Which types of contracts are generally required to use the PCM?

Generally, all long-term contracts must use the PCM, as mandated by IRC Section 460(a). A long-term contract is defined as any contract for the manufacture, building, installation, or construction of property if it is not completed within the taxable year in which it is entered into. This applies to contracts where the taxpayer is engaged in a trade or business of manufacturing, building, installing, or constructing property.

Are there any exceptions to the mandatory use of the PCM?

Yes, there are exceptions. Small construction contracts are exempt if the contract is expected to be completed within two years and the taxpayer's average annual gross receipts for the three preceding tax years do not exceed $29 million (for tax years beginning after 2017, adjusted for inflation). Also, certain home construction contracts are exempt. These exceptions are outlined in IRC Section 460(e).

How is the 'percentage of completion' determined for a contract?

The percentage of completion is typically determined by comparing the contract costs incurred to date with the estimated total contract costs. This is known as the 'cost-to-cost' method and is the most common approach. Alternatively, taxpayers may request permission from the IRS to use another method that accurately measures the extent of completion, as per Treasury Regulation 1.460-4(b)(2).

What IRS forms are required to report income and expenses under the PCM?

Taxpayers using the PCM generally report their contract income and expenses on Form 1120 (U.S. Corporation Income Tax Return), Form 1065 (U.S. Return of Partnership Income), or Schedule C (Form 1040) for sole proprietors. Specifically, Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations, may be relevant for S corporations. Additionally, Form 3115, Application for Change in Accounting Method, is required if a taxpayer is changing to or from the PCM.

What is the 'look-back' method and when is it applied?

The 'look-back' method, described in IRC Section 460(b), requires taxpayers to recompute their tax liability for prior years using actual contract costs and revenues upon completion of a long-term contract. If there's a significant difference between the estimated and actual income, interest is paid by or to the taxpayer. This ensures that the government or taxpayer is compensated for the time value of money due to estimation errors.

Are there any dollar limits or thresholds that impact the PCM?

Yes, the primary dollar limit relates to the small contractor exception. For tax years beginning after 2017, taxpayers with average annual gross receipts of $29 million or less (adjusted for inflation) for the three preceding tax years are exempt from mandatory PCM for contracts expected to be completed within two years. This threshold is subject to annual inflation adjustments by the IRS, as specified in IRC Section 460(e)(1)(B).

What are common mistakes taxpayers make when applying the PCM?

Common mistakes include inaccurate estimation of total contract costs, leading to significant look-back adjustments. Another error is failing to properly allocate indirect costs to contracts, as required by IRC Section 460(c). Taxpayers also sometimes misclassify contracts, incorrectly applying the small contractor exception or failing to use PCM when required, which can lead to penalties.

What are some audit red flags related to the PCM?

Significant and consistent look-back interest payments (either to or from the IRS) can be a red flag, indicating poor cost estimation. Inconsistent application of the PCM across similar contracts or a sudden change in accounting method without filing Form 3115 can also trigger an audit. Additionally, misclassifying long-term contracts to avoid PCM requirements, especially for larger contracts, draws IRS scrutiny.

How does the PCM interact with the accrual method of accounting?

The PCM is a specific method for long-term contracts and generally overrides the general accrual method for those contracts. While a taxpayer may use the accrual method for their overall business, income and expenses from long-term contracts subject to IRC Section 460 must be reported using the PCM. This ensures that income is recognized progressively rather than only upon completion.

Can a taxpayer voluntarily elect to use the PCM if not required?

Generally, if a taxpayer is not required to use the PCM (e.g., they qualify for the small contractor exception), they may elect to use other permissible accounting methods like the completed contract method. However, once a method is chosen, a change requires IRS consent via Form 3115. A taxpayer cannot simply choose PCM if another method is more appropriate for their specific circumstances and contract types.

What is the impact of contract modifications on PCM calculations?

Contract modifications, such as change orders or scope adjustments, require a re-estimation of total contract costs and revenues. These revised estimates must be incorporated into the PCM calculations from the point of modification forward. Failure to update estimates promptly can lead to significant discrepancies and look-back adjustments, as per Treasury Regulation 1.460-4(b)(2)(ii).

How are uninstalled materials treated under the PCM?

