This transcript has been edited for clarity.

David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: top 2025 tax cases, part two.

We're back this week with the second part of our 2025 top tax cases series. Damien Martin and Tony Nitti, tax partners at EY, will finish out their list in this episode.

This is a two-part series, so if you haven't heard part one, you can find that link in the show notes. You can also find both episodes on the Tax Notes YouTube channel.

All right, let's go to that discussion.

Damien Martin: What I like about this first deduction case — I guess it's our fourth case, technical case — is it also deals with an issue we haven't seen. Or I guess [Corri A. Feige v. Commissioner] was a situation where we don't see it often; this is one we have not seen.

[We're] dealing with section 199A. Again, we were talking a little bit earlier about changes we got on the Tax Cuts and Jobs Act, and we got a brand new section of the Internal Revenue Code there. So clearly it didn't have case law history, to the point that we needed the guidance and all that, and we spent the better part of a couple years there digesting and you and I talking about it and all that.

So now we have a case here that deals with an aspect of it that's pretty consequential. So Savage v. Commissioner. It's 165 T.C. No. 5. So what's going on here?

Tony Nitti: Yeah, like you said, this was going to make our list, whether it was a fun case [or a] not-fun case, because we've been waiting. We've been waiting around for a 199A case. Truth be told, it's probably not in the arena of 199A that we thought the first case would be.

Damien Martin: Fair.

Tony Nitti: But still, a fascinating case with, certainly, some far-reaching implications. So let's jump right in here.

I never want to bury the lede and presume everybody understands 199A. We'll do it in the most high-level way imaginable. But the hallmark of the Tax Cuts and Jobs Act, right, Damien, was dropping that corporate rate from 35 percent to 21 percent.

Damien Martin: That's right.

Tony Nitti: The individual rate only went from 39.6 percent to 37 percent. So if Congress had stopped there, all of a sudden, the pendulum would have swung in favor of being a C corporation because there's a much more substantial tax cut there than on the passthrough side, partnership, S corp, individual side, sole proprietorship.

And you would have been kind of pulling the rug out from under all these business owners who had carefully selected their structure to be a passthrough business because, historically, the owner of a passthrough business enjoyed about a 10 percent effective tax rate advantage over their C corp brethren.

So rather than pull that rug out from under the owners of S corps, partnerships, and sole proprietorships, Congress conjured out of thin air this 199A 20 percent deduction against qualified business income. And so, if suddenly, as the owner of an S corp, partnership, personal proprietorship, you're allowed to deduct 20 percent of your income from the passthrough business, you're not really paying tax at the top rate of 37 percent; you're paying tax at the top rate of 29.6 percent, so you're still enjoying a nice relative advantage over C corporations by virtue of that deduction.

The thing is, not everybody fully benefits from 199A on the passthrough side. We know that when the business owner's taxable income gets above a certain threshold based on marital status, that you start to lose the deduction if the business is engaged in what we call a specified service, trade, or business — doctors, lawyers, accountants, actors, athletes, performing artists, brokers, consultants, financial services, service-type businesses.

Damien Martin: Yeah.

Tony Nitti: And we probably would have imagined that our first 199A case would have been about that limitation.

Damien Martin: That's right.

Tony Nitti: What does it really mean to be in the field of health or financial services? Even though we did get some pretty darn detailed regulations that provide definitional guidance. This case is not about that piece; this case is actually about the second way we can start to lose the deduction. Because when our business owner's taxable income gets above those same thresholds, the deduction starts to be limited, in part to the W-2 wages paid by the business.

So as income gets above a threshold, the deduction gets limited to the greater of 50 percent of your share of the W-2 wages paid by the business, or alternatively, 25 percent of those same wages plus 2.5 percent of your share of the unadjusted basis immediately after acquisition of qualified profit. The question here is about those wages included in the limit. Specifically, does a W-2 wage have to be deductible in order to be counted towards that limit?

And just to plant a seed for later, Damien, I would ask you — and I don't mean to put you on the spot — but what was the policy reason you suspect for tying this passthrough deduction at least in part to W-2 wages paid by the business itself?

Damien Martin: Yeah.

Tony Nitti: And I'm not trying to trick you. What do you think?

Damien Martin: No, I think I've got a fairly safe bet here because, I guess, the informal or formal name of the bill: the Tax Cuts and Jobs Act. So hey, it's encouraging you to pay some W-2 wages, right? Let's get some people to employ some people, so it's encouraging jobs.

Tony Nitti: I think that's pretty much the stated purpose, not only of 199A, but the overarching theme, like you said, of the bill itself.

