“State” of the Law
A quick review of the cannabis landscape[i] reveals that most of the tax-related activity remains at the state level. At present, most states have decriminalized the use of cannabis products; it remains illegal in only a handful. Approximately half the states permit the recreational use of such products, and almost all allow some form of medicinal use.
The taxes imposed by States in which recreational use is legal vary; for example, some tax on the basis of weight, others on the basis of THC content. Regardless of the method used, the goal is almost always to raise funds to combat addiction.
Unfortunately, these taxes also make it more difficult for a licensed retailer to compete with the black market, which in turn reduces a state’s tax revenue. Consequently, many states seem to be tweaking their cannabis tax regimes to find the appropriate balance.[ii]
The Feds – Rescheduling
What about the federal treatment of cannabis?
During the 2020 campaign, the last Administration championed the decriminalization of cannabis.[iii] It also favored the rescheduling of cannabis so it would no longer be treated as a controlled substance.[iv] It wasn’t until October 2022, however, that the Attorney General (“AG”) and the Secretary of Health and Human Services (“HHS”) began reviewing the classification of marijuana under federal law. Following this review, in May 2023, the AG exercised his authority to initiate the rulemaking process to transfer marijuana from schedule I to schedule III, which started the process through which the Drug Enforcement Administration (“DEA”) would gather and consider information and views submitted by the public in order to make a determination about the appropriate schedule.
During the Summer of 2024, the DEA announced that it would hold hearings on the AG’s rescheduling proposal. In January 2025, the hearings were, in effect, postponed indefinitely. As of this Summer, the rescheduling hearings have not been rescheduled. Last month, however, the Administration indicated that it was in the early stages of considering the rescheduling proposal.
Section 280E of the Code
Assuming the rulemaking process is revived, cannabis will remain a schedule I controlled substance until a final reclassification rule is published. In other words, a taxpayer operating a cannabis business will continue to be denied any tax deductions for expenses paid or incurred in carrying on its business:[v]
“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
However, the Code does not prohibit a participant in the cannabis industry from reducing its gross receipts by its properly calculated cost of goods sold to determine its gross income. In general, this means that taxpayers who sell cannabis products may reduce their gross receipts by the cost of acquiring or producing the product they sell.
One can imagine how this may have influenced taxpayers’ behavior and reporting as they sought to include as many expenditures as possible in their cost of goods sold. In fact, many of the federal tax cases that have addressed the tax treatment of cannabis businesses involved the determination of whether certain expenses were properly included in cost of goods sold.
A recent decision,[vi] however, illustrated how some “creative” taxpayers attempted a different approach to wring a tax benefit out of the Code.
Section 199A
Taxpayers were shareholders of two S corporations (the “Corps”), the businesses of which included the sale of cannabis and cannabis-derived products; therefore, under section 280E of the Code, certain of their business deductions[vii] were disallowed in determining the Corps’ taxable incomes for the taxable years in question (the “Tax Years”).
On their individual federal income tax returns for those years, Taxpayers each claimed the “qualified business income deduction” under section 199A of the Code with respect to the activities of the Corps.
You may recall that this provision – section 199A, which was recently made “permanent” by OBBBA[viii] – was added to the Code, effective for taxable years beginning on or after January 1, 2018.[ix] Section 199A permits an individual taxpayer with income from a pass-through business entity (such as a sole proprietorship, partnership, or S corporation) – which the individual taxpayer includes in their gross income for purposes of determining their federal tax liability – to deduct up to 20% of the business’s “qualified business income” (or “QBI”)[x] in determining their federal income tax liability. The deduction applies to a broad range of business activities.[xi]
For taxpayers whose taxable income exceeds a statutorily-defined threshold amount, section 199A may limit the taxpayer’s deduction based on (i) the type of trade or business engaged in by the taxpayer,[xii] (ii) the amount of W-2 wages paid with respect to the trade or business (W-2 wages), and/or (iii) the unadjusted basis immediately after acquisition of qualified property held for use in the trade or business. These statutory limitations are subject to phase-in rules based upon taxable income above the threshold amount.
