Retainage and Custom Equipment Contracts: When Is Income Taxed?

Is a custom equipment order a long-term contract?

A custom equipment order is a long-term contract when it isn't finished in the tax year you sign it and the equipment is either unique to the customer or normally takes more than 12 calendar months to build (26 U.S.C. 460(f); Reg. 1.460-2). Other orders are reported on your normal method; deposits on them belong to the customer prepayments guide.

• Not finished in the contracting year is judged by what happens by year-end, not by when you expect to finish (Reg. 1.460-1(c)(1)).
• Unique means designed for one customer's needs, judged on the first unit. An item is not unique if it normally takes 90 days or less to build, if customizing costs are 10% or less of its costs, or if you normally stock similar items in finished goods.
• More than 12 calendar months means normal build time, not backlog. The clock starts once at least 5% of the item's costs are incurred and stops when it is ready. A catalog transformer with an 18-month queue and 8 weeks of build time fails the test.
• The label doesn't matter. A "sale of goods" is still a contract to manufacture if the item isn't built when you sign (Reg. 1.460-1(b)(2)).

Classification runs contract by contract, and one unique item pulls the whole contract under section 460, catalog units included (Reg. 1.460-1(f)(1)). A contract on the percentage of completion method can't later be split without IRS consent, and separate pricing alone doesn't make work a separate contract: the severing and aggregating rules decide, and the IRS can apply them too (Reg. 1.460-1(e)). To apply the test, gather each signed contract and change order, the year-end estimate of total costs, and costs, billings and retainage to date by job.

Is installing it at the data center a construction contract?

Installing it can be. A construction contract includes installing an "integral component" to real property: property built off-site but meant to stay permanently affixed, such as central heating and cooling systems (Reg. 1.460-3(a)). Building the equipment in your plant is manufacturing. Construction work is a long-term contract whenever it isn't finished in the tax year you sign it: the unique and 12-month tests apply only to manufacturing (26 U.S.C. 460(f)).

• Build and install (a hybrid contract) is generally two contracts. You may elect to treat it all as construction only if at least 95% of estimated costs are construction, or all as manufacturing. Each election is made contract by contract, by using that method on the original return for the year (Reg. 1.460-1(f)(2)).
• Installation by others. If the general contractor's electricians set your switchgear, your duty to supervise or start it up goes on your normal method, outside the long-term contract.
• Warranty and maintenance are never part of the long-term contract (Reg. 1.460-1(d)(2)).
• Modular data halls become real property or not depending on how they are affixed and how long they are meant to stay (Reg. 1.263A-8(c)(3)).

How does the percentage of completion method work for tax?

Income for the year equals cumulative costs divided by estimated total costs, times the total contract price, minus income already reported (Reg. 1.460-4(b)). This cost-to-cost method is what section 460 requires.

• Total contract price is what you reasonably expect to receive, including retainage and approved change orders. Bonuses and disputed amounts count once reasonably predictable, and no later than when your financial statements book them.
• Costs count when incurred. Materials count when dedicated to the contract by purchase order, books or shipping instructions (Reg. 1.460-5(b)(2)), and paying a supplier counts even before delivery (Reg. 1.461-4(d)(2)(ii)). Buying transformers or chillers early raises this year's income.
• 10-percent method: an election to report nothing on a contract until 10% of estimated costs are incurred, made by using it on the original return for the year. It covers every long-term contract entered into from that year on (Reg. 1.460-4(b)(6)).
• Simplified cost-to-cost: an election to measure completion with only direct materials, direct labor and depreciation (Reg. 1.460-5(c)).
• Bonus depreciation on equipment with a recovery period of 7 years or less doesn't inflate the completion percentage, now permanently (Public Law 119-21, section 70301).

Is retainage taxable before the customer releases it?

Yes, under the percentage of completion method. Retainage (retention, or holdback) is part of the total contract price, so it is taxed as you incur costs, even while the customer holds it until acceptance (Reg. 1.460-4(b)(4)(i)).

The last row follows Rev. Rul. 69-314 (Rev. Proc. 2025-23, section 16.06). It covers exempt construction contracts kept on overall accrual and work that isn't a long-term contract, and retainage you withhold from subcontractors is treated the same way. Moving to it is an automatic change on Form 3115, with a section 481(a) catch-up adjustment, except for exempt construction contracts, which change for new contracts only.

A trap: a business with audited or other applicable financial statements on plain accrual may have to report retainage when the statements book it, to the extent it could collect if the customer ended the contract that day (Reg. 1.451-3(b)(2)). That rule doesn't reach section 460 methods.