Costs of uninstalled materials are generally included in contract costs for PCM purposes once they are acquired and allocated to the contract. However, for determining the percentage of completion using the cost-to-cost method, only costs incurred for work performed and materials installed are typically considered. This distinction is crucial for accurate progress measurement.

What are the record-keeping requirements for taxpayers using the PCM?

Taxpayers must maintain detailed records for each long-term contract, including original contract documents, change orders, invoices for costs incurred, and documentation supporting cost estimates. These records are essential for substantiating the percentage of completion, total contract costs, and revenues, especially during a look-back calculation or IRS audit. IRS Publication 538 provides guidance on accounting methods.

How does the PCM affect estimated tax payments?

Since income is recognized progressively under the PCM, it directly impacts a taxpayer's estimated tax liability throughout the year. Taxpayers must project their contract income and expenses to make accurate quarterly estimated tax payments. Underestimating income can lead to underpayment penalties, while overestimating ties up capital unnecessarily.

Can a business change from the completed contract method to the PCM?

Yes, a business can change from the completed contract method to the PCM, but it requires filing Form 3115, Application for Change in Accounting Method, with the IRS. The change is generally made under the automatic change procedures if the taxpayer meets the requirements. This ensures proper accounting adjustments are made to prevent income or expense duplication or omission.

What are the potential penalties for incorrect PCM application?

Incorrect application of the PCM can lead to underpayment penalties under IRC Section 6662 for substantial understatement of income tax. Additionally, if the IRS determines a taxpayer intentionally misapplied the method to avoid tax, more severe penalties for fraud could apply. Interest on underpayments will also be assessed from the original due date of the tax.

Are there any specific considerations for joint ventures using PCM?

For joint ventures, each partner or venturer must generally apply the PCM to their share of the long-term contract income and expenses. The joint venture itself may also be required to use the PCM if it is classified as a partnership for tax purposes and meets the criteria for long-term contracts. Proper allocation of costs and revenues among partners is crucial.

How might potential tax law changes in 2026 impact the PCM?

While specific changes are speculative, future tax law changes could impact the PCM by altering the small contractor gross receipts threshold, modifying the look-back interest rates, or introducing new definitions for long-term contracts. For example, the Tax Cuts and Jobs Act of 2017 significantly raised the small contractor threshold. Taxpayers should monitor legislative developments and consult IRS guidance for updates.

Does the PCM apply to international contracts performed by US companies?

Yes, the PCM generally applies to international long-term contracts performed by US companies, provided the contract meets the definition of a long-term contract under IRC Section 460. However, complexities arise with foreign tax credits and the sourcing of income and expenses. Taxpayers must carefully consider the interaction of US tax law with foreign tax regimes and treaty provisions.

Percentage of Completion Method — 2026 Guide

Overview: The Percentage of Completion Method for 2026

The Percentage of Completion Method (PCM) is an accounting method primarily used by contractors and businesses involved in long-term contracts. It allows for the recognition of revenue and expenses over the life of a project, rather than waiting until the project's completion. This method provides a more accurate reflection of a company's financial performance during the duration of a long-term project, aligning revenue recognition with the actual progress of work [1].

What is the Percentage of Completion Method?

The PCM is a revenue recognition method where income and expenses are recognized based on the proportion of work completed on a long-term contract. Instead of recognizing all revenue and costs at the beginning or end of a project, PCM allows for a continuous evaluation of a project's financial impact as work progresses [2]. This method is particularly relevant for projects that span multiple tax periods, providing a smoother and more consistent reporting of financial results.

Who Qualifies for the Percentage of Completion Method?

Generally, taxpayers involved in long-term contracts are required to use the PCM for tax purposes. A long-term contract is defined as any contract for the manufacture, building, installation, or construction of property if not completed within the taxable year in which it is entered into. There are specific exemptions, particularly for small contractors and certain residential construction contracts [3].