Damien Martin: Yeah.

Tony Nitti: We want to reward the job creators here.

Damien Martin: Right.

Tony Nitti: So I do think that's important to understand why that W-2 limit is there: The more people you hire, the more W-2 wages you pay, the more likely you're going to benefit from this deduction at the owner level. So we'll put a pin in that and we'll come back to it.

Damien Martin: Yeah.

Tony Nitti: So the facts in Savage. We're dealing with two S corporations — it doesn't really matter if it's one or two — that occupy a unique space in the tax landscape because these are businesses that sell marijuana.

So why is that unique? Well, because marijuana, while its sale has been legalized in many, many states around the country, it remains — much to your dismay — firmly on Schedule A of the controlled substance list. So it's illegal federally, and that matters greatly from a federal tax perspective.

Damien Martin: Indeed, it does.

Tony Nitti: Because we have section 280E. And remember earlier today, much earlier today, when we were saying if you're in the low 100s of the code, it's the good-news provisions? I always tell people, "If you're in the upper 200s, you're in the bad-news provisions." These are the ones where things are getting disallowed. And 280E disallows a deduction for expenses incurred in the business of trafficking in a controlled substance, and that's what marijuana is.

So what it does is it creates an extremely punitive environment, because it means that marijuana businesses, while legal from a state perspective, on their federal tax returns, they don't get to deduct all their general and administrative costs like everybody else does, including W-2 wages.

Now interestingly — it has nothing to do with the case here today — but even marijuana businesses are able to deduct cost of goods sold. And that comes from an old case called [Jeffrey Edmondson v. Commissioner] because it's a constitutional issue.

We talked about the 16th Amendment in section 61. Our modern income tax is exactly that: a tax on income, not gross revenue. So if any business, even an illegal business, were not permitted to deduct its direct cost of goods sold, there would be very, very sincere and severe constitutional challenges raised. So it doesn't matter if you're in the business of selling marijuana or the business of selling meth, you're allowed to deduct your cost of goods sold, which might surprise some people out there.

Damien Martin: Sure.

Tony Nitti: But that's just how it works.

Damien Martin: No, that is surprising and counterintuitive, but yes. But otherwise, though, what about your other costs? That's a little more tricky, other than your cost of goods sold. Yeah.

Tony Nitti: Yeah, so everything else gets wiped out. And they knew that. These S corporations, they weren't sucker punched by 280E. They did what they were supposed to do: They denied their deductions for the W-2 wages.

However, what that did was have the effect of increasing the taxable income that flowed through to them, which is a hard thing to do in that industry. You're basically paying tax on 100 percent of your revenue minus your cost of goods sold.

But they said, "Well, we have this higher passthrough income now, but at least we get to deduct 20 percent of that under 199A." And in computing that 199A deduction, they included all the wages they had paid in their W-2 wage limit, and the IRS said, "No can do." If the wages are not deductible, they shouldn't be in your W-2 limitation for purposes of computing your 199A deduction. And this is actually something, dude, that I have thought about a lot.

Damien Martin: OK.

Tony Nitti: And I'll tell you why: When we were going through the pandemic, I thought about this, and I was worried this would be how the courts would interpret it. I can sit here and tell you that I don't necessarily agree. It doesn't really matter.

Damien Martin: That's fair. Yeah, yeah.

Tony Nitti: I'm just a guy. But I'll tell you where I disagree and why I align more to maybe the dissent in this particular case. But anyway, let's get into it here. So the IRS said, "Wages need to be deductible to be included in the limit." Ultimately, the court agreed. Why? Strictly a matter of statutory construction.

So they started in 199A(b), specifically in (b)(4), and (b)(4) is looking to define W-2 wages for purposes of the list of limitation. And in (b)(4) it says, "Wages must be properly allocable to QBI under the meaning of 199A(c)." All right, so to be included in W-2 wage limit, it's got to be allocable to QBI under 199A(c)(1) and afterwards. So you jump down to (c)(1), that starts defining QBI, what it means to be QBI. And as you get further down it says, "To be in QBI, that item of income or expense must be allowable in determining taxable income."

So what they did is they connected those dots, D, and they said, "(B)(4) says W-2 wage has to be allocable to QBI under the definition of (c). And under (c), to be a part of QBI, an item needs to be allowable in determining taxable income."

So connecting those dots they just said, "If an item is not allowable in determining taxable income under the meaning of (c), then it doesn't fit into this definition of a wage under (b)(4)." So it was strictly a matter of reading that law, connecting those dots, and saying, "A wage can't be allocable to QBI unless it meets all these requirements for QBI, and one of those requirements is that the wage be deductible." So case closed.

