Only deductible W-2 wages used in determining Sec. 199A deduction

The Tax Court held that the determination of the Sec. 199A qualified business income deduction should take into account only the W–2 wages paid for which a deduction is allowed under Sec. 280E in calculating taxable income.

Background

The Tax Cuts and Jobs Act, P.L. 115–97, lowered the income tax rate applicable to corporations to 21%. To prevent noncorporate business taxpayers (including taxpayers who are taxed on income earned by S corporations and other passthrough entities) from being taxed at a much higher rate than corporations on similar business income, Congress also added Sec. 199A, which provides a deduction for noncorporate taxpayers, the amount of which is generally a percentage of a taxpayer’s qualified business income and the qualified business income passed through to the taxpayer by passthrough entities, such as S corporations, in which the taxpayer owns an interest. However, for some taxpayers, the amount of the deduction is limited by the W–2 wages (as defined in Sec. 199A(b)(4)) that the taxpayers (or passthrough entities passing through the deduction to the taxpayers) pay, among other things. Due to this limit, all else being equal, generally, a taxpayer that pays more W–2 wages may qualify for a larger deduction than a taxpayer that pays less in W–2 wages.

Ayla Savage and Patricia Torres (the taxpayers) co–owned two S corporations, Tru Greenthumb Inc. and Fillabong Inc., for which they filed Forms 1120–S, U.S. Income Tax Return for an S Corporation, for 2018 and 2019. Tru Greenthumb and Fillabong sell cannabis and cannabis–derived products and are subject to Sec. 280E, which 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 that is prohibited by federal law or the law of the state in which the trade or business is conducted.

The taxpayers and the IRS agreed that Sec. 280E limited the amounts of W–2 wages that Tru Greenthumb and Fillabong could deduct from gross income on their 2018 and 2019 Forms 1120–S. The parties stipulated that the combined total amounts of W–2 wages Tru Greenthumb and Fillabong paid in 2018 and 2019 was $1,483,575, and the amounts of W–2 wages Tru Greenthumb and Fillabong could deduct from gross income on their 2018 and 2019 Forms 1120–S after the application of Sec. 280E was only $400,199.

For 2018 and 2019, the taxpayers, on their individual tax returns, claimed Sec. 199A qualified business income deductions based on the qualified business income Tru Greenthumb and Fillabong earned from their activities and passed through to them. In calculating their Sec. 199A deductions for 2018 and 2019, the taxpayers treated as W–2 wages for purposes of the W–2 wage limitation on the deduction under Sec. 199A(b)(2)(B)(i) the full amount of the W–2 wages the two S corporations paid and reported.

The IRS determined that, under Secs. 199A(b)(4)(B) and (c), the taxpayers’ calculations of their Sec. 199A qualified business income deductions should take into account only the W–2 wages that were deductible by the S corporations after the application of Sec. 280E. It thus reduced the amount of the Sec. 199A deductions claimed by the taxpayers.

The taxpayers challenged the IRS’s determinations in Tax Court, contending that the W–2 wages for which a deduction is not allowed under Sec. 280E are included in the term “W–2 wages” under Sec. 199A(b)(4) and that they had properly included them in calculating their Sec. 199A qualified business income deductions for 2018 and 2019.

The Tax Court’s decision

The Tax Court held that, based on a straightforward reading of the relevant statutory text, the taxpayers’ calculations of their Sec. 199A qualified business income deductions should include only deductible W–2 wages and should not include the W–2 wages that the taxpayers’ S corporations paid and reported but were not deductible under Sec. 280E.

W-2 wages: General rule and exception

As the Tax Court explained, the general rule concerning what are considered W–2 wages is contained in Sec. 199A(b)(4)(A), which states that “W–2 wages” means the amounts described in Secs. 6051(a)(3) and (8) paid by a person with respect to employment of employees by the person. However, this general rule is limited by Sec. 199A(b)(4)(B), which states that W–2 wages “shall not include any amount which is not properly allocable to qualified business income for purposes of [Sec. 199A(c)(1)].” Therefore, in determining which wages should be included for purposes of the qualified business income deduction, the court focused on the text of Sec. 199A(b)(4)(B) and, specifically, the meaning of the phrases “properly allocable” and “qualified business income.”

Properly allocable: The court, noting that the term “properly allocable” was not defined in the statute, looked to what the ordinary meaning of the phrase was when Sec. 199A was adopted. The court, reviewing dictionary definitions of “properly” and “allocable,” determined that “properly” meant “[c]haracterized by appropriateness or suitability; fitting” and that “allocable” meant “capable of being allocated.” Putting these two definitions together, the court found “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.”