Are deposits, progress billings and billings in excess of costs taxed when received?

Not on a long-term contract under the percentage of completion method: cash doesn't drive income. A deposit or front-loaded billings above the cost-based amount (billings in excess of costs) aren't income yet, while work done but not yet billed (underbillings) is. Deposits on catalog equipment are covered in the customer prepayments guide.

Can we use the completed contract method instead?

Only for an exempt construction contract; manufacturing contracts have no exception, whatever your size (26 U.S.C. 460(e); Reg. 1.460-3(b)). A construction contract is exempt when:

1. When you sign, you estimate it will be finished within 2 years of the commencement date: the day you or a related party first incur contract costs, design and engineering included, but not bidding or negotiating costs (Reg. 1.460-1(b)(7)).
2. Average annual gross receipts for the 3 prior tax years don't exceed $32,000,000 for contracts entered into in tax years beginning in 2026 (Rev. Proc. 2025-32, section 4.30). Businesses under common control are combined (26 U.S.C. 448(c)(2)); neither section 448 nor Rev. Proc. 2025-32 settles whether a foreign parent and its other foreign subsidiaries count, so a US subsidiary has that question to resolve first.
3. The business isn't a tax shelter barred from the cash method. That includes a partnership, LLC or S corporation that allocates more than 35% of a year's losses to owners not active in the business (26 U.S.C. 448(a)(3); 26 U.S.C. 1256(e)(3); Reg. 1.460-3(b)(1)(ii)).

Exempt contracts may use the completed contract method or another permitted method. Public Law 119-21 also exempts residential construction contracts entered into in tax years beginning after July 4, 2025; data center work isn't residential. For individual partners' alternative minimum tax, exempt nonresidential contracts still use percentage of completion, and look-back applies to that alternative minimum tax income (Form 6251 instructions, line 2p).

When is a long-term contract complete for tax purposes?

A long-term contract is complete at the earlier of (Reg. 1.460-1(c)(3)):

• the customer using the equipment for its intended purpose, other than testing, once you have incurred at least 95% of total costs; or
• final completion and acceptance.

A dispute or a performance bonus doesn't delay completion, and you can't delay it to defer tax. Contract income not yet reported is taken in the year after completion (Reg. 1.460-4(b)(3)).

What is look-back interest, and when is Form 8697 filed?

Look-back interest corrects for estimates. In the completion year you recompute each earlier year with the actual price and costs, then pay or receive interest on the tax under- or overpaid, at the IRS overpayment rate compounded daily (26 U.S.C. 460(b)).

• Filing. Attach Form 8697 to the return when you owe interest; file it separately, by the return's due date including extensions, when interest is due to you. File again in later years if the price or costs change.
• Tax treatment. C corporations deduct look-back interest paid; S corporations, individuals and other taxpayers can't. Interest received is taxable.
• Exceptions. Contracts priced at no more than the lesser of $1,000,000 or 1% of average gross receipts and finished within 2 years. Exempt construction contracts, for regular tax. And, by an election statement headed "NOTIFICATION OF ELECTION UNDER SECTION 460(b)(6)" attached to the timely filed return (extensions included) for its first year, contracts where, for each earlier year, cumulative reported income was within 10% of cumulative look-back income. Once made, that election covers every contract completed that year and later, and can't be revoked without IRS consent. Notes in the current Form 8697 instructions on contracts entered into after July 4, 2025 go beyond the statute; Public Law 119-21 limits its 3-year rule to certain residential contracts.

Does starting or fixing the method need IRS permission?

Starting doesn't: a business whose first long-term contract arrives this year adopts the percentage of completion method on that year's return (Reg. 1.460-1(f)(3)). Fixing does.

• Reporting custom contracts on delivery is an impermissible method. Changing needs IRS consent on Form 3115. A change you request applies to contracts entered into from the year of change, with no section 481(a) adjustment (Reg. 1.460-4(g)); that rule doesn't settle open years the IRS examines. Rev. Proc. 2025-23 lists no automatic change for it.
• Small contractors moving exempt contracts off percentage of completion use the automatic change in section 19.01 of Rev. Proc. 2025-23, as modified by Rev. Proc. 2026-32, on a cut-off basis (new contracts only, no catch-up adjustment).
• Cash to accrual overall is a separate change: see switching from cash to accrual.

What changes for a partnership, S corporation or US subsidiary of a foreign maker?

