Selling a Construction Company: Open Contracts, Look-Back Interest and the ESOP Option

Open contracts are the first tax question

A contractor with jobs that run past year end usually reports them under the percentage-of-completion method, recognizing revenue as costs are incurred (IRC 460(a) and (b)). That works until the company is sold mid-job. Under Treas. Reg. 1.460-4(k)(2), a taxable asset sale (including a deemed asset sale under Section 338) is a constructive completion transaction: the seller is treated as completing each open contract on the closing date. The seller's total contract price becomes what it has received or expects to receive under the contract plus the part of the purchase price allocated to that contract, using the residual method of IRC 1060.

That allocated amount is ordinary contract income, not capital gain. Every dollar of price the buyer assigns to backlog or work in process reduces the price left for goodwill. A stock sale without a Section 338 election is different: the company keeps reporting the contracts, so nothing is deemed completed and the seller's gain is all on the stock.

Look-back interest comes due at closing

Percentage of completion relies on cost estimates. When a contract finishes, IRC 460(b)(2) requires a look-back: the income for earlier years is recomputed with actual costs, and interest is paid to or by the IRS on the resulting underpayment or overpayment, at the adjusted overpayment rate, compounded daily, reported on Form 8697. In a constructive completion transaction the seller applies the look-back for all pre-sale years as of the closing date (Treas. Reg. 1.460-6(g)(2)). Jobs where you underestimated profit produce interest you owe; jobs that came in worse than estimated produce interest the IRS owes you. Run the look-back before you price the deal, because it is a cash item for the seller.

Who escapes the percentage-of-completion rules

• Small contractors: a contract you expect to finish within two years is exempt if the company passes the gross receipts test of IRC 448(c), average annual gross receipts of $32,000,000 or less for 2026 (IRC 460(e)(1)(B); Rev. Proc. 2025-32, section 4.30). Those contractors often use the completed-contract method or cash method, which leaves more untaxed income in the company at the sale.
• Residential builders: the current Code exempts any residential construction contract from the percentage-of-completion rules (IRC 460(e)(1)(A), amended by P.L. 119-21 section 70430 in 2025 to reach beyond 4-unit homes).

A completed-contract or cash-method seller in an asset sale still recognizes that untaxed income at closing, as ordinary income. Receivables, including retainage held back until the owner accepts the work, have a zero basis for a cash-method contractor, so whatever the buyer pays for them is ordinary. Underbillings (costs incurred ahead of billing) and overbillings (cash collected ahead of work) shift the price too; overbillings are a liability the buyer will want credited.

Heavy equipment, bonding and the owner

Excavators, loaders, cranes and trucks that were expensed are Section 1245 recapture at sale, taxed as ordinary income in the year of sale (IRC 1245, 453(i)); see depreciation recapture. A stock sale avoids recapture for the seller but the buyer inherits the low basis and will price that in.

Bonding capacity is often the owner's personal balance sheet: sureties typically require the owners to sign a general indemnity agreement. The buyer has to replace that support, and you want a release from the indemnity for jobs started after closing. Escrows or holdbacks for warranty and bonded-job claims are common. Holdbacks paid in a later year can be reported on the installment method (IRC 453); see earn-out for contingent payments.

Selling to an ESOP and deferring the gain under Section 1042

Construction companies with a deep management bench are frequent ESOP candidates. For a C corporation owner, IRC 1042 defers the long-term gain on stock sold to an employee stock ownership plan when:

• the company is a domestic C corporation with no publicly traded stock, and you held the shares at least 3 years (IRC 1042(b)(4), (c)(1));
• the ESOP owns at least 30% of the company immediately after the sale (IRC 1042(b)(2));
• you buy qualified replacement property (stocks or bonds of U.S. operating companies) from 3 months before to 12 months after the sale (IRC 1042(c)(3), (c)(4)); and
• you file the election and the company's consent statement (IRC 1042(a)(1), (b)(3)).

Gain is recognized only to the extent the sale price exceeds what you reinvest. In our example, reinvesting $5 million of an $8 million sale cuts the current tax from $2,601,097 to $1,041,847. The replacement property takes a carryover basis, so the gain is deferred until you sell it; replacement property still held at death generally gets a stepped-up basis (IRC 1014). For S corporations, a 2022 amendment (P.L. 117-328, section 114) allows 1042 deferral on up to 10% of the amount realized for sales after December 31, 2027. See ESOP and Section 1042.

Minnesota: the investment income surtax

Minnesota taxes capital gains as ordinary income, with a top rate of 9.85% in 2026, and adds a 1% tax on net investment income above $1,000,000 (Minn. Stat. 290.033, 2026). Because the surtax follows the federal net investment income definition, gain on C corporation stock is caught, while an active owner's gain from an S corporation asset sale generally is not. In our example the stock sale carries $285,000 of federal net investment income tax; the S corporation asset version carries only $19,000 of it but more ordinary income, for a total of $2,518,533. See our Minnesota page and net investment income tax on a sale.

Ways contractors keep more

• Prefer a stock sale where the buyer will accept it; it keeps contracts, recapture and look-back inside the company (compare Section 338(h)(10) if the buyer insists on asset treatment).
• Finish or bill out jobs before closing where practical, so less of the price is allocated to work in process.
• Consider an ESOP for a C corporation, alone or for a partial sale of at least 30%.
• Spread the price with an installment sale on the goodwill and stock portion.

To see stock, asset and ESOP paths priced for your company, get the Big Sale Tax Analysis.

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