In Savage v. Commissioner of Internal Revenue and Torres v. Commissioner of Internal Revenue, 165 T.C. No. 5, the Tax Court has ruled shareholders in S corporations subject to IRC Section 280E may not include wages paid to employees of those S corporations in the W-2 limitation used in calculating the IRC Section 199A deduction.

Facts

Ayla A. Savage and Patricia A. Torres, shareholders in three S corporations, filed income tax returns for tax years 2018 and 2019 reporting items related to the S corporations. On those returns, Savage and Torres claimed qualified business income deductions under IRC Section 199A for the income earned by the S corporations and passed through to them. To calculate the IRC Section 199A deductions, Savage and Torres treated as W-2 wages the amounts paid and reported by the S corporations without regard to whether those amounts were deductible in determining taxable income.

Because two of the S corporations are marijuana businesses, they were subject to IRC Section 280E, which disallows all deductions attributable to carrying on a trade or business consisting of trafficking in controlled substances, except for those expenses attributable to costs of goods sold. In calculating the IRC Section 199A deduction, the IRS asserted Savage and Torres should have only taken into account wages that were deductible after the application of IRC Section 280E; as a result, the IRS reduced their IRC Section 199A deductions.

Holding

For tax years beginning after 2017, an individual taxpayer may deduct: (1) 20% of qualified business income (QBI) from a partnership, S corporation or sole proprietorship; and (2) 20% of aggregate qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income. The deduction is not permitted with respect to certain specified service trades or businesses (SSTBs) above certain income levels. The 20% deduction may not be used in computing adjusted gross income and may be utilized both by non-itemizers and itemizers.

For taxpayers above certain income levels, the deduction is limited to the greater of 1) 50% of the W-2 wages with respect to the qualified trade or business, or 2) the sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.

IRC Section 199A(b)(4)(A) defines W-2 wages as amounts paid under IRC Section 6051(a) by a person for the employment of employees during the calendar year ending during the person's tax year. IRC Section 199A(b)(4)(B), however, limits W-2 wages to those wages that are "properly allocable" to QBI for purposes of IRC Section 199A(c)(1).

In turn, IRC Section 199A(c)(1) defines the term "qualified business income" as comprising, for any tax year, the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.

Finally, IRC Section 199A(c)(3)(A)(ii) provides that qualified items of income, gain, deduction and loss include only those amounts "included or allowed in determining taxable income for the year."

Because the wages paid by the S corporations subject to IRC Section 280E are nondeductible in computing taxable income, the Tax Court found those wages are not properly allocable to QBI under IRC Section 199A and, therefore, those wages are not W-2 wages as defined in IRC Section 199A(b)(4).

Accordingly, the court ruled that in computing the proper deduction allowed by IRC Section 199A, the IRS's disallowance of the deductions attributable to the wages paid by the S corporations subject to IRC Section 280E was consistent with the statutory text.

In a dissenting opinion, Judge Jenkins stated that W-2 wages as defined in IRC Section 199A(b)(4) should be "determined without regard to the application of [IRC Section] 280E."

Implications

Born as part of the Tax Cuts and Jobs Act in 2017, IRC Section 199A provides a significant effective tax rate reduction to many owners of sole proprietorships and pass-through businesses. While the IRS was quick and thorough in producing final regulations under IRC Section 199A, there remain many areas of uncertainty that tax advisers and taxpayers alike are eager to see addressed by the IRS and the courts, from the interpretation of what constitutes a SSTBs to application of the aggregation rules to the determination of whether an activity rises to the level of an IRC Section 162 trade or business for purposes of this provision.

The decision in Savage, however, represents the very first appearance of IRC Section 199A in the Tax Court, and while it may not address one of the more eagerly awaited issues, the conclusion in Savage is a very important one with far-reaching implications.

For certain high-income taxpayers, the deduction permitted by IRC Section 199A is limited, in part, to the "W-2 wages" paid by the business. Just because a business has paid W-2 wages, however, does not mean those amounts are deductible in computing the taxable income of the business. In Savage, the Tax Court interprets the statutory language of IRC Section 199A to require that any W-2 wages used by a taxpayer in computing the wage-based limitation must be deductible in arriving at taxable income. It does so by connecting three dots:

1. First, under IRC Section 199A(b)(4), for a W-2 wage to be included in the wage-based limitation, it must be "properly allocable" to QBI as determined in IRC Section 199A(c)(1).
2. Next, IRC Section 199A(c)(1) defines QBI as comprising the net amount of "qualified" items during the year, and
3. Finally, IRC Section 199A(c)(3)(A)(ii) requires that a "qualified" item be allowed in determining taxable income.

Thus, the Tax Court concluded, because nondeductible wages are not included in QBI, they are not "properly allocable" to QBI and cannot be included in the wage-based limitation.

In the immediate case, IRC Section 280E denied a deduction for a portion of the taxpayer's W-2 wages, but in other fact patterns, other provisions could do the same, leading to a reduced benefit under IRC Section 199A. For example, IRC Section 280C denies a deduction for any expenses used in computing certain credits, including the research and development credit and the (now-expired) employee retention credit. As a result, based on the Tax Court's conclusion in Savage, in determining the IRC Section 199A deduction for any taxpayer claiming these credits, the W-2 wages in the computation of the taxpayer's wage-based limitation would not include those amounts rendered nondeductible by IRC Section 280C.

In his dissenting opinion, Judge Jenkins argues that had Congress intended to require that all W-2 wages that are included in the wage-based limitation be deductible, it could have used the same language in defining W-2 wages in IRC Section 199A(b)(4) that it did in defining QBI in IRC Section 199A(c)(3)(A)(ii). Instead, however, IRC Section 199A(b)(4) merely requires W-2 wages included in the wage-based limitation to be "properly allocable" to QBI rather than "included or allowed in determining taxable income," as is required by IRC Section 199A(c)(3)(A)(ii) for the computation of QBI.

Offering an alternative interpretation of the statutory text, Judge Jenkins argues that the requirement in IRC Section 199A(b)(4) that W-2 wages be "properly allocable" to QBI simply reflects the reality that a taxpayer may conduct multiple businesses, some that generate QBI and some that do not, and that before QBI can be computed, all income and expense must be allocated among the business. Once a W-2 wage is allocated to QBI, Judge Jenkins argues, its inclusion in the wage-based limitation is not impacted by whether the amount is ultimately deductible in computing QBI.