Wages Disallowed Under Section 280E Cannot be Used in Calculating QBI Deduction

(Parker Tax Publishing October 2025)

The Tax Court held that, in calculating an S shareholder's qualified business income deduction under Code Sec. 199A, the term "W-2 wages" excludes wages for which a deduction is disallowed under Code Sec. 280E (Expenditures in connection with the illegal sale of drugs). Savage v. Comm'r, 165 T.C. No. 5 (2025).

Background

Ayla Savage and Patricia Torres are shareholders in three S corporations. They filed individual income tax returns for 2018 and 2019 reporting items with respect to those S corporations. Two of the S corporations sell cannabis and cannabis-derived products and are subject to Code Sec. 280E. Code Sec. 280E provides that no deduction or credit is allowed for any amount paid or incurred during the tax year in carrying on any trade or business if such trade or business (or its activities) consists of trafficking in controlled substances that are prohibited by federal law or the law of any state in which such trade or business is conducted.

For 2018 and 2019, Savage and Torres claimed qualified business income deductions under Code Sec. 199A with respect to the activities of the S corporations. Generally, Code Sec. 199A allows a noncorporate taxpayer with qualified trade or business income to deduct a portion of that income. However, the deduction is limited by W-2 wages paid by the taxpayer (or passthrough entity), as well as other limitations. Code Sec. 199A(b)(4) defines the term "W-2 wages" to mean the amounts described in Code Sec. 6051(a)(3) and Code Sec. 6051(a)(8) paid by such person with respect to the employment of employees during the calendar year ending during such tax year. Code Sec. 6051(a) sets out rules for preparing Forms W-2, Wage and Tax Statement. Code Sec. 6051(a)(3) addresses the wages an employer pays an employee, while Code Sec. 6051(a)(8) generally addresses amounts contributed to tax-advantaged retirement accounts and deferred compensation. Under Code Sec. 199A(b)(4)(B), the term "W-2 wages" is limited and does not include any amount which is not properly allocable to qualified business income for purposes of Code Sec. 199A(c)(1).

In computing their deductions under Code Sec. 199A, Savage and Torres treated as "W-2 wages," all of the amounts paid and reported by the S corporations without regard to whether those amounts were deductible in determining taxable income. The IRS audited their tax returns and determined that, under Code Sec. 199A(b)(4)(B) and Code Sec. 199A(c), the Code Sec. 199A deductions taken by Savage and Torres were incorrect as they should have considered only wages that were deductible after applying Code Sec. 280E. It thus reduced their Code Sec. 199A deductions. Savage and Torres disagreed and took their case to the Tax Court. The question before the Tax Court was whether total W-2 wages or deductible W-2 wages should be used in calculating a Code Sec. 199A deduction.

Analysis

In a 17-1 decision, the Tax Court sided with the IRS and held that deductible W-2 wages are used in calculating a taxpayer's Code Sec. 199A deduction, not total wages. Thus, Savage and Torres could not claim deductions under Code Sec. 199A with respect to the activities of the S corporations subject to Code Sec. 280E. The IRS's position, the court said, was consistent with the statutory text of Code Sec. 199A, as well as the regulations issued under Code Sec. 199A.

In reaching its decision, the Tax Court noted that the concept of W-2 wages is critical to the operation of Code Sec. 199A. The definition of "wages" in Code Sec. 199A(b)(4), the court observed, takes the form of a general rule followed by exceptions and both the general rule and one of the exceptions, Code Sec. 199A(b)(4)(B), turn on other statutory provisions. The court then focused on the exception in Code Sec. 199A(b)(4)(B), which states that the term "W-2 wages" does not include any amount which is not properly allocable to qualified business income. As a result, the court said, although certain amounts may be reported by an employer to an employee in a Form W - 2 under Code Sec. 6051(a), those amounts do not constitute "W-2 wages" for purposes of Code Sec. 199A if they are not properly allocable to qualified business income for purposes of Code Sec. 199A(c)(1). According to the court, this means that wages must be "properly allocable" to qualified business income for purposes of Code Sec. 199A(c)(1) in order to be considered "W-2 wages" for purposes of Code Sec. 199A.

Since the term "properly allocable" is not defined in Code Sec. 199A(b)(4)(B), the court was tasked with discerning its ordinary meaning when Code Sec. 199A was adopted. Putting together the definitions of "properly" and "allocable," the court concluded that the ordinary meaning of the phrase "properly allocable" refers to something that may be designated to go with something else and fits appropriately or correctly with it; that an amount is "capable of being allocated" to a category in the abstract is not enough.

The court then examined the statutory definition of "qualified business income" under Code Sec. 199A(c)(3) and noted that wages are included only to the extent they are allowed in determining taxable income for the tax year. Because nondeductible wages are not part of the defined term "qualified items of income, gain, deduction, and loss," the court concluded that they cannot be included in the defined term "qualified business income" for purposes of Code Sec. 199A(c)(1). As a result, the Tax Court held that the Code Sec. 199A deductions for Savage and Torres should consider only wages that are deductible after the application of Code Sec. 280E. The court thus reduced their Code Sec. 199A deductions accordingly.

Dissenting Opinion

Tax Court Judge Jenkins was the sole dissent from the majority opinion. In a lengthy opinion, she noted that Congress created the Code Sec. 199A deduction to reduce the tax rate that applies to certain income from qualified trades or businesses and Congress put some effort into drawing the line between qualified trades or businesses eligible for the deduction and those trades or businesses that are not eligible for the deduction. However, she observed, Congress did not include drug trafficking businesses in the detailed list of businesses that are not eligible for the Code Sec. 199A deduction and Congress did not amend Code Sec. 280E to disallow the Code Sec. 199A deduction.

Practice Tip: As this case shows, while certain amounts may be reported by an employer to an employee on a Form W-2 under Code Sec. 6051(a), those amounts do not necessarily constitute "W-2 wages" for purposes of Code Sec. 199A if they are not properly allocable to qualified business income for purposes of Code Sec. 199A(c)(1).

For a discussion of the qualified business income deduction and wage expenses included in the calculation, see Parker Tax ¶154,155.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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