Qualified business income: Following the reference in Sec. 199A(b)(4)(B) to Sec. 199A(c)(1), the court looked to Sec. 199A(c), which defines the concept of “qualified business income” for guidance on the meaning of that term. According to Sec. 199A(c)(1), qualified business income consists of the “net amount of qualified items of income, gain, deduction, and loss.” The court further found, as provided by Sec. 199A(c)(3)(A)(ii), items are qualified items of income, gain, deduction, or loss for purposes of Sec. 199A(c)(1) only to the extent they are included or allowed in determining taxable income for the year. Therefore, the court concluded that if wages are not allowed in determining a taxpayer’s taxable income for a tax year (i.e., they are nondeductible wages), they are not qualified items of income, gain, deduction, or loss and cannot be included in qualified business income for purposes of Sec. 199A(c)(1).

Application to wages disallowed under Sec. 280E

The court then considered what this meant with respect to the portion of the wages paid by the taxpayers’ S corporations that were not deductible under Sec. 280E in the calculation of their taxable income. Having found that nondeductible wages are expressly excluded from the scope of qualified business income under the terms of Sec. 199A(c)(1), the court determined nondeductible wages are not capable of being designated to go correctly (or being set apart for) and do not “fit” “correctly” with qualified business income. Thus, they are not properly allocable to qualified business income and consequently cannot be “W–2 wages” as defined in Sec. 199A(b)(4). Accordingly, in the taxpayers’ situation, the wages paid by their S corporations that were not deductible under Sec. 280E in calculating their taxable income could not be W–2 wages for purposes of calculating the Sec. 199A(b)(2)(B)(i) limitation on the taxpayers’ Sec. 199A qualified business income deductions.

Taxpayers’ arguments

The taxpayers argued that the IRS was attempting to add conditions and language not in the statute to limit W–2 wages to those allowed to be deducted by the business after the application of Sec. 280E. This, they claimed, was manifestly contrary to the clear statutory language.

The Tax Court, however, found the taxpayers’ view rested on their selective reading of the statute, focusing on the general rule of Sec. 199A(b)(4)(A) while wholly ignoring the express Sec. 199A(b)(4)(B) limitation and the ordinary meaning of the phrase “properly allocable.” The court stated that this was “not an acceptable method of statutory analysis.” In addition, the court determined that the IRS, by following the statutory provision, was not rewriting the statute or adding something to it that is not there.

The court further explained that the text of Sec. 199A(b)(4)(B) focuses on whether an amount is “properly allocable” to “qualified business income,” which is a net amount. It did not refer to “gross receipts” or specific items of income or gain listed in Sec. 199A(c)(3). According to the court, Congress could have used those words and “certainly knew how to do so,” pointing to Sec. 199A(g)(1)(B) as an example of where it had done this. Thus, the court found that the fact that Congress had used language specifying a net amount must be respected.

The Tax Court also concluded that although Sec. 199A was patterned after the now–repealed Sec. 199, this gave the court no license to ignore the actual words Congress used in Secs. 199A(b)(4)(B) and (c) in favor of words that were used in the former Sec. 199. The court stated, quoting Lamie v. U.S. Trustee, 540 U.S. 526, 534 (2004), “The starting point in discerning congressional intent is the existing statutory text … and not the predecessor statutes.”

Finally, the taxpayers made certain policy arguments to support their view, none of which the court thought were well founded. Moreover, as the court stated, “in any event the arguments are misdirected. We have no warrant to rewrite the statutory text Congress wrote.”

Reflections

In the case, which was reviewed by all 18 of the Tax Court judges, one judge dissented, holding that in calculating their Sec. 199A qualified business income deductions, the taxpayers should take into account the full amount of the W–2 wages their S corporations paid and reported. The dissent put forth two main technical reasons for this conclusion, one based on the multistep method under which the Sec. 199A deduction is calculated and the other on the meaning of “properly allocable” under the overall statutory framework of Sec. 199A. In closing, the dissent stated that its position was also supported by a long–standing principle of the Supreme Court, which stated in Merriam, 263 U.S. 179, 187—88 (1923), “in statutes levying taxes … [i]f the words are doubtful, the doubt must be resolved against the government and in favor of the taxpayer.”

Savage, 165 T.C. No. 5 (2025)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.