By: Aaron Scale | 02/11/26
Key Takeaways
The accounting method a contractor uses shapes taxable income, cash flow timing, and how financial performance is reported to lenders and owners. Construction businesses face unique challenges due to long project timelines, retainage, and change orders. Selecting the right approach can be a very important decision for firms.
Cash Method recognizes income when payment is received and expenses when bills are paid. This method is simple and often attractive for smaller contractors because it closely tracks cash flow. However, it can distort profitability on longer projects and may not be permitted for larger firms or those with inventory-intensive operations.
Accrual Method recognizes income when it is earned and expenses when incurred. This provides a clearer picture of project profitability and is often required for bonding, banking, or financial reporting purposes. From a tax standpoint, accrual accounting can be less favorable as taxable income can be recognized before cash is collected, which creates planning challenges.
For long-term contracts, contractors are generally required to use the Percentage of Completion Method unless certain exceptions apply. The Percentage of Completion Method recognizes revenue based on progress toward completion. This approach smooths income over the life of a project but can increase tax liability before final payment is received.
The Completed Contract Method defers income recognition until the project is substantially finished. This can improve cash flow and simplify tax reporting for qualifying contracts. Under the One Big Beautiful Bill Act, most residential construction projects now qualify for this treatment, including large multifamily developments. This change significantly expands planning opportunities for residential builders and subcontractors.
Choosing between these and other options requires careful analysis of project mix, size, and financing structure. The right choice can reduce volatility in taxable income while supporting accurate financial reporting. Sometimes the method of accounting used for tax purposes can differ from the method used on the financial statements to accomplish these goals.
Construction companies incur a wide range of expenses. Capturing these deductions requires consistent documentation and an understanding of which costs can be expensed immediately versus capitalized.
Machinery and Equipment purchases continue to be an important tax deduction opportunity. With the return of 100 percent bonus depreciation for property placed in service after January 19, 2025, contractors can deduct the full cost of qualifying machinery, trucks, tools, and certain technology in the year it is placed in service. Section 179 expensing also remains available, with limits increased to 2.5 million dollars for 2025 and indexed for inflation beginning in 2026.
Financial reporting and tax reporting do not always align, especially for contractors subject to ASC 606 (Accounting Standards Codification Topic 606). While tax law governs taxable income, financial statements must comply with revenue recognition standards that emphasize performance obligations and contract terms.
ASC 606 requires contractors to identify performance obligations within a contract, determine the transaction price, allocate that price to each obligation, and recognize revenue as obligations are satisfied. Many construction contracts involve a single performance obligation satisfied over time but change orders and modifications can complicate the analysis.
Revenue is recognized Over-Time when the customer receives and consumes benefits as the work progresses or when the contractor creates an asset with no alternative use and has an enforceable right to payment. Point-in-time recognition applies when these conditions are not met.
Common errors include failing to properly evaluate contract modifications, misclassifying change orders, or inconsistently measuring progress. These mistakes can create discrepancies between financial statements and tax returns that attract scrutiny.
Contractors should ensure their accounting systems, work-in-progress schedules, and tax reporting methods align as closely as possible. Clear documentation of contract terms and modifications reduces risk and supports compliance with ASC 606.
Sales tax treatment in construction varies widely by state and by the nature of the work performed. Understanding Sales Tax Rules is critical, especially for contractors operating across state lines.
In many states, contractors are considered the end users of materials and must pay sales tax to vendors at purchase. In other jurisdictions, contractors may be required to charge sales tax on certain types of labor or materials billed to customers. The distinction often depends on whether the work is considered real property improvement or tangible personal property installation.
Exemptions may apply for manufacturing facilities, resale transactions, or nonprofit projects, but these exemptions typically require proper certificates and documentation. Working across multiple states adds complexity, as each state has its own nexus standards, filing requirements, and exemption rules.
Contractors should review each project location to determine registration obligations and tax treatment before work begins. Proactive compliance reduces the risk of assessments, penalties, and interest.
Entity choice plays a significant role in construction tax planning. Common structures include limited liability companies, S corporations, and C corporations, each with different tax implications.