Now I think there were 18 judges, ultimately, on this panel, and 17 of them agreed that the statutory construction led to the logical conclusion that a wage had to be deductible to be included in the limitation.

Damien Martin: Sure.

Tony Nitti: There was one dissent, which we'll get into in a minute. I think that was [Judge Rose E.] Jenkins. But right now, if you're sitting there going, "Tell me, Damien, why do I care? I don't work with the marijuana industry." And I know a lot of people do these days, so it may very well be a 280E issue where you see this.

When I was thinking about it, Damien, a few years ago, was when the pandemic hit and there was all those employee retention credit claims.

Damien Martin: Right.

Tony Nitti: Because the ERC, the credit was tied to the W-2 wages paid by the employer, and the credit made very clear that it was subject to the rules of 280C — so a couple letters over from 280E, but again, firmly in the bad-news area of the code.

And 280C says, "We're not going to give you a double dip. If you're claiming the credit based on deductible wages, we're not going to give you both the deduction and the credit." You have to add back your wages to an amount equal to the credit that you claim based on those wages. It makes sense. It's the no-double-dip provision.

But that's where my brain goes, because now I'm thinking about all those ERC returns where the wages were not deductible because 280C made them add it back by virtue of the credit. What were those owners doing from a 199A perspective with those W-2 wages? And if you were including those wages in your limitation, do you now have some exposure hanging out there? So that's a very common occurrence where we could see this. Potentially under the R&D credit stuff, too, I believe.

Damien Martin: Any time you've got to add back deduction, yeah, especially wages that are tied into 199A.

Tony Nitti: I'm going to get into that dissent opinion for a moment.

Damien Martin: Yeah, yeah.

Tony Nitti: Just for what it's worth — and it's not worth anything — this is how I saw it. Number one, it comes back to what you said earlier, the policy motivation behind the W-2 wage limit. We want you hiring people and paying wages.

How is that policy motivation not accomplished if you're paying wages just because some other section of the code comes in and causes those wages to be nondeductible? You still hired the people; you still paid the wages. It doesn't seem to necessarily be aligned with the motivation that you alluded to in the Tax Cuts and Jobs Act of rewarding job creators.

You've done the job, you've hired the people, you've paid the wages. You're just falling victim to whether it's 280E or 280C that's making those wages nondeductible, but is that something that should then end up limiting the 199A deduction? I struggle with that a little bit.

Damien Martin: Sure. It seems logical.

Tony Nitti: Then Jenkins, in the dissenting opinion, just offered a different interpretation of the statutory language. And we know, D, that an entity, a taxpayer, or whatever you want to call it, can have multiple different QBI businesses. They can even have a non-QBI-type business. But they can have multiple QBI businesses, and each one stands on its own unless it's aggregated under the 199A-4 regulations, but you could have multiple QBI lines.

So a basic step in the QBI world is, first, all your income and expenses have to be what? Allocated among your different lines of business. Some might be QBI producing, some might not. So what the dissenting opinion was saying was when they say in (b)(4) that the W-2 wages have to be allocable to QBI, the interpretation that was offered there in the dissent was it has to be when you go through your allocation among your businesses, something that's allocable to QBI, and then hard stop. You don't need to then read into each paragraph of (c) to say, "Well, it also needs to be deductible."

Because the argument was made if they needed it to be allowable in determining taxable income, they could have just said that in (b)(4). Instead, they said properly allocable, which the other 17 judges were interpreting as meaning you have to meet all requirements for QBI.

And here in the dissent, Judge Jenkins is saying, "No, no, no. I think all that matters is it be attributable to a QBI-producing element, and then beyond that we don't have to necessarily read into each requirement for QBI, including that the amount be deductible. I think that's reading into it almost too much." Allocate the wage. If it's allocable to a QBI entity, that's enough for the wage to be included in the limitation. Obviously, if the wage is not deductible, it won't be included in QBI, but that doesn't mean it shouldn't be in the W-2 limit.

Damien Martin: Yeah.

Tony Nitti: So honestly, it was 17 to 1, so take from it what you will. I always worried the interpretation would be the majority, and I always hoped the interpretation would be the dissent, and here we are.

Damien Martin: Yeah. But it even just goes to show you, I guess your earlier point, we're still bound to get cases on 199A related to the other things that maybe we would have anticipated. But even here, we had a revenue procedure — [Rev. Proc. 2019-11], I think — that deals with the wages.

