A contractor finishes a strong year. The income statement shows a healthy profit. The tax return agrees. Then the bill arrives and there is no money to pay it — because a meaningful share of that profit is sitting in someone else's bank account as retainage.
This is not an accounting error. It is how the rules work, and it catches contractors every year.
What retainage is
Retainage (or retention) is the portion of each progress payment the owner or general contractor withholds until the job is complete and accepted — commonly 5% or 10%. On a $2 million project at 10%, that is $200,000 you have earned, performed work for, and will not see until closeout, punch list completion, and sometimes final lien releases from every sub below you.
Across several large projects, a contractor can easily have several hundred thousand dollars of retainage receivable outstanding at year-end.
Why it becomes taxable before you collect it
Whether retainage is income this year depends on your method of accounting and, for long-term contracts, on which contract method applies.
Under the percentage-of-completion method, revenue is recognized as the job progresses, based on costs incurred relative to estimated total costs. The method does not ask whether you were paid. You performed 70% of the work, so you recognize 70% of the contract revenue — retainage included. The cash timing is irrelevant to the income calculation.
Accrual-method contractors on shorter jobs face a similar problem: income is generally recognized when the right to receive it is fixed and the amount is determinable, not when the check clears.
The result is predictable. You pay tax at ordinary rates on money you will not touch for six to eighteen months, and you fund that tax out of working capital you needed for mobilization on the next job.
The exceptions that may help
Section 460 generally requires percentage-of-completion for long-term contracts, but there are exceptions worth examining:
- The small contractor exception. Contractors under an average annual gross receipts threshold — a figure that is indexed and changes over time — may be able to use other methods for contracts expected to be completed within a two-year period. This is the most commonly available relief, and it is also the one contractors most often age out of without noticing.
- Home construction contracts. Contracts where a substantial portion of the work relates to dwelling units in buildings with four or fewer units get separate treatment, which can allow the completed contract method.
- Accrual excluding retainage. For contracts that are not long-term contracts, an accrual method that excludes retainage from income until the right to receive it is fixed may be available depending on the facts.
Which of these you qualify for is a facts question, and the answer changes as you grow. A contractor who crossed the gross receipts threshold two years ago and is still filing as though they did not has a method problem, and correcting it is a formal accounting method change rather than a quiet adjustment on the next return.
Planning that actually works
Since you usually cannot make the income disappear, the goal is to make the cash available when the tax is due.
Forecast the retainage balance in October, not March. Pull your WIP schedule, total the retainage receivable, and estimate what portion will be income this year and uncollected at year-end. That number is the size of the problem, and it is knowable months in advance.
Push closeout where you legitimately can. Punch lists, final documentation, and lien waivers often sit for weeks because nobody is chasing them. Collecting retainage on two jobs in December instead of February changes your cash position without changing a single accounting position.
Time equipment purchases against the spike. Section 179 and bonus depreciation on iron you were going to buy anyway can offset a year that is heavy on uncollected income. The key word is anyway — buying equipment to avoid tax is spending a dollar to save a fraction of one.
Use the estimated tax rules deliberately. Safe harbor provisions let you base payments on the prior year's tax in many cases, which smooths the cash requirement even in a year when income spikes.
Talk to your bank before you need to. A line of credit arranged in November on the strength of a clean WIP schedule and reviewed financials costs far less than one arranged in April under pressure.
The larger point
Contractors do not fail because of a bad quarter. They fail because a cash gap opens at a moment when nothing else is going wrong, and the timing of tax on retainage is one of the most reliable ways to open one. It is completely foreseeable — the numbers are all sitting on the WIP schedule — but only if someone looks before year-end closes.
We work with contractors on contract method selection, retainage planning, and reviewed financial statements for bonding. See how we work with construction companies.