Taxes and retainage in the US

Tax touches a contractor's finances at every level: federal and state income tax on profits, sales and use taxes on materials, payroll taxes held in trust for the government, and special rules for the retainage that owners withhold. Retainage itself is not a tax, but its timing can affect when income is taxable, and in some states money received on a project is held in trust for those who supplied labor and materials. This lesson explains how these rules interact for a general contractor. Tax law changes often and varies by state; contractors should work with an accountant who specializes in construction.

Income tax on long-term contracts

US federal income tax has its own rules for long-term contracts in Internal Revenue Code section 460. A contract for building, installation or construction that is not completed in the tax year it starts is a long-term contract, and the general rule is that its income must be reported on the percentage-of-completion method (PCM), using cost-to-cost progress. Under PCM, contractors must also calculate look-back interest when the contract is finished, paying or receiving interest on the tax that was under- or overpaid because earlier estimates of total cost were wrong.

Section 460 has important exceptions. Home construction contracts (dwellings in buildings of four units or fewer) are exempt. The One Big Beautiful Bill Act expanded this to residential construction contracts more generally, including larger multi-unit buildings, for contracts entered into in tax years beginning after 4 July 2025, and extended the small contractor completion period for residential contracts to three years. Small contractors are also exempt for contracts expected to be completed within two years if their average annual gross receipts for the previous three years do not exceed an inflation-adjusted threshold, reported as $31 million for 2025 and $32 million for 2026. Exempt contracts may be reported under other methods, such as the completed contract method (CCM), the exempt-contract percentage-of-completion method or an accrual method, which often defers taxable income.

# Timing of taxable income: PCM vs CCM for an exempt small-contractor job (illustrative)
price, cost = 4_800_000, 4_416_000
spend = {"Year 1": 2_650_000, "Year 2": 1_766_000}
cum = 0
for yr, c in spend.items():
    cum += c
    pcm = (price - cost) * c / cost
    ccm = (price - cost) if cum == cost else 0
    print(f"{yr}: PCM {pcm:>9,.0f}   CCM {ccm:>9,.0f}")
rate = 0.21   # federal corporate rate; state tax not included
print(f"Federal tax deferred in year 1 by CCM: {rate * (price - cost) * 2_650_000 / cost:,.0f}")

Year 1: PCM   230,435   CCM         0
Year 2: PCM   153,565   CCM   384,000
Federal tax deferred in year 1 by CCM: 48,391

The total taxable profit is the same; only the timing differs. Deferring tax is valuable because it keeps cash in the business, but the deferred tax still has to be paid, and the financial statements record a deferred tax liability for it. Sureties look at the financial statements, not the tax return, so a contractor's tax strategy does not change its bonding capacity directly; it changes its cash.

Corporate income tax rates and structure

US contractors operate as C corporations, S corporations, partnerships or limited liability companies. A C corporation pays federal tax at a flat 21 % plus state tax, and its owners pay tax again on dividends. S corporations, partnerships and most LLCs are pass-through entities: the business pays no federal income tax and its income is taxed on the owners' personal returns, often with the 20 % qualified business income deduction under section 199A, which the One Big Beautiful Bill Act made permanent. Pass-through owners usually take distributions to pay the tax on company income, which reduces the company's equity and working capital and must be planned with the surety and bank (Lesson 9).

Retainage: what it is and why it matters

Most construction contracts let the owner withhold retainage, typically 5 % to 10 % of each progress payment, until substantial or final completion, to secure performance and the correction of defects. Many states cap retainage on public and sometimes private work, often at 5 %, require release within a set time after completion, require interest on retained funds, or allow the contractor to substitute securities or a retainage bond. Federal contracts limit retainage to cases of unsatisfactory progress (CON-310 Lesson 11). For the contractor, retainage is a large and slow receivable, and often the largest single amount owed to it on a finished job.

# Cost of carrying retainage for Kestrel (illustrative)
retainage_receivable = 2_700_000
retainage_payable = 2_100_000
net_carried = retainage_receivable - retainage_payable
rate = 0.0625
print(f"Net retainage financed by Kestrel: {net_carried:,}")
print(f"Annual financing cost at {rate:.2%}: {net_carried * rate:,.0f}")
avg_months = 7      # average time from billing to release
print(f"Gross retainage billed per year at 10 %: {0.10 * 58_400_000:,.0f}; "
      f"average months outstanding {avg_months}")

Net retainage financed by Kestrel: 600,000
Annual financing cost at 6.25%: 37,500
Gross retainage billed per year at 10 %: 5,840,000; average months outstanding 7

Kestrel passes most of the retainage down to its subcontractors, so it carries only the difference, about $600,000, plus the retainage on its self-performed work and markup. A specialty contractor that self-performs most of its work carries much more of its retainage itself.

Income tax on retainage

Under PCM, retainage is part of the contract price and is included in income as the work progresses; there is no separate deferral. Contractors with exempt contracts that use certain accrual methods may be able to defer retainage receivable until it is due and collectible, and to deduct retainage payable to subcontractors when all events have occurred to fix the liability and economic performance has occurred. These rules are technical, and the right treatment depends on the method the contractor has adopted and its contract terms.

Sales and use taxes

There is no federal sales tax in the United States. Most states and many localities levy sales and use taxes, and how they apply to construction varies widely. In most states, a contractor who improves real property is treated as the consumer of the materials and pays sales tax when buying them (or use tax if the seller did not charge it); in others, the contractor is a retailer who collects tax from the owner on the materials or the whole contract price; a few states, such as Washington, Hawaii and New Mexico, tax the contract price or gross receipts. CON-300 Lesson 9 covered how these taxes are priced in a bid. For accounting, the contractor must track use tax owed on untaxed purchases and remit it, and exemptions for government or nonprofit owners must be documented.

Payroll remittances and trust funds

Employers withhold federal income tax and the employee's share of Social Security and Medicare from wages and hold them in trust for the government until deposited. If they are not paid over, the IRS can assess the trust fund recovery penalty under section 6672 against responsible persons, such as owners and officers who decide which bills to pay, personally. Many states have similar rules for state withholding and for sales tax collected. A struggling contractor that uses withheld payroll taxes to pay suppliers is borrowing from the government on its officers' personal credit, and sureties treat unpaid payroll taxes as a serious warning sign.

Construction trust funds

Some states impose a statutory trust on construction funds. Under New York's Lien Law Article 3-A, for example, money received by a contractor for a project is trust money for the subcontractors, suppliers and workers on that project, and diverting it to other uses can bring personal liability and even criminal charges. Other states have construction trust fund statutes of varying strength, and in some, unpaid subcontractors can pursue officers personally. Even where there is no trust statute, using one project's receipts to pay another's debts while subcontractors go unpaid invites lien and bond claims. Contractors should be able to trace receipts to the subcontractors and suppliers on each job. CON-220 discusses the legal details.

Managing retainage