Construction Insurance and Bonding: Surety Bonds, Workers' Comp, and Tax Treatment of Premiums

A general contractor bidding on a $2 million public project needs a surety bond before the bid is even submitted. The surety underwrites the contractor the same way a lender underwrites a borrower: financial statements, bank references, work history, and bonding capacity. If the contractor’s books are not clean, the bond is declined and the bid does not happen. Insurance and bonding are the gate that separates contractors who do small residential jobs from contractors who compete for public, institutional, and large commercial work. The tax treatment of premiums, the accounting for surety indemnity agreements, and the workers’ compensation audit all have implications that flow directly into the tax return.

What insurance does a construction company need?

General liability (GL). Covers third-party bodily injury and property damage arising from the contractor’s operations or completed work. The “operations” coverage applies during construction (a passerby injured by falling debris). The “completed operations” coverage applies after the work is done (a building component fails and injures someone). GL premiums are based on revenue, payroll, or a combination, and vary dramatically by trade: roofers and demolition contractors pay multiples of what a painting contractor pays per dollar of revenue.

Workers’ compensation. Mandatory in nearly every state (Texas is the notable exception, where it is elective for private employers). Covers medical costs and lost wages for employees injured on the job. Premiums are calculated by multiplying the employer’s payroll in each classification code by the rate assigned to that code (expressed per $100 of payroll). Classification codes for construction are specific: code 5213 (concrete work) has a different rate than code 5403 (carpentry), and the rates vary by state. The employer’s experience modification rate (EMR or “mod”) adjusts the premium up or down based on the company’s claims history relative to its industry.

Builder’s risk. Covers damage to the structure under construction (fire, wind, vandalism, theft of materials). The policy covers the project from groundbreaking through completion and typically expires when the owner accepts the work. The cost is usually a percentage of the contract value. On some projects, the owner provides builder’s risk coverage; on others, the contractor must carry it.

Commercial auto. Covers the fleet of trucks, vans, and equipment trailers. Construction fleets take more abuse than typical commercial vehicles, and the claims frequency reflects it. Hired and non-owned auto coverage extends to vehicles the company rents or that employees use for company business.

Inland marine. Covers tools, equipment, and materials in transit or stored at job sites. The name is historical (it evolved from marine cargo insurance); the coverage is for movable property that the standard property policy does not cover because it is not at a fixed location.

Umbrella/excess liability. Sits above the GL, auto, and employer’s liability policies, providing additional limits (typically $1-5 million) that activate when the underlying policy limits are exhausted. Many general contractors and project owners require subcontractors to carry umbrella coverage.

How are insurance premiums deducted?

All business insurance premiums are deductible as ordinary and necessary expenses under IRC 162. The timing of the deduction depends on the accounting method:

Cash method: The premium is deductible when paid. If the contractor pays a 12-month GL premium on July 1, the full premium is deductible in the year paid, even though the coverage extends into the next year. However, if the premium covers a period extending more than 12 months beyond the date of payment, the portion allocable to future periods must be capitalized and deducted ratably (the “12-month rule” under Reg. 1.263(a)-4(f)).

Accrual method: The premium is deductible when all events have occurred that establish the liability (the policy is bound), the amount is determinable, and economic performance has occurred. For prepaid insurance, economic performance occurs as time passes (ratably over the policy period). However, the 12-month rule also provides a safe harbor for accrual-basis taxpayers: if the benefit period does not extend more than 12 months beyond the earlier of the date of payment or the date of the accrual, the full amount can be deducted currently.

Workers’ compensation audit adjustments: At the end of the policy year, the workers’ comp carrier audits the employer’s actual payroll and adjusts the premium. If actual payroll exceeded the estimate, the employer owes an additional premium (deductible when billed or accrued). If actual payroll was less, the employer receives a refund (which reduces the deduction). The audit adjustment is a separate deductible event in the year it is determined, not a retroactive adjustment to the prior year’s deduction.

Self-insured retention (SIR): Some larger contractors carry a self-insured retention (a deductible the contractor pays before insurance kicks in). The SIR payment is deductible when paid for a cash-basis taxpayer, or when the obligation is fixed and determinable for an accrual-basis taxpayer. If the SIR relates to a workers’ comp claim, it is deductible as a business expense; if it relates to a property claim, it may need to be analyzed under the casualty loss rules (though business casualty losses remain deductible after the Tax Cuts and Jobs Act eliminated personal casualty losses).

How does surety bonding work?

A surety bond is not insurance. Insurance transfers risk from the insured to the insurer. A surety bond is a three-party agreement: the surety (the bond company) guarantees to the obligee (typically the project owner) that the principal (the contractor) will perform the contract. If the contractor fails to perform, the surety steps in (by financing completion, hiring a replacement contractor, or paying the obligee directly). The surety then seeks reimbursement from the contractor under the indemnity agreement.

