7.3 Taxes & Payroll

Arizona Transaction Privilege Tax (TPT)

The Arizona Transaction Privilege Tax (TPT) is a tax on the contractor (the seller) for the privilege of doing business in Arizona. It is not a sales tax passed through to the customer, even though many contractors display it as a line item on invoices for transparency. The legal liability sits with the business performing the contracting activity, not the property owner.

Quick Answer: TPT is paid by the contractor (the seller), not the customer — it is a privilege tax on doing business in Arizona, separate from sales tax.

Contracting Activity Classification

Under the Arizona Model City Tax Code and the Arizona Revised Statutes (A.R.S.) Title 42, contracting activity is a specific TPT business classification. The tax base is generally the gross proceeds of sales or gross income from the contracting activity, though certain exemptions and deductions may apply depending on the type of work and jurisdiction. The rate varies by city and county because TPT combines state, county, and municipal portions — contractors file with the Arizona Department of Revenue (ADOR) through the AZTaxes.gov portal and must know the rate for every jurisdiction where they perform work. Because rates are not published in a single statewide figure, confirm the current rate for each jurisdiction with ADOR rather than relying on a blanket percentage.

TPT vs. Sales Tax — Why the Distinction Matters

A practical consequence: if a contractor itemizes TPT on an invoice and the customer refuses to pay that line, the contractor still owes the tax to ADOR. Treat TPT as a cost of doing business, not a receivable you can walk away from.

Federal Income Tax

Contractors pay federal income tax on net business income. Sole proprietors report on Schedule C attached to their personal return; LLCs and S corporations pass income through to owners' personal returns; C corporations pay entity-level tax. Estimated quarterly payments are required when expected tax liability exceeds $1,000 for the year, because no employer is withholding on the business's behalf.

Self-Employment Tax

Self-employment tax covers the Social Security and Medicare contributions that an employer and employee would each pay in a W-2 relationship. For 2026 the rate is 15.3% on net self-employment earnings up to the Social Security wage base (the wage base is adjusted annually), plus 2.9% on earnings above that base (the Medicare portion, unlimited). Sole proprietors and partners pay this on their share of business net income; an S corporation owner pays it only on the reasonable salary drawn, not on distributions.

Payroll Withholding

Contractors with employees must:

1. Withhold federal income tax, the employee's share of Social Security (6.2%) and Medicare (1.45%), and Arizona state income tax from each paycheck.
2. Deposit those withholdings on the IRS deposit schedule (semi-weekly for most employers with larger payrolls).
3. File Forms 941 quarterly and Form 940 annually for federal unemployment tax (FUTA).
4. Report new hires to the Arizona New Hire Reporting Center.

Workers' Compensation

Arizona requires employers with one or more employees to carry workers' compensation coverage, with narrow exceptions (sole owners, partners, and certain corporate officers may elect to be excluded). The workers' comp premium is based on payroll multiplied by a classification rate tied to the work's hazard — roofing carries a far higher rate than finish carpentry. AZ ROC requires proof of workers' comp coverage (or a filed waiver stating no employees) as a condition of licensure. Premiums are audited annually; understating payroll at policy inception produces a large true-up bill later.

Employee vs. Independent Contractor

Misclassifying an employee as an independent contractor shifts payroll tax, workers' comp, and benefit obligations onto the worker — and exposes the contractor to back taxes, penalties, and ROC discipline. The IRS applies three factors:

1. Behavioral control — does the contractor control how the work is done (instructions, training, schedule)? If yes, the worker looks like an employee.
2. Financial control — does the worker have a significant investment, unreimbursed expenses, and the ability to realize a profit or loss? Independent contractors bear their own costs; employees do not.
3. Relationship — is the work ongoing, are benefits provided, is there a written contract? Permanence and benefits point toward employee status.

A licensed subcontractor with their own business, insurance, and multiple customers is a classic independent contractor. A roofer who shows up every day, uses your truck and tools, and takes direction from your superintendent is an employee in substance, regardless of what the paperwork says.

Summary of Contractor Tax Obligations

Quick Answer: A contractor pays TPT on gross contracting income, federal income and self-employment tax on net income, remits payroll withholding for employees, and carries workers' comp for anyone who is an employee rather than an independent contractor.