Yes, government contractors pay taxes. The federal government’s immunity from state and local taxation does not pass through to the private companies and individuals who perform work under its contracts, so a contractor owes federal income tax, payroll or self-employment tax, state income tax in the places it works, and sales or use tax on the materials it buys. The Supreme Court settled the core question in 1941, holding that a contractor purchasing materials for a cost-plus federal project was fully subject to state sales tax even though the government would reimburse the cost.1GSA SmartPay. State Tax Legal History Working for the government makes you a taxpayer like any other business; the details depend on how you’re organized, where you work, and what kind of contract you signed.
Federal Income and Payroll Taxes
Every contracting business owes federal income tax on its net profit. Where that tax lands, and what payroll or self-employment tax rides on top of it, depends on the entity.
Sole Proprietors and Single-Member LLCs
If you work a contract as a sole proprietor or single-member LLC, business income and expenses go on Schedule C with your Form 1040, and the net profit is taxed at ordinary individual rates.2Internal Revenue Service. About Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship) You also owe self-employment tax at 15.3% because no employer is splitting the bill: 12.4% Social Security on net earnings up to the wage base, plus 2.9% Medicare on all net earnings with no cap.3Office of the Law Revision Counsel. 26 USC 1401 Rate of Tax For 2026, the Social Security portion applies to the first $184,500 of combined wages and self-employment income.4Social Security Administration. Contribution and Benefit Base Above that, the 2.9% Medicare tax still applies, and self-employment income over $200,000 (or $250,000 filing jointly) picks up an Additional Medicare Tax of 0.9%.5Internal Revenue Service. Questions and Answers for the Additional Medicare Tax
Partnerships, Multi-Member LLCs, and S-Corporations
These pass-through entities file informational returns but pay no federal income tax at the entity level. Profits flow to the owners’ personal returns and are taxed at individual rates.
S-corporations give contractor-owners a lever worth knowing. The owner takes a salary subject to FICA payroll taxes, and any remaining profit paid out as a shareholder distribution avoids FICA. The IRS requires the salary to be “reasonable compensation” for the work actually performed before distributions can be taken.6Internal Revenue Service. S Corporation Employees, Shareholders and Corporate Officers Courts have consistently upheld employment tax assessments against shareholder-employees who paid themselves unreasonably low wages.7Internal Revenue Service. Wage Compensation for S Corporation Officers
Pass-through owners may also qualify for the Section 199A qualified business income deduction, which allows eligible taxpayers to deduct up to 20% of qualified business income from a sole proprietorship, partnership, or S-corporation.8Internal Revenue Service. Qualified Business Income Deduction The deduction was made permanent by legislation signed in 2025. It is subject to income-based limitations and does not apply to C-corporation income or to wages earned as an employee.
C-Corporations
A C-corporation pays a flat 21% federal income tax on net taxable income.9GovInfo. 26 USC 11 Tax Imposed When it distributes after-tax profits as dividends, shareholders pay individual tax on those dividends at rates up to 23.8% including the net investment income tax. That double taxation is the defining trade-off of the structure, and most smaller contractors get no benefit from accepting it.10Internal Revenue Service. Forming a Corporation
State Income Tax Follows the Work, Not the Client
Performing contract work inside a state creates nexus, which is enough of a connection to require you to file and pay that state’s income tax on income earned there. The client being the federal government makes no difference. For pass-through entities, nexus in multiple states means owners may need to file nonresident returns in each state, with income apportioned by factors like payroll, property, and sales.
Several states also impose a gross receipts tax on total revenue before any deduction for expenses, meaning a contractor operating at a net loss can still owe. Revenue from federal contracts is included in the gross receipts tax base unless a specific state exemption applies. Many states additionally charge minimum franchise taxes or annual registration fees for the privilege of doing business there, which are modest individually but multiply for contractors registered across jurisdictions.
Sales and Use Tax on Materials
This is where contractors get the biggest surprises. The federal government is immune from state sales tax under the intergovernmental tax immunity doctrine rooted in the Supremacy Clause.11Congress.gov. Constitution Annotated – ArtI.S8.C1.1.5 Intergovernmental Tax Immunity Doctrine That immunity belongs to the government. It does not belong to you.
You Are the End User
States treat the contractor as the end user of materials consumed during contract performance. Lumber, concrete, equipment, and supplies bought to perform a federal contract carry sales tax like any other purchase. That was the holding in Alabama v. King & Boozer, where a contractor on a cost-plus federal project owed state sales tax on materials even though the government reimbursed the cost and title would pass to the government on delivery.1GSA SmartPay. State Tax Legal History If a vendor doesn’t collect sales tax at the point of purchase, you owe use tax at the same rate in the state where you first put the item to use.
The Narrow Purchasing-Agent Exemption
An exemption exists when the contractor can prove it acted strictly as a purchasing agent for the federal government. That generally requires the contract to establish that the government is bound by the purchase, that title passes directly from vendor to government without the contractor taking ownership, and that the government bears direct liability for the price. Meet those conditions and the transaction is treated as a direct government purchase, exempt from sales tax. Most standard contracting arrangements don’t. The FAR addresses state and local tax questions but puts the burden of documenting agency status on the contractor.12eCFR. 48 CFR Part 29 Subpart 29.3 – State and Local Taxes
Some states separately exempt materials that become a permanent physical component of the property delivered to the government. Rented scaffolding, office supplies, and fuel remain fully taxable because they never become part of what you hand over. Scope varies widely by state, and relying on general contract language instead of checking each state’s rules is a reliable way to draw a back-tax assessment.
Which Taxes the Government Reimburses on Cost Contracts
Contractors on cost-reimbursement or cost-plus contracts should know which taxes flow back to the government and which stay on the contractor’s books. The FAR draws the line at 31.205-41.13Acquisition.GOV. 31.205-41 Taxes As a general rule, federal, state, and local taxes a contractor is legally required to pay are allowable and billable to the government, including state income taxes, payroll taxes, and sales or use taxes on materials. Several categories are explicitly unallowable:
- Federal income and excess profits taxes. Your own income tax bill is yours.
- Taxes you could have avoided. If an exemption is available to you or because the government is the end user, the tax is unallowable unless the contracting officer agrees the exemption isn’t worth pursuing.
- Taxes on non-government work. Property or excise taxes on assets used only for commercial work can’t be charged to government contracts.
- Taxes tied to corporate refinancing, reorganizations, and similar transactions.
The practical consequence: on cost-type contracts you have an obligation to pursue available exemptions. Paying a sales tax you didn’t have to pay and then billing it to the government is an unallowable cost, and a DCAA auditor will find it.
Falling Behind on Taxes Can Cost You the Contract
Owing back taxes is not only an IRS problem. It can shut you out of federal contracting. During bidding, contractors certify under FAR 52.209-5 whether they have any delinquent federal tax liability above a specified threshold.14Acquisition.GOV. 52.209-5 Certification Regarding Responsibility Matters A false certification is grounds for prosecution, and a truthful disclosure can lead a contracting officer to question your responsibility.
A delinquent federal tax liability exceeding $10,000 is a listed cause for debarment under FAR 9.406-2, which would bar you from federal contracting for a period of time.15Acquisition.GOV. Causes for Debarment A liability is “delinquent” only once it has been finally assessed and you have no pending administrative or judicial challenge. Entering an IRS installment agreement and staying current on payments removes the label. But contractors who ignore tax bills or slip on estimated payments can lose access to the federal market entirely.