Tony Nitti: Oh, yeah, yeah.

Damien Martin: And how to treat them and methods. Not the deductibility issue, but just the mechanics of it. And yet, we still have this fundamental issue that had to go to the Tax Court to be decided. It's kind of interesting. So maybe we'll see more to come on that, but quite fascinating nonetheless.

Tony Nitti: Like I said, I wouldn't have guessed that would be our issue in our first 199A case, but —

Damien Martin: Absolutely not. But I don't know. So you foreshadowed our fifth case here that we had an interesting interplay between code sections, so we'll see if it delivers what you're promising here.

But this is [Michael R. Kelly v. Commissioner]. It is a Ninth Circuit decision that we're looking at here, handed down back in June. It deals with bad debt deductions, cancellation of debt, related parties. Yeah, lay this one out for us.

Tony Nitti: Yeah, and as I'm known to do, my enthusiasm is now getting the better of me and I take back what I said earlier, and I think this might actually be my favorite case of this list.

Damien Martin: Oh, OK. I won't tell the other cases. We'll let it go.

Tony Nitti: It's awesome because we all encounter this fact pattern.

Damien Martin: Yeah.

Tony Nitti: Every one of us.

Damien Martin: Yeah, seriously, very much.

Tony Nitti: If you look through some of our other cases with the prison account and things, you might say, "Oh, I don't run into this every day." We all have clients who conduct business through a tangle of related entities, and they oftentimes are funding loans back-and-forth between the entities.

Damien Martin: Right.

Tony Nitti: And invariably, at some point they come to us for guidance and say, "How can I make all this go away, all these intercompany loans, in a pain-free manner?" And my advice has always been, "Find a way to just pay it off."

Damien Martin: Just pay it off, yeah.

Tony Nitti: Anything else you try to do, be creative, it all carries risk, and this case is a wonderful cautionary tale to that point. This is our first — I think this is our first case from the appeals circuit. This is a Ninth Circuit case.

Damien Martin: Yeah, yeah.

Tony Nitti: So the Tax Court case was loaded with goodies. The Ninth Circuit was just focused on a piece of it, and we can really simplify that piece.

We've got Kelly, who had this tangle of entities, and he, through a single-member LLC that was disregarded, made loans to a lot of these related entities. And it's much more expansive than this, but for our purposes we'll simplify it.

Imagine he's got two S corporations on the side and his disregarded entity loans $23 million to the S corporations. We have already established, D, that if I loan you money, you might feel richer, [but] you're not richer because you have to pay me back.

But if I come back to you in a week's time and say, "D, you look like you've fallen on some hard times, buddy. You need this money more than I do. Keep it, I don't want it back." Now the math has changed. That money I loaned you, you don't owe it back to me anymore.

Damien Martin: Right, my bill is gone. Yeah.

Tony Nitti: Now, the irony is you might not feel any richer because you might have already spent the money. It doesn't matter.

Damien Martin: Fair enough.

Tony Nitti: Under an old Supreme Court case called [United States v. Kirby Lumber Co.] and this freeing of assets theory, even if you spent the $100 I loaned you, or whatever it is, I can't remember my numbers now. But it was $100, I'm no more generous than that; that's the most you're getting out of me.

Damien Martin: I think you were going to give me $1,000 I think is what you said.

Tony Nitti: All right, fine.

Damien Martin: OK.

Tony Nitti: The $1,000 I gave you, even if you don't have it anymore, if you don't have to give it back to me, in theory it frees up $1,000 you may have elsewhere that you can now use.

So, eventually, codified in section 61(a)(11) is this concept that when you have debt that you owe forgiven, now you've got taxable income. So that's the basic premise here. So when income ends up being forgiven, income event under section 61(a)(11).

However, this freeing of assets theory might not always apply, because if I forgive your $1,000, in theory you have $1,000 elsewhere that you can now use for whatever you want, [but] you might be so underwater that it's not freeing up anything.

Damien Martin: Anything, it's already gone.

Tony Nitti: Yeah. It's not a happy day for you; it's just lessened the pain a little bit. So we have a host of exclusions under section 108 — we're back in the low 100s of the code, good-news provisions — 108 of the code where, even though you're recognizing this cancellation of debt income, you may not have to pick up the income on your federal tax return.

And we have exclusions for bankruptcy and for principal residences, but the one we're going to encounter most often is 108(a)(1)(B), which simply says, under this freeing of assets theory, if a debt is forgiven at a time when you are insolvent — the liabilities you have exceed the fair market value of your assets — you can exclude that income event to the extent of the insolvency. So there's actual math that has to take place. If you're $40 insolvent and you get $100 of debt forgiven, you're going to pay tax on $60. So you have this insolvency exclusion that can help wipe out your income.