A partnership or S corporation changes who runs look-back; a US subsidiary may find its parent's work counts.

• Widely held partnership or S corporation: look-back runs at the entity level at the highest tax rate, for contracts with substantially all income from US sources.
• Closely held partnership or S corporation (50% or more held by 5 or fewer persons at any time): details pass on Schedule K-1 and each owner files Form 8697 (26 U.S.C. 460(b)(4)).
• US subsidiary: the parent's build time on components counts toward the 12-month test (Reg. 1.460-2(c)(2)), unless more than 50% of the parent's receipts from that component come from unrelated buyers. A related US company that engineers or builds subassemblies for the subsidiary's contract must also use percentage of completion (Reg. 1.460-1(g)).

Why doesn't taxable income match revenue in the financial statements?

Revenue in your financial statements is a book measure; the return follows section 460, with its own cost pools, contingent-amount rules and 10-percent option. The financial statement income rule doesn't reach section 460 methods (Reg. 1.451-3(a)(13)). The gap is reconciled on Schedule M-1 or M-3. Most state returns start from federal taxable income, so the timing carries through.

How does Canada treat the same contract?

Canada has no statutory long-term contract rule. A Canadian maker's own Canadian contracts follow general income rules; a US subsidiary follows the US column.

Example

Illustrative figures in US dollars.

A $10,000,000 switchgear lineup with 10% retainage

A Texas C corporation with $60,000,000 of average gross receipts signs in March 2026 for a custom lineup for a data center campus near Dallas, accepted in 2027. Estimated costs: $8,000,000. Its size doesn't matter: manufacturing contracts have no small-business exception.

• Cash in 2026: a $2,000,000 deposit plus $4,000,000 of progress billings, less $400,000 retainage withheld: $5,600,000 collected.
• Income: $5,000,000 of costs by December 31 is 62.5% complete, so 2026 gross receipts are $6,250,000 and profit $1,250,000, not the $6,000,000 billed or $5,600,000 collected. The $400,000 retainage is taxed in 2026.
• Look-back: final costs reach $8,500,000. 2026 should have shown 58.8% and about $882,000 of profit, so $367,647 was overreported: about $77,200 of tax at 21%. For 2027, the completion year, the company files Form 8697 separately to claim interest, which is taxable.

$4,500,000 of cooling skids installed on site

An Ohio LLC taxed as a partnership, with $20,000,000 of average gross receipts, signs in September 2026 for six custom CDU and chiller skids at $3,750,000 (cost $3,000,000) plus installation in 2027 at $750,000 (cost $600,000).

• Two contracts: installation is 16.7% of costs, short of the 95% needed to elect construction treatment.
• Skids: $1,800,000 of 2026 costs is 60%, giving $2,250,000 of receipts and $450,000 of profit in 2026.
• Installation: exempt (receipts under the limit, finish expected within 2 years, and the LLC isn't a tax shelter). Under the completed contract method, its $150,000 profit falls in 2027. For the partners' alternative minimum tax, it still runs on percentage of completion, with look-back.
• Owners: the LLC is closely held, so each partner files Form 8697 from K-1 details when the skid contract closes.

A $6,000,000 order of catalog UPS modules

The US subsidiary of an Ontario maker signs in June 2026 for 40 catalog UPS modules, delivered in 2027 after an 18-month backlog. Each takes about 8 weeks to build, counting the parent's work. Not unique and under 12 months, so it isn't a long-term contract: income follows the company's normal method, typically when the modules ship or are delivered, and the $1,800,000 deposit follows the customer prepayments rules. One custom-engineered switchgear lineup in the same order would put all $6,000,000 under percentage of completion.

Different for you?

• Custom contracts reported on delivery or when paid until now: the fix needs IRS consent and look-back may apply. See data center services.
• Deposits on catalog equipment or prepaid capacity: customer prepayments and deposits.
• Past the small business limit, or leaving the cash method: switching from cash to accrual.
• Installers buying materials: sales tax on installed cooling and power equipment.
• State taxes: Texas franchise tax deductions, gross receipts taxes in other states, business income tax in other states, and Ohio city income tax for crews.
• Research or prototypes outside a customer contract: deducting hardware research and prototypes. Imported components: tariffs and duties.
• Foreign maker signing or installing in the US without a US company: does a Canadian corporation file a US return?
• US subsidiary of a foreign maker: Form 5472 and intercompany pricing.
• Corporate rate, losses and estimated tax: how C corporations are taxed.