How to Account for Retainage in Construction Projects
Retainage in construction refers to the practice of withholding a percentage of funds from each progress payment in a construction project, to be paid after the project is (substantially or fully) complete. This practice was created in the 1840s when railroads were being built around England—and many left incomplete—as a kind of security for the project owner.
Even now, retainage serves as a financial incentive for general contractors to finish each construction project on time and for subcontractors to do their best work. However, retainage has some downsides, too. It can negatively affect cash flow in the short term and be abused by the hiring parties.
If you are considering a construction contract that includes a retainage agreement, it's essential to understand how retainage works, how retainage affects accounting for construction, and key federal and state-based retainage laws.
How Retainage Works in a Construction Project
When a general contractor signs a construction contract, that contract will state the terms of payment, including the retainage percentage (if any) and when the retained funds will be paid. This percentage is deducted from each progress payment and may be held in an escrow account, especially for larger projects.
After project completion (or substantial completion, depending on the agreement), the contractor must be paid the retained funds within a certain timeframe. He or she will then pay out any subcontractors and suppliers from whom funds were retained. The exact timeframes for the release of retainage vary from state to state.
What Is the Typical Project Retainage Percentage?
In most cases, the retainage percentage is between 5 and 10 percent. The percentage can be fixed (staying the same throughout the course of the project), or variable (starting higher and reducing or even being eliminated once the project reaches a certain threshold—such as 50% complete).
According to a study from Clemson University, the average retainage percentage in the United States is 7.59% for private projects, 5.56% for state projects, and 3.26% for federal projects. It's important to note that some state laws don't allow retainage while others don't place a cap on retainage for private projects. However, as contractors are unlikely to accept construction contracts with unfavorable terms, retainage rates for private projects tend to sit around the industry average.
How Is Retainage Calculated?
For a fixed-rate agreement, the retainage percentage is applied to the entire contract price and divided by the number of progress payments. For example, if the complete project cost is $200,000 to be paid in five progress payments and the percentage to be retained is 5%, the calculation would be as follows:
200,000 x 0.05 = 10,000 total retainage amount
10,000 divided by 5 = 2,000 retainage withheld from each progress payment
On the invoice, the construction business will calculate the full progress payment amount and deduct the retainage amount on the next line:
|
Item |
Amount |
Less |
|
Foundation |
40,000 |
|
|
Retainage |
2,000 |
|
|
Total Due |
38,000 |
It’s then the hiring party’s responsibility to deduct the retainage percentage and hold it in a separate account. This may be an account held with the construction lender, an escrow account, or a trust fund.
The Impact of Retainage on Construction Accounting
Retainage has several implications for cash flow management and financial reporting, making it an important consideration in construction bookkeeping and accounting.
Negative Cash Flow
For starters, a contractor or subcontractor might buy all of the supplies up front and have a negative cash flow until the retainage withheld is paid out (often one month or more after project completion). This lag also means that there are no funds for investing in the next project as soon as the current project is complete.
Delayed Payment for Subcontractors and Suppliers
Retainage can also create a negative cash flow for subcontractors and suppliers, who might finish their role early in the construction process (and still have to pay their employees) but don't receive the money withheld until the entire project is complete.
Tax Calculations
Retainage can make it difficult to calculate your taxable income and self-employment taxes, especially since construction projects can run over multiple years and a retainage payment might be received in a different fiscal year than the final payment for the project itself. If you're not sure how retainage affects your taxable income, an experienced small business tax accountant can help you prepare an accurate return.
Abusive Practices
While retainage helps to prevent contractors and subcontractors from deserting a construction project before it's completed or from doing shoddy work, this practice can also be abused.
Owners can intentionally find fault with the construction or draw it out with multiple changes of mind to delay the release of the funds.
Contractors can withhold a higher retainage percentage from subcontractors and suppliers than the retainage percentage that was withheld from them.
Contractors can delay payment of retainage to subcontractors and suppliers after the funds are paid to them.
In cases where subcontractors aren't paid in full, they can file for a mechanic's lien to make sure they get paid. Banks take liens seriously, and the owner might have difficulties refinancing if they don't take steps to remove the lien.
The only issue with this provision is that the deadline for applying for a mechanic's lien (usually two months to one year after the work is done) is often long before the property owner is obliged to pay retainage. This can place subcontractors in a catch-22 situation.
If they decide to pursue this avenue, subcontractors should find out how long they have to file and then make sure to file for the lien before the deadline.
