Cortical layer 1 (L1) interneurons have been proposed as a hub for attentional modulation of underlying cortex, but the transformations that this circuit implements are not known. We combined genetically targeted voltage imaging with optogenetic activation and silencing to study the mechanisms underlying sensory processing in mouse barrel cortex L1. Whisker stimuli evoked precisely timed single spikes in L1 interneurons, followed by strong lateral inhibition. A mild aversive stimulus activated cholinergic inputs and evoked a bimodal distribution of spiking responses in L1. A simple conductance-based model that only contained lateral inhibition within L1 recapitulated the sensory responses and the winner-takes all cholinergic responses, and the model correctly predicted that the network would function as a spatial and temporal high-pass filter for excitatory inputs.Our results demonstrate that all-optical electrophysiology can reveal basic principles of neural circuit function in vivo and suggest an intuitive picture for how L1 transforms sensory and modulatory inputs.