Pass-through entities such as LLCs taxed as partnerships or S corporations allow income to flow through to owners, who may benefit from the now permanent 20 percent Qualified Business Income (QBI) Deduction. This deduction applies before calculating individual tax liability and can significantly reduce effective tax rates.
S corporations also offer potential savings on self-employment taxes by allowing reasonable salaries subject to payroll tax, with remaining income distributed as dividends. However, reasonable compensation requirements must be carefully managed.
C corporations may offer advantages for firms planning to reinvest profits or pursue long-term growth, but they face entity-level tax and potential double taxation on distributions.
State tax considerations further complicate the decision. Some states impose entity-level taxes or limit deductions differently than federal law. Periodic review of entity structure helps ensure alignment with growth plans and changing tax rules.
Beyond deductions, contractors may qualify for valuable credits that directly reduce tax liability. Hiring incentives such as the Work Opportunity Tax Credit reward employers for hiring individuals from targeted groups. These groups can include qualified veterans, individuals receiving SNAP benefits, long-term unemployment recipients, and certain ex-felons. Proper screening, certification, and documentation are essential to secure and defend these credits.
Energy-related incentives remain available but are tightening. Section 179D provides deductions for energy-efficient commercial buildings but generally expires for projects beginning construction after June 30, 2026. Documentation of project start dates and efficiency certifications is critical. Qualifying improvements include lighting, HVAC, and building envelope systems that meet specified efficiency standards. The deduction may be claimed by building owners or, for certain government-owned projects, allocated to designers and contractors.
Some construction activities may qualify for Research and Development (R&D )Credits when firms bear the risk of loss and engage in qualifying technical activities. Immediate deduction of domestic research costs has returned, but determining eligibility remains complex.
State and local incentives may also be available for projects that promote economic development. Contractors should review opportunities annually to ensure nothing is missed.
Cash flow management and tax planning are closely linked in construction. Timing of income and expense recognition can significantly affect tax liability and liquidity.
Managing retainage and progress billing helps align cash receipts with tax obligations. Estimated tax payments should be reviewed regularly to avoid underpayment penalties while preserving working capital.
Year-end planning may include accelerating deductions through equipment purchases, deferring income when permissible, and reviewing work-in-progress classifications. Effective construction tax planningsupports smoother cash flow and fewer surprises.
What accounting method is best for small construction contractors?
Many smaller contractors prefer the cash method due to its simplicity and alignment with cash flow. However, eligibility depends on revenue levels and project type. Residential contractors may also benefit from the completed contract method under new rules, making professional guidance important.
How can construction businesses reduce their tax liability in 2026?
Key strategies include using 100 percent bonus depreciation, maximizing available credits, selecting the right accounting method, and timing income and expenses carefully. Proactive planning throughout the year is more effective than last-minute decisions.
What are the most valuable tax credits for construction contractors?
Hiring credits such as the Work Opportunity Tax Credit, energy efficiency incentives like Section 179D, and potential research credits can provide meaningful savings. Eligibility depends on project details and documentation.
Do contractors need to charge sales tax on labor and materials?
It depends on state law and the nature of the work. Some states require contractors to pay tax on materials, while others require tax to be charged to customers. Each project location should be reviewed individually.
How should construction companies handle multi-state tax compliance?
Contractors should evaluate nexus, registration, and filing requirements in each state where they operate. Consistent review of project locations and state rules reduces risk and supports compliance as the business grows.
Final Thoughts:
Construction firms that take time to understand these changes can turn compliance into a strategic advantage. With thoughtful planning, accurate documentation, and regular review, contractors can strengthen profitability while staying aligned with evolving tax rules in 2026 and beyond. Staying proactive rather than reactive often makes the difference between merely complying and truly optimizing tax outcomes.
For many owners, applying these practical small construction business tax tips is a good start, but complex situations often require deeper expertise. Engaging qualified tax and accounting professionals can help identify opportunities, reduce risk, and ensure strategies are implemented correctly as regulations continue to evolve.
If you’re looking for strategic construction tax consulting to navigate financial reporting, international growth and business transactions, we can help. Get to know Aaron Scale, Aaron Epp, or Adrien Echols and schedule a consultation.
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