The three bond types in construction:

Bid bond. Guarantees that if the contractor is awarded the contract, the contractor will enter into the contract and provide the required performance and payment bonds. If the contractor fails to do so, the surety pays the obligee the difference between the contractor’s bid and the next-lowest bid (up to the bond amount, typically 5-10% of the bid). Bid bonds are usually issued at no additional cost to the contractor when the surety has already established a bonding relationship.

Performance bond. Guarantees that the contractor will complete the project according to the contract terms. If the contractor defaults, the surety has several options: finance the contractor to complete the work, hire a new contractor, or pay the obligee the cost to complete (up to the bond amount, typically 100% of the contract price). The Miller Act (40 USC 3131-3134) requires performance bonds on all federal construction contracts over $150,000. Most states have “Little Miller Acts” imposing similar requirements on state and local public projects.

Payment bond. Guarantees that the contractor will pay subcontractors, suppliers, and laborers. If the contractor fails to pay, the unpaid parties can make a claim against the payment bond. The Miller Act requires payment bonds on the same federal contracts that require performance bonds. Payment bonds protect subcontractors who cannot file mechanic’s liens against public property.

What determines bonding capacity?

The surety evaluates three factors (the “three C’s”):

Character. The contractor’s track record: years in business, project completion history, references, litigation history, and the personal credit of the owners. A contractor with a history of claims, contract disputes, or financial instability will not qualify.

Capacity. The contractor’s ability to perform the work: management depth, technical expertise, equipment, and workforce. A contractor that has only completed $500,000 projects is unlikely to receive a bond for a $5 million project.

Capital. The contractor’s financial strength, measured primarily by: working capital (current assets minus current liabilities), net worth, and the ratio of backlog (uncompleted work under contract) to working capital. The surety’s underwriting guidelines typically require:

• Working capital of at least 10-15% of the single-project bond amount
• A backlog-to-working-capital ratio of no more than 10:1 to 15:1
• Reviewed or audited financial statements (CPA-prepared, not compiled) for bond programs over approximately $500,000

The financial statement is the foundation. The surety reviews the balance sheet for: cash and liquid assets, accounts receivable aging (concentrated receivables are discounted), underbillings vs. overbillings on the WIP schedule (chronic underbillings may indicate the contractor is funding the owner’s project), equipment ownership vs. leases, and the contractor’s personal assets (which are pledged under the indemnity agreement).

The indemnity agreement. Every contractor (and usually their spouse) signs a general agreement of indemnity (GAI) that pledges personal assets as collateral for the surety’s exposure. The GAI creates a contingent personal liability that exists for the duration of every bonded project plus the statute of limitations for claims. This contingent liability does not appear on the balance sheet (it is disclosed in the notes under GAAP, if the contractor prepares GAAP statements), but the surety tracks it as part of the contractor’s overall exposure.

How are bond premiums deducted?

Surety bond premiums are deductible as ordinary and necessary business expenses under IRC 162. The premium is typically a percentage of the contract price (ranging from 1-3% for performance and payment bonds combined, depending on the contractor’s qualifications and the project type).

For cash-basis taxpayers, the premium is deductible when paid. For accrual-basis taxpayers, the premium is deductible when the bond is issued and the obligation to pay the premium is established.

If the contractor is on the percentage-of-completion method (PCM) for long-term contracts under IRC 460, bond premiums are an allocable contract cost. They are included in the cost-to-date for the cost-to-cost PCM calculation, which means the premium is effectively recognized as the contract progresses rather than all at once.

For contractors who capitalize costs under the simplified production method or the PCM, the bond premium is an indirect cost that must be allocated to contracts in progress under IRC 263A (the uniform capitalization rules). Small contractors exempt from 263A (gross receipts under $31 million for 2025) can deduct bond premiums as period costs.

What should I do next?

If you are considering surety bonding, start with the financial statements: a CPA-prepared review or audit is the price of entry for any meaningful bond program. If your books are on the cash method, you will likely need to convert to the accrual method (or at least prepare an accrual-basis balance sheet) for the surety’s analysis. If your workers’ compensation premiums have been volatile (large audit adjustments year to year), review the classification codes with your insurance broker, as misclassification can inflate premiums by thousands of dollars.

• Construction contractor tax deductions, WIP accounting, PCM, and the tax treatment of contract costs
• Construction job costing, the cost tracking system that feeds the WIP schedule the surety reviews
• Construction equipment depreciation, Section 179, bonus depreciation, and MACRS for the equipment on the balance sheet
• Construction worker classification, the 1099 vs. W-2 decision that determines whether workers’ comp covers the worker
• Construction change orders, how change orders affect the WIP schedule and the financial statements the surety reviews
• Trust fund recovery penalty, personal liability for unpaid employment taxes (a parallel personal exposure to the surety indemnity agreement)

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.