Small Contractor Exemption: Contractors whose average annual gross receipts for the three preceding taxable years do not exceed $29 million (for contracts entered into in 2026, this threshold is subject to inflation adjustments) may be exempt from PCM for contracts expected to be completed within two years [4].
Residential Construction Contracts: The One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025, significantly changed the rules for residential construction contracts. Previously, the exemption from PCM was limited to home construction contracts (buildings with four dwelling units or less). The OBBBA replaces this with a broader definition of “residential construction contracts,” eliminating the four-unit limitation. This means many larger residential construction contracts now have greater flexibility in choosing accounting methods, potentially allowing for the completed contract method or cash method [1]. This change applies to contracts entered into in tax years beginning after July 4, 2025 [1].

How to Claim the Percentage of Completion Method

Claiming the Percentage of Completion Method involves specific accounting and reporting procedures. Taxpayers generally use Form 3115, Application for Change in Accounting Method, to request a change to or from the PCM, though certain automatic changes may apply [5].

Measuring Progress: The percentage of completion is typically determined by comparing costs incurred to date with the total estimated costs of the contract. Other methods, such as the work performed, may also be acceptable if they accurately depict the extent of completion [6].
Revenue and Expense Recognition: As the percentage of completion is determined, a corresponding portion of the total contract revenue and estimated costs are recognized in the current tax year.
Look-Back Method: For certain long-term contracts, the look-back method under IRC Section 460(b) may apply. This method requires taxpayers to pay or receive interest on the difference between the tax liability calculated using the estimated contract price and costs, and the tax liability calculated using the actual contract price and costs upon completion of the contract. However, the OBBBA has expanded the AMT percentage of completion exemption to include residential construction contracts, aligning alternative minimum tax treatment with regular tax rules, and the look-back method no longer applies to residential construction contracts entered into in tax years beginning after July 4, 2025 [1].

2026 Limits, Amounts, and Rates

For the 2026 tax year, the primary limit associated with the Percentage of Completion Method relates to the small contractor exemption. The threshold for average annual gross receipts for the three preceding taxable years is subject to inflation adjustments. While the exact inflation-adjusted amount for 2026 is yet to be officially released by the IRS, based on current trends, it is expected to be around $29 million to $30 million [4]. Contractors exceeding this threshold are generally required to use the PCM for long-term contracts.

Common Mistakes That Cost Taxpayers Money

Navigating the PCM can be complex, and several common mistakes can lead to significant tax liabilities:

Inaccurate Cost Estimates: Underestimating total contract costs can lead to over-recognition of income in early stages, resulting in higher tax payments than necessary. Conversely, overestimating can defer income excessively, potentially triggering issues with the IRS.
Improper Application of Exemptions: Failing to correctly apply the small contractor exemption or the residential construction contract exemption can lead to incorrect accounting methods being used, resulting in penalties and interest.
Lack of Documentation: Insufficient documentation to support the percentage of completion calculations, cost incurred, and estimated costs can lead to disputes with the IRS during an audit.
Ignoring OBBBA Changes: For residential contractors, not understanding and implementing the changes introduced by the OBBBA for contracts entered into after July 4, 2025, can result in missed opportunities for tax deferral or incorrect method application [1].
Failure to Apply Look-Back Method (when applicable): For contracts where the look-back method still applies, failing to properly calculate and pay or receive interest can lead to compliance issues.

IRS Code Section Reference

The primary Internal Revenue Code (IRC) section governing the Percentage of Completion Method is IRC Section 460, Long-Term Contracts. This section outlines the general rules for accounting for long-term contracts, including the requirement to use the PCM, exceptions to its use, and the application of the look-back method [7].

Ready to Optimize Your Tax Strategy?

Understanding and correctly applying the Percentage of Completion Method can significantly impact your business's cash flow and tax liability. Given the complexities and recent changes, especially for residential construction contracts, expert guidance is invaluable. Don't leave money on the table or risk compliance issues.

Book a call with a tax strategist at Uncle Kam today to discuss how these rules apply to your specific situation and to develop a tailored tax strategy that maximizes your savings and ensures compliance. Book Your Consultation Now!

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Percentage Of Completion Method

Overview: The Percentage of Completion Method for 2026

What is the Percentage of Completion Method?

Who Qualifies for the Percentage of Completion Method?

How to Claim the Percentage of Completion Method

2026 Limits, Amounts, and Rates

Common Mistakes That Cost Taxpayers Money

IRS Code Section Reference

Ready to Optimize Your Tax Strategy?

References

Percentage Of Completion Method FAQs

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