So taking all that, we've got Kelly, and Kelly has loaned, as I said, $23 million to two S corporations. And year rolls around, he wants all this stuff to be done, and so he forgives the debt. He's in his individual capacity because it's through a DRE, forgives debt owed to his S corporations, and we all encounter transactions like this.

Now the S corporations have forgiven debt, so under 61(a)(11) they have cancellation of debt income, but they believe themselves to be insolvent, and so they can use the insolvency exception under 108(a)(1)(B).

Insolvency is interesting, D, because if you're an S corporation or a C corporation, that insolvency is measured at the corporate level. If you're a partnership or an individual, it's measured at the individual level, which it's harder to establish insolvency as an individual than it is at the corporate level.

So he's forgiven all this different debt around, so a lot of it is pouring out at his individual level because they're coming from partnerships, some of it at the S corp level. Long story short, he believes he can exclude all of it — the income at the individual level from the partnerships because he's personally insolvent, but more germane to our facts, the S corps.

He forgives the S corp income; he says the S corps are insolvent. They've got liabilities in excess [of their assets], so I'm going to exclude the income there. But that's one side of the equation. He has forgiven debt, that party has recognized the income as they're required to do, they've availed themselves of 108(a)(1)(B) as they're entitled to do, they're not going to pay tax on that income. But what about the other side? The deduction side?

Damien Martin: I was going to say we got back to income, but it shows the interrelationship here.

Tony Nitti: Yeah.

Damien Martin: But all right. So the deduction side, what do we got there?

Tony Nitti: So if I made that loan to you of $1,000, D, and now you're not paying me back, I'm not getting $1,000 back.

Damien Martin: Right.

Tony Nitti: I'd like some kind of tax benefit. And fortunately for me, [section] 166 allows for a bad debt deduction. But it's a tricky area of the law. There are two distinct types of bad debt deductions. The one that you generally prefer is what we call a business bad debt. And a business bad debt you prefer because it's, one, ordinary income. Two, you can claim a partial bad debt deduction, so the debt doesn't have to be entirely worthless. But it's hard to establish that something's a business bad debt. It really needs to be a loan that's made as part of being in the business of making loans, or it needs to be a loan made as part of your operating business. It's a hard standard, particularly for an individual to achieve.

If you can't get to a business bad debt, you can get to a nonbusiness bad debt — not nearly as attractive because a nonbusiness bad debt generates a short-term capital loss, but still attractive.

So Kelly forgives this $23 million of debt, the income gets wiped out under the insolvency rule, but he claims a $23 million — it actually ends up being $87 million when you compare it to all the other entities, but we're just focused on the debt to the S corp today — he claims a $23 million bad debt deduction short-term capital loss at the individual level.

And the IRS comes in and says, "We don't think you're entitled to this deduction." Why? I love this. But first thing's first, what do you need to have a nonbusiness bad debt? The debt needs to be truly a debt. There's so much ambiguity in the tax law. Is it a debt, is it equity? And even in the Tax Court case, some of his debt was not viewed as a debt, but it needs to be respected as a debt for federal tax purposes. This debt was fine.

Number two, you have to establish you have a basis in the debt to claim the deduction. That wasn't a problem here, either.

But number three, with a nonbusiness bad debt, you have to prove the debt went entirely worthless during the year — entirely worthless. So there's no partial worthless — entirely worthless. And this is where, you don't want to use the word semantics [as] being the thrust of the case, but how you interpret a couple words makes all the difference. Because in Kelly's mind, "My debt is worthless. How do I know it's worthless? Because I forgave it. I'm never getting it back. I discharged that debt; it's never coming back to me. There's no greater proof that this debt is worthless to me because I'm not going to be able to collect it because I'm not even trying to collect it."

And you can probably already see where the problem lies, D, is the IRS and the courts said, "Hold on a sec. You're using two words interchangeably, worthlessness and discharge of debt." Or if you want to keep it simple, worthlessness and forgiveness. And those are not the same thing. Forgiving a debt is a choice that you made. You unilaterally say, "I don't want to collect that debt." That's on the income side and they picked up their income. To get a deduction, it needs to be objective. There's a Supreme Court case called [Whipple v. Commissioner] that talks about this objective standard. We need proof that there's worthlessness here.

