IRC Section 460 long-term contract rules require most contractors and certain manufacturers to recognize income on jobs that cross a tax year-end as the work progresses, using the Percentage of Completion Method (PCM). The statute sets PCM as the default, then carves out narrow exceptions for smaller construction contractors, home builders, and residential projects. If your contract falls under Section 460 and doesn’t fit an exception, you calculate income each year from a cost-to-cost ratio and settle up at the end through a look-back interest calculation.
Which Contracts Section 460 Covers
A long-term contract is any agreement to manufacture, build, install, or construct property that isn’t finished within the tax year it begins.1Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts The trigger is purely calendar-based. A job signed on December 30 and finished on January 2 counts as long-term for a calendar-year taxpayer, even though only a few days crossed the line.
Construction contracts are the most common covered type. Manufacturing contracts qualify only under a narrower test: the item must either be unique (not normally carried in the manufacturer’s finished goods inventory) or one that typically takes more than 12 calendar months to produce, regardless of the contract terms.2Office of the Law Revision Counsel. 26 US Code 460 – Special Rules for Long-Term Contracts A factory mass-producing standard widgets under a multi-year supply agreement isn’t caught. A shipbuilder constructing a custom vessel is.
Section 460 applies to corporations, partnerships, S corporations, and individuals engaged in covered activities. The commencement date is the first date any costs are incurred other than bidding expenses, and that date matters for several timing rules that follow.
Exceptions That Let You Choose a Different Method
Not every long-term contract triggers mandatory PCM. Two exceptions let qualifying taxpayers pick their own method, including the more tax-favorable Completed Contract Method (CCM), which defers all profit recognition until the job is done.
Small Construction Contract Exception
A construction contract is exempt if, when the contract is signed, the taxpayer reasonably expects to finish within two years of the commencement date and passes the gross receipts test under Section 448(c).3Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts – Section: Exception for Certain Construction Contracts That test looks at whether average annual gross receipts over the three preceding tax years fall below an inflation-adjusted threshold. The Tax Cuts and Jobs Act set the base figure at $25 million, and annual inflation adjustments have pushed it to roughly $31 million for recent years. The IRS publishes the current number each fall in its annual inflation revenue procedure.
Contractors meeting both prongs can use the cash method, accrual method, or CCM.4Internal Revenue Service. Land Developers and Subcontractors – Proper Method of Accounting Note the scope: this exception covers construction contracts only. Manufacturing contracts that qualify as long-term have no small-business carve-out.
Home Construction Contracts
A separate exception applies to home construction contracts regardless of the contractor’s size. A contract qualifies if at least 80 percent of estimated total contract costs are attributable to building dwelling units in buildings with four or fewer units, plus directly related site improvements.5Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts – Section: Definitions Relating to Residential Construction Contracts Each townhouse or rowhouse counts as a separate building, so a row of six townhomes still qualifies. These contractors are fully exempt from mandatory PCM and look-back and may elect CCM.
Residential Construction Contracts
A broader residential category uses the same definition but allows any number of dwelling units per building. A 200-unit apartment building qualifies as residential construction even though it doesn’t qualify as home construction. If the residential contract doesn’t also meet the small-contractor two-year and gross-receipts tests, the taxpayer may use PCM or the Percentage of Completion-Capitalized Cost Method (PCCM).6eCFR. 26 CFR 1.460-3 – Long-Term Construction Contracts Under PCCM, only a portion of contract income runs through PCM; the balance is deferred until completion. It’s less favorable than CCM but more flexible than straight PCM.
How the Percentage of Completion Method Works
For contracts that don’t fit an exception, PCM is mandatory. You recognize income each year in proportion to how much of the work you’ve done. Measuring “how much” is the hard part, and the statute gives you only one way to do it.
The Cost-to-Cost Formula
Divide cumulative allocable costs incurred through year-end by total estimated allocable contract costs. That ratio is your completion percentage. Multiply it by the total contract price to get cumulative gross receipts recognized to date, then subtract gross receipts recognized in prior years to arrive at the current year’s figure.7Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts – Section: Percentage of Completion Method Engineering estimates, physical inspection, and other progress measures aren’t acceptable substitutes.
A quick illustration: on a $5,000,000 contract with $4,000,000 in estimated costs, incurring $1,000,000 in Year 1 gives you 25 percent completion and $1,250,000 of Year 1 gross receipts. Against $1,000,000 of costs, that’s $250,000 of taxable income for the year.
Handling Changed Estimates
Cost overruns and design changes are routine, and the PCM formula absorbs them without amendment. Each year you plug the updated cost estimate into the denominator and recalculate the cumulative completion percentage. Because you always subtract prior-year recognized income from the new cumulative figure, revisions flow through as current-year adjustments.8eCFR. 26 CFR 1.460-4 – Methods of Accounting for Long-Term Contracts If total estimated costs jump in Year 2, the completion percentage drops and recognized income for the year may be far lower than expected. A shrinking estimate accelerates income.