Federal and State Retainage Laws
The Federal Acquisition Regulation describes rules for federal construction contracts in the United States. According to the ACEC, federal laws put a limit of 10% on retainage and don't require the full 10% of the contract value to be withheld. Federal projects for the Department of Defense, General Services Administration, and Department of Transportation do not use retainage.
State laws govern public and municipal construction projects and may apply to private construction projects as well. These laws vary greatly from state to state. For example:
Florida - A public entity can withhold up to 5% of the payment as retainage when the value of the construction project is $200,000 or more. This percentage can be reduced as the project progresses, and the owner or lender can release all or a portion of the funds at any time. When retainage funds are released to the contractor, the contractor must release retainage funds to subcontractors and suppliers.
North Carolina - For public projects with a value of $100,000 or more, 5% of the payment may be withheld as retainage up to 50% completion, after which 5% retainage may only be withheld in the case of non-satisfactory progress. After the architect or engineer certifies that the construction project is complete or the owner occupies the improvement, the retainage must be released to the prime contractor within 45 days. The prime contractor then has to release retainage withheld from subcontractors within 7 days. From the date that the release of retainage is due (either to the prime contractor or subcontractors), interest starts to accrue on the retained funds at a rate of 1%.
Nevada - In private projects, 5% may be withheld as retainage and must be released within 30 days once the owner occupies the improvement. For public projects, 5% may be withheld as retainage, up to 50% completion. After that, the retainage percentage must be eliminated and the funds released or reduced to 2.5% if progress is not satisfactory. Once the funds are released to the prime contractor, the prime contractor has 10 days to pay retainage to subcontractors and suppliers.
Oregon - For private projects, a hiring party (owner, contractor, or subcontractor) may retain up to 5% of the payment as retainage. Retainage for construction projects with a cost higher than $500,000 must keep the funds in an interest-bearing escrow account. This requirement does not apply to retainage in construction jobs with a value of less than $500,000.
In some states, securities can be used instead of retainage.
In some states, retainage funds must be repaid with interest. Interest may:
Start to accrue from the date the retainage is due or at a specified time after the payment request is accepted
Be capped at a certain interest rate, often 1%
Apply only when the construction project cost is higher than a specified threshold
In some states, the deadline for paying retainage can be extended if there is a relevant "good faith dispute" between the parties that needs to be resolved.
Defining "Completion" and "Substantial Completion"
Definitions of "completion" and "substantial completion" differ by state, and it's essential to know what these terms refer to before signing a contract or demanding the release of retained funds.
While definitions vary, "completion" may occur when:
The engineer, architect, or designer certifies that the construction project is complete.
The owner occupies the improvement.
The improvement is made available for use.
Construction has ceased for 60 days.
Construction has ceased for 30 days (with an assurance of completion).
"Substantial completion" may occur when:
The owner occupies the improvement.
The improvement is available for use.
Some states, including California, provide different benchmarks, such as "95% complete." In this case, the percentage of completion is calculated based on the amount spent so far divided by the total construction cost and multiplied by 100.
Strategies for Minimizing the Impact of Retainage
While retainage can't always be avoided in the construction industry, it may be possible to minimize its impact. For example:
Construction companies with an excellent reputation may be able to negotiate an earlier release of retained funds (at substantial completion or when there is satisfactory progress), a lower percentage, or the elimination of retainage once the project is 50% complete.
The contracting parties may be able to agree on an alternative form of security, such as performance and payment bonds, certificates of deposit, an irrevocable letter of credit, securities, bonds, a trust fund, or an interest-bearing escrow account.
Construction companies may be able to receive the interest earned on the retainage withheld, which can make the arrangement more lucrative and help to offset any inconveniences caused.
Construction companies can work with a small business accountant to improve their cash flow so that retainage doesn't affect their ability to finance the next stage of construction.
Ideally, retainage funds should be your profit rather than regular business cash that's spent on supplies. However, as profit is often reinvested in future construction projects, it makes sense to get access to retainage earlier rather than later if you can.
Make Retainage Work for You
Whether or not you agree with retainage, construction businesses will usually need to deal with this practice at some point and it's best to be prepared. When all parties do their part, retainage money can motivate you to do your best work and turn into a kind of savings plan (with interest) to help you manage cash flow for future projects. On the flip side, failing to account for retention money in your cash flow projection can leave you high and dry.
As the practice of withholding retainage can be abused, it's important to read the fine print in construction contracts and only accept the projects that are clearly worded. "Substantially complete," "100% complete," and “95% complete” can leave room for interpretation and have a significant impact on when you're paid out. In general, working with an accountant who is experienced in construction accounting and the legal limitations set on retainage in your state can help you protect your bottom line.
