Tax for Construction
A self-employed general contractor filing Schedule C with $145,000 net profit in 2026 may owe approximately $19,800 in self-employment tax and $17,500 in federal income tax before deductions. The 20% QBI deduction (construction is a non-SSTB) and Section 179 equipment expensing typically reduce the combined federal burden to approximately $28,000. Long-term contracts over 24 months may require the percentage-of-completion method under IRC Section 460, and all subcontractors paid $600+ must receive Form 1099-NEC by January 31.
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General contracting sits at the intersection of every trade-specific tax issue — subcontractor management, heavy equipment depreciation, long-term contract accounting, workers' compensation, and prevailing wage compliance — while adding its own layer of complexity around retainage, Davis-Bacon requirements, and multi-state nexus. A self-employed general contractor typically nets $100,000 to $200,000 annually, with income heavily influenced by project size, geographic market, and the mix of residential versus commercial work. The tax stakes are proportionally higher: a construction business with $500,000 in gross revenue and $145,000 in net profit faces combined federal self-employment and income tax exposure of $30,000 to $40,000, making aggressive but defensible deduction strategies worth thousands annually.
Common business structures
- Sole Proprietorship (Schedule C) — viable for small residential contractors, but the liability exposure of general contracting makes this the least advisable structure
- Single-Member LLC — adds personal asset protection against jobsite liability, construction defect claims, and subcontractor disputes; same Schedule C tax treatment
- S-Corporation (Form 1120-S) — strongly advantageous above ~$90k net profit for construction; FICA savings of $6,000–$15,000/year on distribution income; also helps with bonding and lending appearances
- Partnership / Multi-Member LLC (Form 1065) — common for construction joint ventures and partnerships between a licensed GC and a capital partner
- C-Corporation (Form 1120) — used by larger construction firms for retained earnings, employee benefit structures, and corporate bonding capacity; 21% flat rate can be advantageous for firms retaining profits for equipment purchases
Key mechanics
Long-Term Contract Accounting: Percentage-of-Completion vs. Completed-Contract Method
The accounting method for long-term construction contracts is one of the most consequential tax decisions a general contractor makes. IRC Section 460 requires the percentage-of-completion method (PCM) for most long-term contracts — defined as contracts for the manufacture, building, installation, or construction of property that are not completed within the tax year in which they are entered into.
Under PCM, income is recognized each year based on the ratio of costs incurred to total estimated costs. If a $500,000 contract has estimated total costs of $350,000 and $175,000 has been incurred by year-end, the contractor recognizes 50% of the contract price ($250,000) as income, regardless of how much has been billed or collected. The "costs incurred" include all direct costs (materials, labor, subcontractor payments) and allocable indirect costs (equipment depreciation, insurance, supervision).
The completed-contract method (CCM) — which defers all income recognition until the project is substantially complete — is available only for contracts that meet the small construction contract exception under IRC Section 460(e)(1). To qualify, the contract must be for construction (not manufacturing) and the taxpayer must have average annual gross receipts of $30 million or less for the three preceding tax years ($29 million indexed, per TCJA). Home construction contracts are exempt from PCM regardless of taxpayer size, provided 80% or more of estimated total costs are for dwelling units in buildings with 4 or fewer units.
The choice between PCM and CCM has enormous cash flow implications. On a two-year contract, CCM allows the contractor to defer all income to the completion year, while PCM forces recognition as costs are incurred. For a contractor with multiple overlapping projects, PCM creates a smoother but higher current-year tax obligation, while CCM produces lumpy income — potentially pushing the contractor into higher brackets in completion years.
The IRS requires a look-back calculation under IRC Section 460(b)(2) for PCM contracts. When a project is completed, the contractor must compare actual income recognition with what would have been recognized using actual (rather than estimated) costs. If the contractor underestimated costs (recognizing too much income early), the IRS owes the contractor interest; if costs were overestimated (too little income recognized early), the contractor owes the IRS interest. This calculation is performed on Form 8697 (Interest Computation Under the Look-Back Method).