And keep in mind, worthlessness is not the same as being insolvent. You can be insolvent but still have plenty of assets, just not enough assets to wipe out your debt. But you're conflating these topics and thinking because you discharged [debt voluntarily], that that means it's worthless. No. We need to know that it's worthless.

And they said something I loved, Damien. They said, the bad debt deduction under 166 is kind of supposed to make a taxpayer whole the same way a casualty loss does under 165. But allowing the taxpayer to make loans between related parties, decide what year they want to make them go away, and be able to claim a bad debt deduction in that year and control the timing would be akin to giving a casualty loss deduction to someone who burns down their own house.

So I get where they're coming from. It's a little harsh, but the point is you chose to forgive it. You have not proven to us that you couldn't have collected something if you wanted to. And in fact, you have shown that while insolvent, these S corps had value, and so your debt was never worthless under the definition of 166. So goodbye, $23 million — or actually $87 million — short-term capital loss for a bad debt deduction.

And I love cases like this. I love cautionary tales where you can use it to just scare people straight and make sure you understand that, yeah, when we create these loans, it's so easy to do, it's so hard to unwind. And you really want to be able to unwind it the natural way, which is paying these loans off. Things that you start doing to get creative, whether it's contributing debts to capital or making journal entries, all of it can lead to a bad place.

Damien Martin: Yeah.

Tony Nitti: Now we have a perfect example.

Damien Martin: I think the big takeaway — and I do agree, it is helpful to be able to, when these issues come up, to be able to point to something. That's why I think this case is really — OK, maybe it is a favorite. You could crown it that.

Because one is, I think there is — and maybe there's some level of you try to apply a logic or intuitive whatever that OK, it's a bad debt, it's gone. I should be able to write off a little. Well, yeah, but there is no partial nonbusiness bad debt. It's in the regs.

Tony Nitti: Right.

Damien Martin: It's not unclear.

Tony Nitti: Yeah.

Damien Martin: But I think there's this notion that, "Oh, I can write it down," because you get that concept in other areas when it's not a nonbusiness bad debt.

Tony Nitti: Yeah.

Damien Martin: But I think it also just goes back to your point of it's almost like one of those — you read enough cases, you apply enough facts and circumstances. Whenever you feel like you're in a spot where the taxpayer can maybe game the system or you feel like you've found a spot, that's where I think the alarm bells start to go off and say, "Well, maybe something's not landing right, maybe there's an issue here." I think that's really what we're saying here, is these two standards are not the same. Because if they were, you'd end up — yeah, you could pick and choose and burn down your own house, so to speak.

Tony Nitti: An $87 million bad debt deduction with no corresponding COD pickup because of insolvency.

Damien Martin: Yes. It violates the basic tenet of the tax law. It's not a "heads I win, tails I win, too."

Tony Nitti: Yeah.

Damien Martin: Those are not the types of situations that you want to find yourself in. There are those. Again, that's not an over-the-top statement, but that's just a general, my gut-check reaction. I start reading the case, "Where is this going?" That's the kind of thing.

You start to see those facts where it's like, "Hey, it looks like there's some gamesmanship going on here," whether intentional or not. Or maybe even just the opportunity. Well, then maybe there's an issue.

Tony Nitti: Well, you and I, last year we talked about the [Ju et al. v. USA] case from a 1202 perspective.

Damien Martin: Yeah.

Tony Nitti: And we said that was a good cautionary tale. And let me tell you, I use that as a cautionary tale all the time in the QSBS space, telling people, "Hey, this case shows us we got to crunch some numbers, we got to show the math." So it's wonderful to have cases like this in your back pocket.

Damien Martin: Yeah. And again, another good reminder: Go back and check out the last episodes of the podcast here.

Tony Nitti: That's all I'm doing, it's shameless self-promotion.

Damien Martin: Exactly. All right. Well, we're at our sixth case here. We got to bring it full circle here in our deduction — our third deduction case, Weston v. Commissioner. That's T.C. Memo 2025-16, it came out back in, I think, February. So what was the situation here?

And again, to your point, I don't know, this interplay of code sections or how things work around deductions, I love this case for that reason. Yeah, set us up. What are the facts, what are the code sections, what's the takeaway?

Tony Nitti: Well, this case, D, it's artistry. Why? Because we started the day on the income side, differentiating income from three possible exclusions. Now we bookend that with our final case on deductions, where the taxpayer is arguing for three alternative ways to claim a deduction. It is artistry, the circle of life the way it all comes together.

Weston, I'll try to keep the facts as simple as possible because there are, I won't say moving parts, but there's a lot of noise happening in the facts section. But pretty simple. You got a guy out in California, and he makes a business acquaintance, and that acquaintance is aligned with a large national firm that flips houses, and he invests some money, and things go well.