In computing their section 199A deductions, Taxpayers treated as “W-2 wages”[xiii] all of the amounts paid and reported by the S corporations without regard to whether those amounts were deductible in determining taxable income.
As indicated above, and as relevant here, the amount of the deduction may be limited by the “W-2 wages” the taxpayer (or the passthrough entity) pays.[xiv] Thus, all else being equal, a taxpayer who pays more “W-2 wages” may qualify for a larger deduction than a taxpayer who pays less “W-2 wages.”
Section 199A(b)(4) defines the term “W-2 wages.” The question before the Court was whether that term includes or excludes wage amounts for which a deduction is disallowed under section 280E of the Code. If such amounts are included in “W-2 wages,” Taxpayers would receive larger section 199A deductions and, thus, owe less tax.
Taxpayers maintained that wage amounts for which a deduction is disallowed under section 280E are included in the term “W-2 wages” under section 199A(b)(4).
The IRS took the contrary view.
The Court concluded that “a straightforward reading of the relevant statutory text supports the [IRS].”
Court’s Analysis
The parties, the Court began, agreed that section 280E limited the amount of W-2 wages that the Corps may deduct from their gross income on their Forms 1120-S for the Tax Years. The parties also stipulated, the Court continued, the amounts of W-2 wages the Corps paid in the Tax Years (Total W-2 Wages) and the amounts of W-2 wages they may deduct from gross income on their Forms 1120-S for the those years after the application of section 280E (“Deductible W-2 Wages”). The Total W-2 Wages far exceeded the Deductible W-2 Wages.[xv]
The Court stated that the only remaining disagreement between the parties was whether (a) Total W-2 Wages or (b) Deductible W-2 Wages should have been used for computing the Taxpayers’ section 199A deductions for the Tax Years.
The Court’s analysis began “with the plain language of the statute,” though it added that “[r]esolution of the dispute before us requires close reading of rather technical Code provisions that contain nested definitions.”[xvi] The Court then explained that, “when a statute includes an explicit definition, we must follow that definition, even if it varies from a term’s ordinary meaning.”[xvii]
With that, the Court turned to the language of section 199A; specifically, the definition of “W-2 Wages.”
The Court noted that, for some taxpayers, the amount of the section 199A deduction is limited by the “W-2 wages” they (or, as in the present case, their passthrough entities) paid.[xviii]
Section 199A(b)(4) defines the term as follows:
- (4) Wages, etc. —
- (A) In general. — The term “W-2 wages” means, with respect to any person for any taxable year of such person, the amounts described in paragraphs (3) and (8) of section 6051(a) paid by such person with respect to employment of employees by such person during the calendar year ending during such taxable year.
- (B) Limitation to wages attributable to qualified business income. — Such term shall not include any amount which is not properly allocable to qualified business income for purposes of subsection (c)(1).
- (C) Return requirement. — Such term shall not include any amount which is not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for such return.
The Court observed, first, that the above definition takes the form of a general rule followed by exceptions; and, second, that both the general rule and one of the exceptions turn on other statutory provisions.
The Court explained that one of those referenced provisions (section 6051(a)) sets out rules concerning the preparation of Forms W-2, Wage and Tax Statement. Paragraph (3) of section 6051(a) addresses the wages an employer pays an employee, while paragraph (8) generally addresses amounts contributed to tax-advantaged retirement accounts and deferred compensation.
Piecing these references together, the Court concluded that, to determine what “W-2 wages” means for purposes of section 199A, one must start with the Form W-2 statements filed by an employer; more specifically, with certain of the amounts reflected in those statements.
According to the Court, however, amounts that may have been reported by an employer to an employee in a Form W-2, would not be treated as “W-2 wages” for purposes of section 199A if they were not properly allocable to qualified business income for purposes of section 199A(c)(1). In other words, wages must be “properly allocable” to qualified business income in order to be considered “W-2 wages” for purposes of section 199A.
