Tax Court Limits Cannabis Pass-Through Deductions

The US Tax Court’s Recent Decision in Savage v. Commissioner (165 TC 5) struck a blow to the cannabis industry which already receive unfavorable tax treatment.   Section 280E of the Internal Revenue Code already prevents cannabis businesses for taking deductions for items most other businesses can claim deductions for such as employee salaries, rent, and utilities expenses.  The Savage decision now limits cannabis businesses ability to claim pass-through deductions.

Pass-through entities such as S-Corporations, LLCs, sole proprietorships, and partnerships may qualify for a pass-through deduction under Section 199A of the Internal Revenue Code of up to 20% of the pass-through entities’ income.  Not every business can claim the full 20% deduction.  The pass-through entity’s Section 199A deduction is limited by the greater of

• 50% of its W-2 wages OR
• 25% of its W-2 wages plus 2.5% of its unadjusted basis in its property.

In Savage, the Taxpayers were S-Corporation shareholders of cannabis businesses.  The Cannabis business was not allowed to claim a deduction for W-2 wages paid to their employees under Section 280E.  At issue is whether the W-2 wages the cannabis business paid to their employees could be used to calculate the size of the business’ pass-through deduction.  The majority of the Tax Court held the Cannabis’ business W-2 wages could not be used to calculate the pass-through deduction.  This reading of Section 199A puts the pass-through deduction largely out of reach of many cannabis businesses. 

In Savage, the Majority Opinion looked to a couple of phases in Section 199A to reach its conclusion.  The court points out the statue’s definition of the term “W-2 wages” excludes any amount which “is not properly allocable to qualified business income.”  The court goes on to point out the definition of “qualified business income” includes items of income or loss that “are included or allowed in determining taxable income for the taxable year.”  The Majority opinion reasoned the W-2 wages the cannabis business paid its employees did not meet Section 199A’s definition of W-2 wages because they could not be used to determine taxable income under Section 280E (the section that prevents Cannabis businesses from claiming most deductions). 

It should be noted the Majority Opinion’s reading of the statute is likely not helpful for a cannabis business that claims a large pass-through deduction based on the basis of property it may hold such as expensive equipment or real estate.  The statute limits the deduction to 2.5% of the basis of “qualified property.”  The statute defines “qualified property” as “subject to the allowance for depreciation.”  However, Section 280E prevents cannabis businesses’ from claiming most deductions (including depreciation deductions).

There was a dissenting opinion in the case.  Among other things, the dissent points out that Section 199A specifically limits certain businesses such as law practices and medical practices from claiming the pass-through deduction.  The statute makes no mention of cannabis businesses or any other business subject to 280E.  It remains to be seen whether the Taxpayers in the Savage case will appeal the ruling (perhaps backed by their colleagues in the industry who have a high potential stake in a favorable ruling at the Court of Appeals). 

As we pointed out in previous posts, the Internal Revenue Code does not do any favors for Cannabis businesses.  Not only are they prevented from claiming deductions such as rent, salaries, and utilities – they are now limited in claiming the pass-through deduction.  Cannabis businesses that claimed the pass-through deduction may need to look into filing amended returns or revisiting their tax plans.

RJS LAW and its experienced attorneys provide tax planning (domestic and international), audit representation, and other tax related services to individuals and for businesses across a wide spectrum of industries.   We provide representation before the IRS and other taxing agencies such as the CDTFA, Franchise Tax Board, and EDD.  For a free consultation, please contact us at RJS LAW or by telephone at 619-595-1655. 

Written by Joseph Cole, Esq., LL.M.