Long-term construction contracts generally require the percentage-of-completion method of accounting, with an exception for small contractors and home builders. (IRC Section 460 (long-term contracts), IRC Section 460(e)(1) (small construction contract exception), IRC Section 460(b)(2) (look-back method), Form 8697)
Davis-Bacon Prevailing Wage and Tax Implications
The Davis-Bacon Act requires contractors on federal construction contracts exceeding $2,000 to pay workers no less than the locally prevailing wages and fringe benefits as determined by the Department of Labor. The prevailing wage determination includes a base hourly rate and a fringe benefit rate for each classification (laborer, carpenter, electrician, plumber, etc.). The contractor may pay the fringe component as actual fringe benefits (health insurance, retirement contributions) or as cash in lieu of fringes — and the choice has direct tax consequences.
When fringe benefits are paid as actual benefits (employer-provided health insurance, 401(k) contributions), they are deductible business expenses that are also excluded from the employee's taxable income. When paid as cash in lieu of fringes, the entire amount is wages — subject to FICA, FUTA, and income tax withholding. For a contractor paying a prevailing wage of $45/hour base + $18/hour fringes to 5 workers over a 6-month project, the annual fringe component is approximately $187,200. Paying that as actual benefits versus cash creates a significant difference in employer payroll tax cost: the FICA employer share alone on $187,200 is approximately $14,321.
The Davis-Bacon Act also requires weekly certified payroll submissions (WH-347) to the contracting agency. These submissions create a paper trail that the IRS can cross-reference against payroll tax filings. Contractors who underreport wages on Form 941 while accurately reporting on WH-347 create an obvious audit target. The DOL's Wage and Hour Division conducts independent audits and shares information with the IRS when discrepancies are found.
For self-employed general contractors who do not employ workers directly but manage subcontractors, Davis-Bacon compliance flows through to the subcontractors. The GC is responsible for ensuring each subcontractor pays prevailing wages and submits certified payrolls. This does not change the GC's own tax treatment, but failing to enforce subcontractor compliance can result in the GC being held liable for back wages and penalties — costs that are not deductible as they arise from violation of law (IRC Section 162(f) disallows deductions for fines and penalties).
State prevailing wage laws (also called "little Davis-Bacon" acts) apply to state-funded construction in approximately 28 states plus the District of Columbia. The thresholds, wage determinations, and enforcement mechanisms vary by state. Contractors bidding on both federal and state projects must track compliance separately, as wage determinations may differ even for the same trade classification in the same geographic area.
Federal construction contracts over $2,000 require prevailing wage payments, with the fringe benefit allocation method affecting both employer payroll taxes and worker income tax treatment. (40 U.S.C. 3141-3148 (Davis-Bacon Act), IRC Section 162(f) (non-deductibility of fines/penalties), 29 CFR Part 5 (DOL enforcement regulations))
Retainage: Cash Flow, Income Recognition, and Lien Rights
Retainage — the portion of a contract payment withheld by the project owner or general contractor until project completion or a defined milestone — is standard practice in construction, typically 5–10% of each progress payment. For a contractor on a $500,000 project with 10% retainage, $50,000 is held back across the life of the project, creating both a cash flow burden and a tax timing question.
For cash-basis taxpayers (most sole proprietors and small LLCs), retainage is income when received, not when earned. This means the $50,000 held back from a project spanning 2026–2027 is not taxable until actually paid, which may not occur until 30–90 days after substantial completion and punch list resolution in 2027. This natural deferral is one of the few advantages of the cash method for construction businesses.
