The Small-Contractor Exemption, Explained
For tax purposes, the IRS generally expects contractors on long-term contracts to use the percentage-of-completion method, recognizing income as the job progresses. But there’s an important carve-out that lets many smaller contractors use a more favorable method and defer tax. It’s commonly called the small-contractor exemption, and understanding whether you qualify can meaningfully change your cash flow.
Note: this is a high-level overview, not tax advice for your specific situation. The thresholds and rules below change periodically and depend on facts unique to your business. Confirm the current-year figures and your eligibility with your CPA before making any election.
What the exemption does
If you qualify, you’re generally not required to use percentage-of-completion for tax on certain contracts. Instead you may be able to use a method like completed-contract, which defers recognizing the profit on a job until it’s finished, deferring the tax along with it. For a growing contractor, that deferral can free up working capital at exactly the time it’s needed most.
The two main tests
Eligibility generally turns on two questions:
- The gross-receipts test. Your average annual gross receipts over the prior three years must fall below an inflation-adjusted threshold. This figure is updated periodically, so always check the current-year amount rather than relying on a number you remember from a few years ago.
- The contract-duration test. The contract is generally expected to be completed within a two-year window.
Home construction contracts have their own, more generous set of rules that are worth a separate conversation if that’s your work.
Why it matters for cash flow
The whole value here is timing. Deferring profit recognition on open jobs means deferring the tax on that profit. That’s not a permanent savings. The tax comes due when the job closes. But the time value of holding onto that cash, especially while you’re scaling, is real.
The catch
Method choices have consequences. The method you use for tax can differ from what you use for your bank and bonding financials, which means you may be maintaining more than one view of the same jobs. There are also alternative-minimum-tax considerations and look-back interest rules that can apply. This is precisely the kind of decision that benefits from a CPA who works in construction every day.
Wondering if you qualify? Alter Accounting CPA works exclusively with contractors and builders across the Southeast. Get in touch and we’ll check it against your numbers.