What Goes Into the Cost Base
Which costs land in the PCM formula matters. Inflating the denominator slows income recognition; understating it accelerates the tax hit. The statute requires allocating all costs that directly benefit or are incurred because of the contract. That includes direct costs (materials, labor, subcontractor payments) and indirect costs supporting the work, such as equipment depreciation and job-site overhead.9Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts – Section: Allocation of Costs to Contract
Production-period interest is allocated to the contract using the Section 263A capitalization framework that applies to self-constructed assets. The production period begins on the later of the contract commencement date or, for accrual-method taxpayers, the date when at least 5 percent of estimated total costs have been incurred.
Some costs are specifically excluded from the contract cost base:
- Independent research and development not tied to an existing contract.
- Unsuccessful bid and proposal costs.
- Marketing, selling, and advertising expenses.
The 10 Percent Deferral Election
Early-stage contracts can create a mismatch: mobilization and design costs run through the PCM formula before real work has begun. The 10 percent election defers all income and cost recognition on a contract until the first tax year in which at least 10 percent of estimated total contract costs have been incurred.10Office of the Law Revision Counsel. 26 US Code 460 – Special Rules for Long-Term Contracts – Section: Election to Use 10-Percent Method
Once you cross the threshold, all deferred amounts drop into that year’s computation and PCM continues normally. The election applies to every long-term contract you enter in the election year and every year after. It isn’t available to taxpayers using the simplified cost allocation method, and the look-back still applies.
The Look-Back Method
Because PCM relies on estimates that never match final numbers exactly, Section 460 includes a correction step at the end. When the contract is complete, you recalculate what the income allocation would have been in every prior year if the actual contract price and actual total costs had been known from the start.11Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts – Section: Look-Back Method
The recalculation doesn’t reopen any prior return. Instead it produces a hypothetical overpayment or underpayment of tax for each year of the contract. If you underestimated profit during the job, tax was deferred and you owe interest on the resulting underpayment. If you overestimated profit, the IRS pays you interest on the resulting overpayment.12eCFR. 26 CFR 1.460-6 – Look-Back Method Interest runs at the adjusted overpayment rate under Section 6621, compounded daily; the IRS publishes the applicable rate each quarter.13Internal Revenue Service. Internal Revenue Bulletin 2026-08
De Minimis Exception
Not every completed contract triggers look-back. A contract is exempt if the final gross price doesn’t exceed the lesser of $1,000,000 or 1 percent of average annual gross receipts for the three preceding tax years, and the contract was completed within two years of commencement.14Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts – Section: Look-Back Method Not to Apply to Certain Contracts For a midsize contractor with $20 million in average gross receipts, the ceiling is $200,000. Many smaller PCM jobs escape the look-back paperwork on this basis.
Form 8697
The look-back computation goes on IRS Form 8697. You file it for every tax year in which a PCM contract is completed, and again in any later year the contract price or costs are adjusted post-completion.15Internal Revenue Service. Instructions for Form 8697 – Interest Computation Under the Look-Back Method for Completed Long-Term Contracts The form calculates the interest owed to or refundable from the IRS.
Pass-Through Entities
Partnerships, S corporations, and trusts that aren’t closely held apply the look-back at the entity level rather than passing it through to owners. A pass-through is closely held if 50 percent or more of the beneficial interests by value are held directly or indirectly by five or fewer persons during any contract year with contract income.16Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts – Section: Simplified Look-Back Method for Pass-Thru Entities Closely held entities don’t use the entity-level simplified method; the look-back flows to the individual partners or shareholders instead. Entity-level computations use the highest marginal rate: the highest individual rate if more than 50 percent of the interests are held by individuals, otherwise the highest corporate rate.
When One Contract Is Really Two (or Vice Versa)
How you draw the boundary of a “contract” for Section 460 can move income between years. The IRS may treat a single agreement as multiple contracts, or several agreements as one, whenever necessary to clearly reflect income. The analysis looks at whether items in one agreement are independently priced, whether separate agreements have interdependent pricing, whether delivery and acceptance are separate, and whether a reasonable businessperson would have entered into each agreement independently.
This surfaces most often in phased projects. A developer signs a master agreement covering site work, vertical construction, and interior finishing, then argues that site work is a separate contract that can be closed out and deferred on its own. The IRS will look at whether each phase was priced separately and whether the contractor would have taken any phase on the same terms without the others. Bundled pricing points toward a single contract.
Changing Your Accounting Method
If you’ve been using the wrong method for long-term contracts, or your circumstances change so a different method is now required or allowed, you file Form 3115 (Application for Change in Accounting Method) to switch.17Internal Revenue Service. Instructions for Form 3115 – Application for Change in Accounting Method The most common trigger is a growing contractor whose average gross receipts cross the Section 448(c) threshold, disqualifying the small-contractor exception and forcing a switch from CCM to PCM.
Many long-term contract method changes qualify for automatic consent, meaning no user fee and no letter ruling. You file Form 3115 with the return for the year of change and follow the applicable revenue procedure. Non-automatic changes require a user fee and IRS approval. A separate Form 3115 is generally required for each distinct method change and each separate trade or business.
The transition can produce a significant one-time income adjustment. Moving from CCM to PCM requires a Section 481(a) adjustment reflecting the cumulative difference between income under the old and new methods on all open contracts. Positive adjustments are typically spread over four tax years, softening the hit. Negative adjustments are recognized entirely in the year of change.