protectionOwners often require the general contractor to be bonded. In these cases, the general contractor is required to purchase a guarantee or surety bond. The purpose of the bond is to guarantee to the owner and lender that, should the general contractor fail to finish the project, the funds will be available to hire a replacement. A general contractor's bonding capacity is based upon their financial statements and past performance. A bond request will be denied if it exceeds the bonding capacity.

A contractor may leave what appears to be an unusually large amount of cash in the company for the purpose of increasing his or her bonding capacity. This should be considered when determining whether or not accumulated earnings tax is applicable. The following types of bonds are available:
  • Bid bonds provide for payment to the owner of the difference between the bid that is accepted and the next lowest bid if the general contractor with the accepted bid fails to enter into a contract.
  • Contract bonds indemnify the owner against the failure of a general contractor to comply with the requirements of a contract.
  • Performance or completion bonds guarantee completion of the project by the general contractor.
  • Labor and material payment bonds guarantee the owner that all costs of labor, material, and supplies incurred by the general contractor in connection with the project will be paid, thus voiding mechanics' liens.
  • Maintenance bonds guarantee the owner against defects in workmanship and are usually one year in duration.
  • Subcontracting bonds are performance and payment bonds issued by the subcontractor to the general contractor to guarantee the subcontractor's performance and payment of obligations required under the contract.
State and federal contracts usually require surety bonds. In other cases, collateral bonds in which the contractor pledges real or personal property as collateral with value equivalent to the contract price may be used.

When a performance bond is defaulted, it is not unusual for the insurer or bonding company to hire the defaulted contractor to complete the job, because they are familiar with the project. Most bond defaults result from financial difficulties with the project at hand, rather than from the lack of technical ability on the part of the contractor. Thus, the bonding company can act as another third-party control on the business and accounting practices of the contractor.

IRS Construction Industry Audit Technique Guide (ATG) - Chapter 1, Publication Date - May 2009
The information on this page is taken from the IRS Website and it claims that this is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. It is current through the publication date noted above. In general, it is a good reference guide through the subjects discussed.