Cannabis businesses' wages are ineligible for business income deductions for pass-throughs because they sell controlled substances, according to the U.S. Tax Court. The ruling on Sept. 11, 2025 clarifies that wages disallowed as deductions under section 280E are not included as W-2 wages for purposes of calculating the section 199A qualified business income (QBI) deduction. This decision affirms the Internal Revenue Service’s position and provides important guidance for businesses — particularly those in the cannabis industry — subject to section 280E.

Background

Section 199A, enacted as part of the Tax Cuts and Jobs Act (TCJA), allows certain noncorporate taxpayers, including S corporation shareholders, to deduct up to 20% of their QBI. However, the deduction is subject to limitations, including a cap based on the amount of W-2 wages paid by the business.

Section 280E disallows deductions or credits for amounts paid or incurred in carrying on a trade or business that consists of trafficking in controlled substances prohibited by federal or state law. This provision most commonly affects cannabis businesses, which, while legal under some state laws, remain illegal under federal law.

Key Issue

The central question before the Tax Court was whether W-2 wages for purposes of the section 199A deduction include all wages reported on Forms W-2, or only those wages that are deductible after application of section 280E. The petitioners, shareholders in S corporations engaged in cannabis sales, argued for the broader inclusion, while the IRS maintained that only deductible wages should count.

Court’s Analysis and Holding

The Tax Court conducted a detailed statutory analysis, focusing on the definitions and cross-references within section 199A:

• Section 199A(b)(4) defines “W-2 wages” and specifically excludes any amount “not properly allocable to qualified business income.”
• Section 199A(c)(1) defines “qualified business income” as the net amount of qualified items of income, gain, deduction, and loss, and section 199A(c)(3) further limits “qualified items” to those “included or allowed in determining taxable income.”
• The court concluded that wages disallowed under section 280E are not “allowed in determining taxable income” and therefore are not “properly allocable to qualified business income.” As a result, such wages are excluded from the “W-2 wages” calculation for section 199A purposes.

The court rejected the petitioners’ argument that all wages reported on Forms W-2 should be included, emphasizing that the statutory language and structure require a narrower reading. The decision also aligns with existing Treasury regulations, which limit “W-2 wages” to those associated with wage expenses taken into account in computing QBI.

Implications for Businesses

• Cannabis and Other Section 280E Businesses: Businesses subject to section 280E cannot include nondeductible wages in their “W-2 wages” calculation for the section 199A deduction. This may significantly reduce the allowable QBI deduction for such businesses.
• Statutory Interpretation: The decision underscores the importance of closely following statutory definitions and cross-references when determining eligibility for tax benefits.
• Consistency with IRS Guidance: The ruling affirms the IRS’s interpretation and provides clarity for taxpayers and advisors navigating the intersection of sections 199A and 280E.

Dissent

A dissenting opinion argued that Congress did not intend to exclude wages disallowed under section 280E from the “W-2 wages” calculation, emphasizing the job creation and rate reduction purposes of section 199A. However, the majority’s interpretation prevailed.

Conclusion

The Tax Court’s decision provides definitive guidance: for purposes of the section 199A deduction, only wages deductible after application of section 280E are included as W-2 wages. Businesses operating in industries affected by section 280E should review their QBI deduction calculations to ensure compliance with this interpretation.

For more information, please contact John G. Hodnette at jhodnette@foxrothschild.com, JT Schuweiler at jschuweiler@foxrothschild.com or a member of the firm’s Cannabis Law Practice Group.

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