The IRS does not walk into a contractor's audit blind. It walks in with a book. Publication 5522, the Construction Industry Audit Technique Guide, revision date April 19, 2021, is the IRS's training manual for examining contractors. It is public. Most contractors have never read it.
They should. The guide says out loud what examiners are told to look for. Here is what is in it, and what it means for your next audit.
A word about what the guide is
The guide itself says it is not an official pronouncement of the law or the position of the IRS and cannot be cited as authority. It is also current only through its revision date, and Congress has changed construction accounting rules since 2021. But as a window into how examiners think, it is the best document you will find.
Unreported income is issue number one
The guide's discussion of income issues is blunt. It says smaller contractors not faced with bonding or similar financial statement requirements might report income for only a portion of their work, for example reporting only the income reflected on Forms 1099. It says some contractors may be willing to work for 20 to 25 percent less if the customer does not issue a Form 1099 or pays in cash.
The guide also warns examiners that, because of check-cashing schemes, a payment by check is not enough of a control to validate income using bank deposit records. Examiners are told to compare a central element of the specialty contractor's business to another source, such as an indirect method, and, for smaller contractors, to look at the owner's return, lifestyle, assets and county records.
Translation: the examiner will not take your bank statements at face value. If you cash customer checks instead of depositing them, the examiner has been told to look for exactly that.
The minimum income probes
Chapter IX of the guide applies the Internal Revenue Manual's minimum income probes to contractors. For individual business returns, it lists a financial status analysis, an interview about financial history and cash on hand, a tour of the business and job sites, an evaluation of internal controls, and a reconciliation of the return to the books and to information returns the IRS has on file.
The guide tells examiners to always pay special attention to the possibility of unreported income, interview the taxpayer about how the business operates, review internal controls and review construction contracts to see how customers pay. The contract is called an invaluable source for income, materials, completion dates, job costs, gross profit and change orders that could produce additional income.
Indirect methods
If the books do not hold up, the guide points examiners to the formal indirect methods in the IRM: bank deposits and cash expenditures, source and application of funds, net worth, markup, and unit and volume. It lists the potential defenses as showing the computation is flawed, showing the difference came from a nontaxable source, or showing it came from cash accumulated in earlier years. We cover the bank deposits method in our guide to bank deposit audits.
Income that is easy to miss
The guide lists income sources examiners should probe beyond contract revenue:
- Sales of construction equipment.
- Consulting fees.
- Forgiveness of debt income.
- Constructive dividends.
- Scrap sales.
- Interest earned on retainages or deposits.
- Income from court settlements and arbitration of contract claims.
- Income from remote construction projects, where expenses get recorded but income does not.
It also flags delayed billings. Depending on the accounting method, a contractor may delay billings or recording receivables to push income into a later year. Examiners are told to sample job folders and compare billing terms, progress billing applications and owner payment records.
Retainage timing
Retainage is the amount a customer holds back from progress billings until the job is accepted. The guide explains that when retainage receivable hits income depends on the method of accounting:
| Method | Retainage receivable is income |
|---|---|
| Cash | When received or constructively received |
| Accrual | When received, due or earned, whichever is first; an election under Revenue Ruling 69-314 can defer it until billable |
| Completed contract | When the contract is completed |
| Percentage of completion | Included in the total contract price as the job progresses |
The guide adds a symmetry rule. If an accrual-method contractor defers retainage receivable under Revenue Ruling 69-314, it must also defer retainage payable to its subcontractors until paid. Starting that deferral is a change in accounting method. Retainage also matters in collection, because receivables can be levied; see our guide to IRS levies on receivables and retainage.
Long-term contracts and the small contractor exception
IRC 460 generally requires the percentage of completion method for long-term contracts, with look-back interest. Section 460(e) carves out exceptions. Under section 460(e)(1)(B), a construction contract is exempt if, when it is entered into, the contractor estimates it will be completed within 2 years and the contractor meets the gross receipts test of IRC 448(c) for the year the contract is entered into.
The guide uses the post-2017 base figure of $25 million. That number is indexed. Under Rev. Proc. 2025-32, for tax years beginning in 2026 the section 448(c) test is met if average annual gross receipts for the prior 3 taxable years do not exceed $32,000,000.
The rules changed again in 2025. Public Law 119-21 rewrote section 460(e)(1)(A) to exempt any "residential construction contract," not just a "home construction contract," for contracts entered into in tax years beginning after July 4, 2025. The 2021 guide predates that change. If your company builds residential projects, have your accounting method reviewed against the current statute, not the guide.
The guide's list of accounting method issues examiners pursue includes improper computation of average annual gross receipts, failing to aggregate gross receipts of related businesses, improper use of the completed contract method, deferring costs under percentage of completion and misallocating indirect costs.
Personal use and related parties
Examiners are told to sample invoices for deliveries to the contractor's own residence and look for excess building supplies charged to jobs. The guide says contractors may not deduct the cost of improving a personal residence or that of a friend or relative, and in a corporation these costs can become constructive dividends or distributions. It also notes that a discount on a home sold to an employee is not a qualified employee discount, because IRC 132(c)(4) excludes real property, so the discount is wages.
Vehicles and per diem
The guide notes that contractors commonly use SUVs and that IRC 179 limits the expensing of a sport utility vehicle. For tax years beginning in 2026, Rev. Proc. 2025-32 sets that limit at $32,000. On travel, the guide points to Revenue Procedure 2011-47 for per diem substantiation; per diem rules are now governed by Rev. Proc. 2019-48 and the annual IRS rate notice.
Employment tax
The guide's employment tax note is short and pointed: the use of subcontractors is common, many taxpayers treat employees as subcontractors to avoid employment taxes, examiners may bring in IRS employment tax help, and backup withholding can apply to subcontractors. Those issues are covered in our guide to subcontractor misclassification and our guide to 1099 and backup withholding penalties.
Getting ready
- Deposit every customer payment. Do not cash customer checks.
- Keep signed contracts, change orders and pay applications in each job file.
- Reconcile billings and receipts to the return before the examiner does.
- Document your gross receipts test, including related businesses.
- Keep job costs clean: nothing for your house goes on a customer's job.
If an examination has started, read how the firm approaches IRS audits before the first interview.
The IRS wrote down how it audits contractors. Read it before your examiner quotes it to you.