For accrual-basis taxpayers, the treatment of retainage is more complex. Under the all-events test, income is recognized when the right to payment is established. Retainage tied to substantial completion — where the contractor has a right to the retainage upon meeting a defined milestone — may be recognized before actual receipt if the right to payment has been established and the amount is determinable. However, if retainage is subject to inspection, approval, or other contingencies that could reduce the amount, recognition may be deferred until the contingency is resolved. The IRS and Tax Court have litigated this issue extensively (see, e.g., Commissioner v. Hansen, 360 U.S. 446).
Retainage also intersects with mechanic's lien rights. In most states, contractors who file mechanic's liens must do so within a defined period after last furnishing labor or materials (30–120 days depending on the state). The lien secures payment of retainage and any unpaid progress payments. Filing a lien is not a tax event, but the cost of lien filing and enforcement (attorney fees, court costs) is deductible as a business expense if incurred in connection with the trade or business. Amounts received through lien enforcement are ordinary income.
The cash flow impact of retainage is substantial enough that many construction lenders offer retainage financing — essentially factoring the retainage receivable at a discount. The discount (interest/fees on retainage financing) is deductible as a business interest expense under IRC Section 163, subject to the Section 163(j) business interest limitation for larger firms.
Retainage is recognized as income when received (cash basis) or when the right to payment is established (accrual basis), with mechanic's lien enforcement costs deductible as business expenses. (IRC Section 451 (year of inclusion), IRC Section 461 (year of deduction), IRC Section 163 (interest deduction), Commissioner v. Hansen, 360 U.S. 446 (1959))
Heavy Equipment: Section 179, Bonus Depreciation, and Disposition
Construction businesses invest more in depreciable equipment than virtually any other trade. A general contractor's equipment inventory may include excavators ($80,000–$300,000), skid steers ($35,000–$75,000), dump trucks ($60,000–$150,000), concrete mixers, compactors, generators, scaffolding systems, and aerial lifts. The tax treatment of these purchases — and their eventual sale or trade-in — is a primary driver of the contractor's annual tax liability.
Section 179 permits full expensing of qualifying equipment in the year placed in service, up to the OBBBA limit. This is particularly powerful for construction: a contractor who purchases a $120,000 mini-excavator and a $65,000 dump truck in 2026 may deduct the full $185,000 in year one if the equipment is used primarily for business and the deduction does not exceed active business income. The income limitation is critical for construction — Section 179 deductions cannot create a net loss. Excess Section 179 amounts carry forward to future years under IRC Section 179(b)(3)(B).
Bonus depreciation under IRC Section 168(k) provides an alternative that is not subject to the active income limitation. A contractor experiencing a loss year (common during project ramp-up or after a major equipment purchase) may prefer bonus depreciation because it can create or increase a net operating loss (NOL), which can then be carried forward to offset future income under IRC Section 172. The NOL deduction is limited to 80% of taxable income in the carryforward year.
When construction equipment is sold or traded, the tax treatment depends on the depreciation method used. Equipment that was depreciated under MACRS or expensed under Section 179 is subject to ordinary income recapture under IRC Section 1245 to the extent of depreciation previously claimed. If a contractor expensed a $120,000 excavator under Section 179 in 2024 and sells it in 2027 for $70,000, the entire $70,000 is ordinary income (not capital gain) because the Section 179 deduction exceeded the sale price. Only the amount exceeding the original cost basis would qualify for Section 1231 capital gain treatment.
Like-kind exchanges under IRC Section 1031 are not available for equipment or personal property — the TCJA limited Section 1031 to real property only. Contractors who previously relied on equipment trade-ins to defer gain must now recognize gain on the sale and capitalize the new equipment separately. This change increased the importance of Section 179 and bonus depreciation timing for equipment replacement cycles.