Then that individual that was aligned with this large firm that Weston had been working with comes back to him in his individual capacity, no longer aligned with the big firm, and said, "Hey, let's do this just you and I now."

And what they're doing is, Weston's in California, but this other fellow, he's in Indiana, and he wants Weston to finance this business where they're going to buy up a bunch of homes in Indiana, they're going to flip them, make some money.

So Weston agrees to fund these acquisitions of these homes and fund the necessary renovations, and so on and so forth. And this is really important to our decision here: They strike a deal where Weston will get his cash back first, plus a small return — 7 to 8 percent — and then everything else will be split 50-50.

And again, not to put you on the spot here, D, but if you and I agree to share profits 50-50 after a preferred term, what would we kind of call that in the tax law for the most part?

Damien Martin: Partnership? You're sharing expenses, right? Yeah, yeah.

Tony Nitti: You're undefeated today. Yeah, you're undefeated. Well done.

Damien Martin: I was getting nervous on that one. I didn't want to blow my streak.

Tony Nitti: They didn't come up with a partnership agreement.

Damien Martin: No. No, they didn't.

Tony Nitti: They didn't talk to partnership attorneys, but I do think that's relevant. I agree with what you said, that that's probably how it's best viewed. So in addition, this guy in Indiana has a second business that's going to do knocking structures down. Basically, just cleaning house on property and getting things ready to demolish.

Damien Martin: Demolition.

Tony Nitti: We'll just call it that. And he wants Weston to finance all of that, as well. So the years become important here. So late 2016 into 2017, he's the finance arm of this whole thing.

So he's sitting in California and he's firing off checks for both of these businesses, and they're buying houses and they're renovating, and they're doing the demolition business, for lack of a better word. It's going to drive me nuts now, not thinking about —

Damien Martin: Excavation maybe?

Tony Nitti: Yeah, let's go with that. Let's go with excavation. So he's funding both of these businesses, just cutting checks.

And interestingly, a woman he worked with in California was visiting Indiana and went by one of these properties that she knew she had been cutting checks to for renovation, and she's like, "I don't see anything happening here." This is at the end of 2017. So she starts getting a little bit worried that maybe this money is not being put to its intended use.

Weston gets a little bit worried, too, but he's in California; he doesn't have enough really to go on. He trusts this guy. He does start reaching out and saying, "Something doesn't feel right," but he's still cutting checks, and he's cutting checks well into 2018. He cuts off the house flipping business a little bit sooner than the excavation business — that one he keeps financing well through the end of 2018.

But eventually he realizes that money that this guy in Indiana is collecting that should be going back to him is going into this guy's pocket. He can just tell that this deal is not going well, and eventually he cuts all ties with this other person. And in 2018 they start selling off some of the houses that they had acquired, just trying to liquidate this whole investment that's gone bad. At one point, he sends an email to the guy and says, "It's going to take me years to dig out from what you did to me here."

So as 2017 is coming to a close, he has his assistant just type up a spreadsheet of every dollar he's contributed to these two businesses, and it comes out to, I think, in the neighborhood of $2.1 million. And he deducts that $2.1 million on his federal tax return for 2017, and the IRS comes in and denies the deduction.

And just like the mirror image here of Cantor Fitzgerald, he puts forth three alternative arguments for why he should be able to deduct the $2.1 million that he put into this venture throughout 2017, even though some of it related to different years, but just by a little bit. And he goes zero for three, D. He puts forth three arguments.

Number one, that these are ordinary and necessary trade or business expenses deductible under [section] 162. Alternatively, if that doesn't float your boat, this is just a business loss under [section] 165(c)(1). If that doesn't work, I was robbed — this is a theft loss under [section] 165(c)(3).

So take them one by one and it's not as difficult, and it doesn't require as much analysis maybe as the income side did on Cantor Fitzgerald. But this notion that these were ordinary and necessary expenses of carrying on a trade or a business — 162, it is the corollary on the deduction side to 61. It's — most of our deductions that are conjured up into the tax code are going to fall under 162 because, like I said, it gives you a deduction for ordinary and necessary expenses of carrying on a trade or business.

So the big question, of course, is what's a trade or business? And it's a question we have to encounter a lot in the modern tax law, because so many new things are tied to carrying on a 162 trade or business. Opportunity zones, 199A, they all want a 162 trade or business, and so we need to know when do we or when don't we have a 162 trade or business.