Of course, the term “properly allocable” is not defined in the statute. “Accordingly, we must discern its ordinary meaning,” the Court stated, when section 199A was adopted.[xix]
At this point, I’ll spare you the Court’s exercise in semantics.[xx] Suffice to say 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 stated. “The item must go appropriately or correctly with the category.”
Next, the court turned to the meaning of “qualified business income.” Section 199A(c) defines the concept of “qualified business income” for all purposes of section 199A; it provides:[xxi]
“The term “qualified business income” means, for any taxable year, the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.”
Thus, according to section 199A(c)(1), “qualified business income” consists of the net amount of certain items — which the statute terms “qualified items of income, gain, deduction, and loss.” The latter phrase is further defined:[xxii]
“The term “qualified items of income, gain, deduction, and loss” means items of income, gain, deduction, and loss to the extent such items are . . . (i) effectively connected with the conduct of a trade or business within the United States . . . , and (ii) included or allowed in determining taxable income for the taxable year.”
After setting out the definitions in all their detail, the Court noted that “[w]orking backwards from the statutory definitions makes it easy to understand how the provision works.” Wages, the Court stated, are included in the term “qualified items of income, gain, deduction, and loss” only “to the extent” they are “allowed in determining taxable income for the taxable year.” In other words, if certain wage amounts are not “allowed in determining taxable income for the taxable year,” those amounts are not part of the term “qualified items of income, gain, deduction, and loss” for purposes of section 199A(c).
Because such nondeductible wages are not part of the defined term “qualified items of income, gain, deduction, and loss,” the Court concluded they could not be included in the defined term “qualified business income” for purposes of section 199A(c)(1).
Thus, wages are required to be “properly allocable” to “qualified business income for purposes of [section 199A(c)(1)]” in order to be considered “W-2 wages” for purposes of section 199A. “Under ordinary usage, for wages to be properly allocable to qualified business income, they must be capable of being designated to go with . . . qualified business income and must fit appropriately, suitably, or correctly with qualified business income.”
But nondeductible wages could not be included in “qualified business income” for purposes of section 199A(c)(1) because the statute expressly excludes them from the scope of that concept. “In view of that statutory command,” the Court explained, “such wages are not capable of being designated to go correctly with” qualified business income. They do not “fit correctly” under that statutory construct, the Court stated, and, therefore, are not properly allocable to it. And if nondeductible wages are not properly allocable to qualified business income, they cannot be “W-2 wages” as defined in section 199A(b)(4)(B).
The Court noted that the parties agreed that portions of the wages the Corps paid were not allowed as deductions (under section 280E) “in determining the taxable income” of those corporations. Thus, for purposes of section 199A those wages were nondeductible wages. Under the Court’s analysis, above, those amounts could not constitute “qualified items of income, gain, deduction, and loss” under section 199A(c)(3) or be part of “qualified business income” for purposes of section 199A(c)(1). Thus, they were not “W-2 wages” within the meaning of section 199A(b)(4)(B).
Amounts that are not “allowed in determining taxable income for the taxable year” must be excluded from qualified business income.[xxiii] They are not “properly allocable” to such income. Therefore, nondeductible wages likewise cannot be “W-2 wages” as the statute defines that term.[xxiv]
With that, the Court held for the IRS.
Parting Thoughts
The last three posts (inclusive of this one) have been focused on statutory interpretation.
For those of you following along, in one post I concluded that “stacking” under section 1202 of the Code was not permissible;[xxv] in the second, I concluded that the 90-day rule for filing a petition with the Tax Court was jurisdictional.[xxvi]
In the present case, however, I have to agree with the Tax Court’s holding, and ultimately with the conclusion that only with the rescheduling of cannabis will the outcome change.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] You may need a higher vantage point, above the smoke, to see clearly.
[ii] For example, California is about to reduce its tax rate on cannabis.
[iii] Not the same as legalization. If cannabis is decriminalized, an individual would not be prosecuted for possession of up to a specific amount. Legalization, however, would remove all legal prohibitions, as a result of which cannabis would be available for purchase and use by all adults.