Heavy construction equipment may be fully expensed under Section 179 or bonus depreciation, with ordinary income recapture upon disposition and no like-kind exchange deferral available for personal property. (IRC Section 179 (expensing), IRC Section 168(k) (bonus depreciation), IRC Section 1245 (recapture), IRC Section 1031 (limited to real property post-TCJA), IRC Section 172 (NOL))
Deductions
| Category | Examples | Schedule C line |
|---|---|---|
| Vehicle expenses | Pickup trucks, work vans, fuel, insurance, maintenance, mileage (72.5 cents/mile for 2026), parking, tolls, trailer towing costs | Line 9 (car and truck expenses) |
| Subcontractor payments | Payments to all 1099-NEC subcontractors: electricians, plumbers, HVAC, drywall, painters, roofers, concrete, excavation | Line 11 (contract labor) |
| Materials and supplies | Lumber, concrete, drywall, fasteners, adhesives, caulk, paint, gravel, rebar, PVC, conduit, roofing materials consumed in projects | Line 22 (supplies) or cost of goods sold (Part III) |
| Equipment depreciation / Section 179 | Excavators, skid steers, dump trucks, concrete mixers, generators, compactors, scaffolding systems, aerial lifts, laser levels | Line 13 (depreciation and Section 179) |
| Insurance premiums | General liability, commercial auto, workers' compensation, builder's risk, professional liability (E&O), umbrella/excess, surety bond premiums | Line 15 (insurance) |
| Licensing and permits | General contractor license renewal, building permits (if not billed to client), continuing education, OSHA training certifications | Line 27a (other expenses) / Line 23 (taxes and licenses) |
| Home office / job trailer | Dedicated estimating/project management space (simplified: $5/sq ft up to $1,500); job trailer depreciation and setup costs for long-duration sites | Line 30 (business use of home) / Line 13 (job trailer depreciation) |
| Employee wages and payroll taxes | W-2 wages to employees, employer FICA (7.65%), FUTA, state unemployment taxes, prevailing wage fringe benefits | Line 26 (wages) / Line 23 (employer payroll taxes) |
| Equipment rental | Crane rental, aerial lift rental, concrete pump rental, dumpster/roll-off container rental, temporary fencing | Line 20b (machinery and equipment rental) |
| Professional services | Accountant/CPA fees, attorney fees for contract review, architect/engineer consulting, plan review services | Line 17 (legal and professional services) |
Vehicle treatment
General contractors typically operate multiple vehicles — a personal truck for site visits and supervision (15,000–25,000 business miles/year) and dedicated work trucks/trailers for material hauling. At 72.5 cents per mile (2026), the supervisory truck alone produces a deduction of $10,875 to $18,125 under the standard mileage method. Work trucks with GVWR over 6,000 lbs (Ford F-250/F-350, Ram 2500/3500, Chevy 2500HD/3500HD) qualify for Section 179 full expensing without Section 280F luxury auto caps. Trailers used exclusively for business (equipment trailers, dump trailers, enclosed tool trailers) are depreciable property — typically 5-year MACRS or Section 179 eligible. For contractors who use the standard mileage rate on their supervisory vehicle, all tolls and parking remain separately deductible in addition to the per-mile rate. Mileage logs must be contemporaneous and should distinguish between different vehicles when multiple vehicles are used for business.
Depreciation examples
A general contractor who purchases a $140,000 Caterpillar mini-excavator, a $68,000 Ford F-350 dump truck (GVWR 11,500 lbs), and a $22,000 equipment trailer in 2026 may elect Section 179 on all three. The excavator at 100% business use: $140,000 deduction. The dump truck at 95% business use: $64,600 deduction. The trailer at 100%: $22,000 deduction. Total first-year equipment deduction: $226,600 — but Section 179 cannot exceed the contractor's active business income. If net profit before the Section 179 election is $145,000, only $145,000 of Section 179 is usable; the remaining $81,600 carries forward. The contractor could instead split: take $145,000 in Section 179 (covering the excavator and part of the truck) and apply bonus depreciation under Section 168(k) to the remainder, since bonus depreciation is not limited by business income and can create or increase a net operating loss.
