Nondeductible W-2 wages not included in Sec. 199A deduction computation

The Tax Court held that W-2 wages paid by two S corporations that were not deductible under Sec. 280E in computing their taxable income could not be taken into account in calculating the Sec. 199A qualified business income (QBI) deduction of their owners.

Facts: The taxpayers, Ayla A. Savage and Patricia A. Torres, co-owned Tru Greenthumb Inc. and Fillabong Inc., both S corporations and cannabis businesses subject to Sec. 280E. Sec. 280E limits the deductions and credits that can be taken by trades or businesses (or the activities that comprise the trades or businesses) that consist of trafficking in controlled substances under Schedules I and II of the Controlled Substances Act (CSA).

The taxpayers and the IRS agreed that Sec. 280E limited the amounts of W-2 wages that the S corporations could deduct from gross income on their 2018 and 2019 Forms 1120-S, U.S. Income Tax Return for an S Corporation. Out of the combined total W-2 wages the S corporations paid and reported in 2018 and 2019 of $1,483,575, the amount of W-2 wages they deducted from gross income on their Forms 1120-S after the application of Sec. 280E was only $400,119.

On their individual tax returns for 2018 and 2019, the taxpayers claimed Sec. 199A QBI deductions based on the income passed through to them from the S corporations. However, in calculating their Sec. 199A QBI deductions for 2018 and 2019, for purposes of the Sec. 199A(b)(2)(B)(i) W-2 wage limitation of the Sec. 199A QBI deduction, the taxpayers treated as W-2 wages the full amount of the W-2 wages the two S corporations paid and reported rather than the amounts of W-2 wages they deducted on their Forms 1120-S.

The IRS determined that, under Secs. 199A(b)(4)(B) and (c), the taxpayers’ calculations of their Sec. 199A QBI deductions should take into account only the W-2 wages that were deductible by the S corporations after the application of Sec. 280E. Taking into account only the S corporations’ deductible W-2 wages, the IRS reduced the taxpayers’ QBI deductions for both 2018 and 2019. The taxpayers challenged the IRS’s determinations in Tax Court.

Issues: The parties disputed only one issue: the amount of W-2 wages that could be taken into account in the computation of the taxpayers’ Sec. 199A QBI deduction.

To find the answer to this question, the Tax Court examined the plain language of the statute. Sec. 199A defines W-2 wages using a general rule followed by exceptions. Specifically, Sec. 199A(b)(4)(A) references Sec. 6051(a), which defines “W-2 wages” as, with respect to any person for any tax year of the person, the amounts described in Sec. 6051(a)(3) (wages as defined in Sec. 3401(a)) and Sec. 6051(a)(8) (elective deferrals under Secs. 402(g)(3) and 457) paid by the person with respect to employment of employees during the calendar year ending during the tax year. However, Sec. 199A(b)(4)(B) provides that W-2 wages “shall not include any amount which is not properly allocable to qualified business income.” Thus, to determine how Sec. 199A(b)(4)(B) applies, the court considered the meaning of the phrases “properly allocable” and “qualified business income.”

With regard to “properly allocable,” because the statute did not define the phrase, the Tax Court relied on its ordinary meaning at the time Sec. 199A was enacted. It determined that this was “something that may be designated to go with something else and fits appropriately or correctly … with it.”

The court found that the phrase “qualified business income” is defined in Sec. 199A(c)(1) as “the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.” Sec. 199A(c)(3) clarifies that “‘qualified items of income, gain, deduction, and loss’ means items of income, gain, deduction, and loss to the extent such items are … included or allowed in determining taxable income for the taxable year.”

Based on these meanings for the two phrases, the court found that W-2 wages not deductible in determining taxable income could not be “properly allocable” to W-2 wages for the purposes of the Sec. 199A QBI deduction. Therefore, the court found that W-2 wages are taken into account in determining the Sec. 199A QBI deduction only to the extent they are deductible in determining taxable income. Consequently, W-2 wages disallowed under Sec. 280E in computing taxable income are not W-2 wages for purposes of computing the Sec. 199A QBI deduction.

The taxpayers argued in their petition that the IRS ignored the plain text of Sec. 199A by applying “conditions and additional language not in the statute.” They contended that W-2 wages are defined as “all remuneration included on the W-2s issued by the business.” The court rejected their interpretation, finding that it relied on a selective reading of the statute because it failed to consider the Sec. 199A(b)(4)(B) limitation and the ordinary meaning of “properly allocable.”

The court further held that policy arguments by Savage and Torres were ill-founded and misdirected. “Achieving a better policy outcome … is a task for Congress, not the courts,” the court stated, citing Hartford Underwriters Insurance Co. v. Union Planters Bank, N.A., 530 U.S. 1, 13—14 (2000).

Holding: The court held that the computation of the taxpayers’ Sec. 199A QBI deductions should take into account only wages that were deductible after the application of Sec. 280E. Thus, the IRS had correctly applied Sec. 199A in the taxpayers’ case. (Note that President Donald Trump, in an executive order on Dec. 18, 2025, directed the attorney general to “take all necessary steps to complete the rulemaking process to reschedule Marijuana to Schedule III” of the CSA.)

• Savage, 165 T.C. No. 5 (2025)

— Jack Horner is a student in the Charles H. Dyson School of Applied Economics and Management at Cornell University. John McKinley, CPA, CGMA, J.D., LL.M., and Thomas Godwin, CPA, CGMA, Ph.D., are both professors of the practice in accounting and taxation in the SC Johnson College of Business at Cornell University. To comment on this column, contact Paul Bonner, the JofA‘s tax editor.