anticipated loss is recognized immediately in the period the shortfall becomes evident. You do not spread it across remaining years, and you do not hold it back hoping to offset it with future work from the same client.

This applies whether you spot the problem in year one or year five, and whether or not the loss is currently deductible for tax purposes. The provision must include all allocable costs, meaning the same indirect costs that feed the PCM ratio. Companies may elect to measure the loss at either the individual contract level or the performance-obligation level, but the choice has to be applied consistently across similar contracts.

Balance Sheet Effects

PCM does more than move numbers on the income statement. It generates specific balance sheet positions that auditors and lenders read closely.

When recognized revenue exceeds what you have billed, the difference is a contract asset representing work performed but not yet invoiced. Before ASC 606, these were labeled “costs and estimated earnings in excess of billings.” When billings exceed recognized revenue, the difference is a contract liability, reflecting an obligation to perform future work for money already requested or received. Each contract is evaluated on its own and presented net: a single contract appears entirely as one or the other, never split.

Retainage, the 5 to 10 percent that construction customers typically withhold from each progress payment, generally does not sit as a receivable. Because the right to that money is conditional on future performance rather than just the passage of time, it is folded into the contract asset or liability for the individual job. Retainage moves to a receivable only after the underlying conditions have been satisfied and only the payment date remains.

The Look-Back Method

PCM runs on estimates, and estimates are almost always off in some direction. When a contract is completed, the look-back method reported on IRS Form 8697 reruns each prior year’s completion percentage using the actual total costs and actual total price. If the recalculation shows you underpaid tax in an earlier year, you owe interest to the IRS. If you overpaid, the IRS pays interest to you.⁶

Interest is calculated at the federal overpayment rate under Section 6621, compounded daily, and runs from each affected year’s original return due date to the due date of the return for the completion year. Interest you pay is deductible; interest you receive is taxable.⁶

When Look-Back Does Not Apply

Residential construction contracts entered into after July 4, 2025 are exempt, using the newly expanded definition that covers buildings of any size. Before that date, only home construction contracts with four or fewer dwelling units were exempt.⁷
Small construction contracts are exempt if the contractor estimated at signing that the work would be finished within two years and the three-year average gross receipts figure is within the Section 448(c) threshold ($31 million for contracts entered into in tax years beginning in 2025).⁷
For contracts entered into before July 5, 2025, look-back does not apply to any contract completed within two years if the gross price at completion is the lesser of $1 million or 1 percent of the contractor’s three-year average gross receipts. For contracts entered into after July 4, 2025, that window extends to three years.⁷
A de minimis election lets you skip the calculation in the completion year if cumulative reported income was within 10 percent of what the recomputation would have shown for every prior year of the contract.⁷

The de minimis election is underused. On a large contract where estimates were reasonably close, it can save substantial compliance time without moving the tax number by more than a rounding error.

What the IRS Examines

The estimated-cost-to-complete figure is the single most sensitive input in the calculation, and it is where audit attention concentrates. The IRS Construction Industry Audit Technique Guide directs examiners to test both the numerator, costs incurred to date, and the denominator, estimated total costs, and to verify that every required cost category is included in both.⁸

A recurring error is including an indirect cost such as project supervision or equipment depreciation in the denominator as an estimated future cost while omitting it from the numerator as work proceeds. That mismatch understates the completion percentage and defers taxable income. Examiners also check that warranty costs are excluded from the calculation entirely and that legally nondeductible amounts, like the disallowed portion of meals or illegal payments under Section 162(c), are stripped from both sides of the ratio.⁸

Beyond the math, examiners cross-check reported costs against physical evidence. They compare materials specified in the contract to materials actually charged to the job and benchmark reported gross profit against industry averages. On construction jobs they may test physical quantities such as cubic yards of concrete or board feet of lumber against the size of the structure.⁸ Year-end bonuses draw attention too. Bonuses paid based on completed-job profitability generally should not be allocated to in-progress contracts, while bonuses expected to be paid on in-progress jobs belong in the denominator as an estimated cost. Errors in either direction shift income between years.

Clean, contemporaneous job-cost records are the best defense against both IRS adjustments and financial statement restatements. When estimates change mid-project, and they always do, document why. A well-supported revision reads as responsible project management. An undocumented one reads as income manipulation.

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. Revenue Procedure 2024-40
4
eCFR. 26 CFR 1.460-4 – Methods of Accounting for Long-Term Contracts
5
eCFR. 26 CFR 1.460-5 – Cost Allocation Rules
6
eCFR. 26 CFR 1.460-6 – Look-Back Method
7
Internal Revenue Service. Instructions for Form 8697
8
Internal Revenue Service. Construction Industry Audit Technique Guide