The Small Contractor Exemption: Who Can Skip Percentage-of-Completion

Ask ten contractors about the percentage-of-completion requirement and most will tell you it applies to them. For firms doing $1M–$10M, that's usually wrong — Congress wrote an exception into the tax code specifically for companies your size, and it's one of the most valuable timing levers you own. The small contractor exemption decides whether the IRS dictates when your job profit hits the return or whether you get to choose. Here's who qualifies, how the test is actually measured, and the traps that catch growing firms at the edge.

What the Exemption Actually Says

Under IRC §460, any long-term contract — one not completed in the tax year it's signed, even if it only spans a few weeks across New Year's — defaults to the percentage-of-completion method for tax. Section 460(e) then exempts a construction contract that passes two tests at the time the contract is signed:

• The two-year test. You reasonably expect, at signing, that the contract will be completed within two years of the start date. This is judged contract by contract — a 30-month job fails even if everything else about your company qualifies.
• The gross-receipts test. Your average annual gross receipts for the three prior tax years are at or below the threshold in IRC §448(c) — set at $25M by the 2017 tax law and indexed for inflation since, so confirm the current-year figure before you rely on it.

Pass both, and that contract is an exempt contract: percentage of completion is optional, not mandatory. Fail either, and that particular contract goes on percentage of completion no matter how the rest of your book looks.

The Gross-Receipts Test Is Wider Than Your Company

Two details in the receipts test catch people. First, it's gross receipts, not profit — total revenue before a single cost is subtracted. A firm netting $700K on $9M of revenue is measured on the $9M. Second, related businesses are aggregated: companies under common ownership or control — your GC entity, the equipment-leasing LLC that rents it machines, a related development company — generally count as one taxpayer for the test. Owners who split operations across entities for liability reasons sometimes assume each one gets its own threshold. They don't, and discovering that in an exam is expensive.

The three-year averaging cuts the other way, in your favor: one breakout year doesn't disqualify you by itself. It flows into the average, which means you can usually see the threshold coming two or three years before you actually cross it — if someone is watching.

What Qualifying Actually Buys You

For exempt contracts, you can use your normal accounting method: completed contract (defer everything to the finish year), cash, accrual, or even a voluntary exempt-contract version of percentage of completion. We walk through how those compare in percentage of completion vs. completed contract; the short version is that deferral on open jobs is the prize.

An illustrative example: your firm averages $6M in receipts and finishes the year with three open commercial jobs carrying $450K of earned gross profit under percentage of completion. On completed contract, none of that is taxable this year — at an assumed combined federal and state rate of 35%, that's roughly $157,500 of tax pushed into later years (35% × $450K; figures illustrative, and deferred is not erased). For a contractor funding payroll and retainage out of working capital, a year's use of six figures matters.

The same §448(c) threshold also gates other small-business simplifications — the overall cash method for entities that otherwise couldn't use it, and relief from certain inventory and UNICAP capitalization rules — so staying under it is a bigger deal than §460 alone.

Home Construction Is Its Own Lane

A home construction contract — one where 80% or more of estimated contract costs relate to buildings with four or fewer dwelling units — is exempt from mandatory percentage of completion regardless of company size. A $60M homebuilder still qualifies on those contracts. Remodelers and custom-home builders across our six states often sit entirely in this lane without knowing it; townhome and small-multifamily work can qualify too, while a 20-unit building doesn't. The classification is worth getting right in your construction accounting, because it changes the tax answer job by job.

Crossing the Threshold

The exemption is tested every year, for each new contract. The year your three-year average finally exceeds the threshold, long-term contracts signed that year must go on percentage of completion — but jobs already in progress generally keep the method they started with. The switch itself is an accounting method change, typically handled through Form 3115 rather than by just booking things differently, and percentage of completion brings friends: the look-back interest computation on Form 8697, tighter cost-allocation rules, and estimates the IRS can second-guess.

Because of the averaging, none of this should be a surprise. If this year's revenue puts your three-year average on a path to cross, the transition can be planned — which contracts to sign before year-end, whether a completion is worth accelerating, how the method change interacts with entity and equipment decisions. That's tax strategy work, and the year you cross is one of the highest-stakes planning years a contractor has.

Three Traps at the Edges

• The AMT shadow. For individual owners, alternative minimum tax rules can require percentage of completion on exempt commercial contracts even when the regular tax doesn't (home construction contracts that meet the small-contractor tests are spared). For most owners it's a non-issue; for some it claws back part of the deferral — project it, don't assume it.
• The two-year test is per contract. Winning a larger, longer job is exactly when firms trip this. A contract you expect to run 25 months goes on percentage of completion by itself, whatever your revenue.
• Your surety doesn't care about any of this. Exempt or not, bonding and banking still run on accrual, percentage-of-completion financial statements built from a monthly WIP schedule. The exemption is a tax-return tool, not a bookkeeping method.

Whether you're comfortably under the threshold, straddling it across related entities, or watching a growth year push your average toward the line, the exemption belongs inside a coordinated plan — the accounting-method chapter of our construction tax planning guide shows where it fits alongside entity structure and equipment timing. If nobody has ever measured your aggregated gross receipts or asked what happens when you cross, that's a gap our advisory work closes. Let's talk while the method choice is still yours to make.