Tax Court Rules Cannabis Business Cannot Deduct W-2 Wages to Calculate IRC Sec. 199A Deduction

On September 11, 2025, the U.S. Tax Court published its opinion Ayla A. Savage et al. v. Commissioner. The Tax Court held that for purposes of the IRC Sec. 199A deduction, W-2 wages do not include wages disallowed under IRC Sec. 280E.

What Is IRC Sec. 280E?

Since its enactment in 1982, IRC Sec. 280E has disallowed federal tax deductions and credits from gross income if a taxpayer is engaged in the business of the manufacture, distribution, or sale of certain controlled substances classified as Schedule I or Schedule II under the 1970 Controlled Substances Act. The sole exception is the deduction allowed for the cost of goods sold (COGS). Under the Controlled Substances Act, cannabis is considered a Schedule I drug. Accordingly, any sales activity involving cannabis is considered trafficking under federal law. If cannabis were to be reclassified as a Schedule III substance, IRC Sec. 280E would no longer apply to the industry.

Background of IRC Sec. 199A

The Tax Cuts and Jobs Act (TCJA) temporarily created IRC Sec. 199A, also known as the qualified business income (QBI) deduction, and it was made permanent under the One Big Beautiful Bill Act. The provision allows taxpayers to deduct up to 20% of their QBI from an eligible business, operated directly or through a pass-through entity (S corporation or partnership). For most taxpayers, the IRC Sec. 199A deduction is subject to a limitation based on W-2 wages paid by the business.

Key Facts and Rulings from Ayla A. Savage et al. v. Commissioner

The taxpayers co-owned three S corporations that filed tax returns for 2018 and 2019. On their individual federal income tax returns for those years, they claimed the IRC Sec. 199A deduction on the income earned from the businesses. Two of the corporations sell cannabis and cannabis-derived products subject to IRC Sec. 280E limitations. The disagreement between the IRS and taxpayer was whether (a) total W-2 wages or (b) deductible W-2 wages should be used for computing the IRC Sec. 199A deductions.

The Tax Court sided with the IRS, stating that IRC Sec. 199A expressly provides that the term “W-2 wages” does not include any amount which is not “properly allocable” to QBI for purposes. Nondeductible wages under IRC Sec. 280E are not part of the defined term “qualified items of income, gain, deduction, and loss;” they cannot be included in the defined term “qualified business income” for purposes of IRC Sec. 199A.

In a rare departure for an IRC Sec. 280E court case, one of the judges dissented in favor of the taxpayer. Judge Jenkins argued that disallowing wages to be used for IRC Sec. 199A deduction is contrary to the purpose of the code section’s enaction. Judge Jenkins argued in his opinion that the goal of IRC Sec. 199A’s enactment in the TCJA was to benefit small businesses that create jobs and pay wages.

The Tax Court’s ruling was unfavorable to the taxpayer, but the mere fact that the IRS did not challenge the entire IRC Sec. 199 deduction is a welcome tax development for the cannabis industry. It should be noted, though, that the Tax Court did state that this opinion does not express a view on any further interactions between IRC Secs. 199A and 280E. If you have questions about how this Tax Court decision could impact you, contact us below.