[iv] Schedule I or II of the Controlled Substance Act.
[v] IRC Sec. 280E.
[vi] Savage v. Commissioner, U.S. Tax Court, docket number 21606-22 (filed Sept. 11, 2025)
[vii] The parties agreed to certain facts by stipulation; this appears to have included the fact that Taxpayers operated more than one business, not all of which were subject to IRC Sc. 280E’s deduction disallowance rule.
A single taxpayer may have multiple trades or businesses, some of which are subject to IRC Sec. 280E and some of which are not; or they may have a single trade or business consisting of multiple activities all of which would be subject to IRC Sec. 280E, even if the activities are undertaken through separate entities.
The Court indicated that the record did not disclose the precise trades or businesses of the Corps, but the Court assumed the parties’ stipulations were not inconsistent with the Court’s caselaw on the proper delineation of trades or businesses for purposes of applying IRC Sec. 280E.
[viii] Pub. L. No. 119-21 https://www.taxslaw.com/2025/07/closely-held-businesses-and-their-owners-ask-whats-big-and-beautiful-in-the-recent-tax-law/. Without OBBBA, this deduction would no longer have been available for taxable years beginning on or after January 1, 2026.
[ix] By the Tax Cuts and Jobs Act (“TCJA”); Pub. L. No. 115-97.
[x] In addition to income arising in the ordinary course of a business, QBI may include certain gain from the sale of the assets of a business, such as inventory, receivables, and depreciation recapture property.
[xi] IRC Sec. 1366. Deduction for noncorporate business taxpayers, including the shareholders of S corporations, who include in gross income their pro rata share of the S corporation’s items of income, deduction, etc.
[xii] I.e., specified services trades or businesses.
[xiii] Within the meaning of IRC Sec. 199A(b)(4).
[xiv] IRC Sec. 199A(a), (b)(2).
[xv] Total W-2 Wages for the Tax Years: approximately, $1.48 million; Total Deductible W-2 Wages: just over $400,000.
[xvi] So much for “plain language”?
[xvii] “By contrast,” the Court continued, “when the statute does not define a term, we ask what that term’s ‘ordinary, contemporary, common meaning’ was when Congress enacted the relevant provision.”
[xviii] IRC Sec. 199A(a), (b)(2).
[xix] “The starting point in discerning congressional intent is the existing statutory text . . . and not the predecessor statutes.”
[xx] If you’re interested in seeing what the Court had to say about the meanings of the words “”proper” and “allocable” in different editions of The American Heritage Dictionary or Black’s Law Dictionary, you’re welcome to read the opinion.
[xxi] IRC Sec. 199A(b)(4)(B).
[xxii] IRC Sec. 199A(c)(3).
[xxiii] The Court noted that Taxpayers did not object to using wages limited by section 280E (that is, Deductible W-2 Wages) to calculate qualified business income for the Corps. That is understandable, as using the lower wage number in this particular calculation produced more qualified business income, and the potential for higher section 199A deductions for Taxpayers. But their interpretation of the statute produced an inconsistency: They asked the Court to use Deductible W-2 Wages for one aspect of the section 199A computation and Total W-2 Wages for another.
[xxiv] The Court observed that the text of IRC Sec. 199A(b)(4)(B) focuses on whether an amount is “properly allocable” to “qualified business income,” which is a net amount. The text does not refer to “gross receipts” or specific items of income or gain listed in IRC Sec. 199A(c)(3). According to the Court, Congress could have used those words if it had wished to. The fact that it did not must be respected.
[xxv] https://www.taxslaw.com/2025/09/gifting-qualified-small-business-stock-can-you-stack-the-section-1202-odds-in-your-favor/
[xxvi] https://www.taxslaw.com/2025/09/responding-timely-to-a-90-day-letter-is-it-jurisdictional/
I should add that the House will be considering H.R. 5349, The Tax Court Improvement Act, pursuant to which, if enacted, taxpayers would be allowed to appeal dismissals of their late-filed petitions. The bill would also authorize the Tax Court to grant extensions of time for filing petitions.