State variance
Colorado
Colorado imposes a flat income tax of 4.4% (reduced from 4.55% in prior years). The state requires general contractor licensing only at the municipal level — there is no statewide GC license, though many cities (Denver, Colorado Springs, Aurora) require their own registrations. Colorado's prevailing wage law (SB 22-161, effective 2023) requires prevailing wages on state-funded projects exceeding $500,000. The altitude and climate conditions in Colorado create unique construction challenges (foundation requirements, snow load engineering) that do not directly affect tax treatment but influence project cost structures.
California
California imposes the strictest contractor licensing through the Contractors State License Board (CSLB), requiring a B-General Building Contractor license for work over $500. State income tax reaches 13.3% (14.4% above $1M). Workers' compensation insurance is mandatory for all construction employers — California has some of the highest workers' comp rates in the nation for construction classifications. The California Prevailing Wage Law applies to all public works projects over $1,000 (lower threshold than federal Davis-Bacon). AB 5 (ABC test) applies to worker classification, making it exceptionally difficult to classify construction helpers as independent contractors.
New York
New York State income tax reaches 10.9%, with NYC adding up to 3.876% plus the 4% Unincorporated Business Tax on net income above $100,000 for sole proprietors. New York's Scaffold Law (Labor Law 240) imposes absolute liability on contractors and property owners for gravity-related injuries — this is a strict liability statute with no comparative negligence defense, making New York construction insurance premiums among the highest in the nation. New York requires prevailing wages on all public construction contracts regardless of dollar amount. The combined tax and insurance burden makes New York the most expensive state for construction contractors.
Texas
Texas has no state income tax and does not require a statewide general contractor license (licensing is municipal). Texas is one of the few states where workers' compensation insurance is optional — contractors who opt out ('non-subscribers') lose the exclusive remedy defense but avoid premium costs of 8–15% of payroll for construction classifications. Texas imposes sales tax (6.25% + up to 2% local) on tangible personal property, but labor on new construction and real property improvements is generally exempt. The combination of no income tax, optional workers' comp, and no state GC license makes Texas the lowest-regulation state for construction contractors.
Common audit triggers
- Worker misclassification (employee vs. subcontractor): The single most common audit issue in construction. The IRS, DOL, and state agencies actively pursue construction businesses that classify regular crew members as 1099 subcontractors. Key red flags include workers who use the contractor's tools, work exclusively for one GC, are paid hourly, and follow the GC's schedule.
- Long-term contract accounting method errors: Contractors who use the completed-contract method on projects that require percentage-of-completion under IRC Section 460 — or who compute PCM incorrectly — face income restatements plus interest. The IRS examines this carefully on contractors with multi-year projects.
- Materials vs. labor split for sales tax purposes: Many states exempt labor on real property improvements from sales tax while taxing materials. Contractors who lump-sum invoice without breaking out materials and labor create sales tax audit exposure. The IRS may also question the split if it appears to minimize taxable supply purchases.
- Retainage timing on accrual basis: Accrual-basis contractors who defer retainage income beyond the point where the right to payment is established (substantial completion) risk IRS adjustment to accelerate income recognition.
- Excessive equipment depreciation without business-use substantiation: Claiming Section 179 or bonus depreciation on equipment that may have personal or rental use without adequate records of business-use percentage. The IRS presumes mixed use unless records prove otherwise.
- Cash economy and unreported income: Residential construction, particularly small renovation and handyman work, involves significant cash transactions. The IRS uses bank deposit analysis and subcontractor 1099 cross-matching to identify income gaps.
Frequently asked questions
What happens if I miss the April 15 tax deadline?+
Do I need a CPA or can I file my own taxes?+
How do quarterly estimated tax payments work?+
When does a construction contract require the percentage-of-completion method?+
How should a general contractor handle the tax treatment of change orders?+
Can a general contractor deduct the cost of a surety bond premium?+
What are the tax consequences of receiving retainage from a project that spans two tax years?+
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