And I have always said, to me, it's like what the Supreme Court once said about pornography: You may not be able to define a 162 trade or business, but you tend to know it when you see it. It's like, you've got a dental practice that's open six days a week, you can feel pretty comfortable it's a trade or business, but it's not always that clear.

So once again we look at the Supreme Court, in this case in a case called [Groetzinger v. Commissioner], which I imagine you and I have talked about on this podcast before.

Damien Martin: No doubt, yes.

Tony Nitti: But Groetzinger really lays out three requirements to be conducting a trade or business. Number one, the activity needs to be entered into for profit. Number two, it needs to be conducted in a regular, continuous, and substantial manner. It can't be sporadic; it can't be a hobby. And then third, you can't simply be managing your own investments. That comes from another Supreme Court case called [Higgins v. Commissioner].

So here, they said, "We got a problem. You want to claim a 162 deduction here, but that's only available to you if you were conducting a trade or business." And what did we establish, Damien? That Weston is sitting in California and he's cutting checks to somebody in Indiana, and it looks more to you and I like he was making a contribution to a partnership.

Damien Martin: Yeah.

Tony Nitti: So that's where the court was focused. They said, "You're not engaged as is required under Groetzinger in this activity on a regular, continuous, substantial basis. You're just cutting checks, and you have said here in your testimony that you viewed yourself as more of an investor into this business. So these expenses that you're cutting checks for, they're not ordinary expenses, at least not to you. They're going presumably into an investment that may be using them for business deductions, maybe not; we'll have to see that next.

But what you're doing here is what they said in Higgins is not a trade or business. You're managing your investment in, really, capital assets. So there's no avenue to give you a 162 deduction at the Weston individual level because all you've done is make investments, and we know that managing your own investments is not a 162 trade or business." Which I think is the right answer.

Damien Martin: Right, I would agree. And to your point, and obviously we have to go and split these because we have to look at Groetzinger, we have to look at Higgins, because the term is not defined in the code or the regs.

Tony Nitti: Yeah.

Damien Martin: So therein lies why it's such an interesting fundamental core issue, because it's used all over the place, it's referenced all over the place, but you know it when you see it, I guess. OK. Yeah, they worked through that, applied Groetzinger and said, "OK, this doesn't look like a trade or business."

Tony Nitti: So then, I think he takes what is a logical next step and says, "All right, I see what you're getting at here: service. You're saying I put my money into what's probably best viewed as a partnership. So maybe these weren't trade or business deductions of mine, but they were deductions of the partnership that generated a loss for the partnership that should then be allocated back to me, and so I should be able to claim a trade or business loss under 165(c)(1)." The issue you run into there — aside from allocation questions, like why would he be getting 100 percent? And maybe he should; he's the one who fronted all the money. Who else would it go to?

The bigger issue here is, OK, if we follow this logic and say your money was put into a partnership and then the partnership paid these expenses, not all expenses when paid are treated equally. We have to look at, what were they paid for?

We talked about, in Cantor Fitzgerald, about deductible expenses like rent and things like that, but we have one of those bad-news provisions, [section] 263, upper 200s. 263A in specific says if your expenses are acquiring an asset or creating an asset that you're going to benefit from beyond the end of the tax year, you don't get to expense that. That's a capitalized cost because you are going to benefit beyond the end of this year.

So all of these costs incurred in the property flipping business, they all went into the basis of homes. You don't get to deduct those when you pay it; you'll recover the basis when you sell the homes, which you started doing in 2018.

So even if we follow your logic and say, "These are expenses incurred by a business which are ultimately attributable back to me as a business loss" — whether it's through a fictional [Schedule] K-1 allocation or however he wanted to come up with it — bottom line is those expenses when paid were going to capitalized assets in the flipping business. The excavating business, it wasn't quite as clear because some of those could be ordinary costs. Others might be for capitalized assets, like an excavator, which featured prominently in this case.

And the point is the court said, "You can't establish for us which costs went to deductible costs, which ones didn't, and so we're going to deny you a deduction under 165(c)(1) as well, at least until such time that you start disposing of the assets in the business, and then you'll recover your cost."

Damien Martin: Right, it's timing. It's not saying pay forever. But it's, right, to be able to deduct it currently, it's like you say, you got to be able to show that you didn't have to capitalize it. OK, so that was a dead end, I guess?

Tony Nitti: Yes.

Damien Martin: All right. Where did they go next? What was the third direction they went? I guess you already spoiled us, that we maybe know where this is going.

Tony Nitti: Yeah.

Damien Martin: Not in Weston's favor here.

Tony Nitti: So we said this a long time ago, the opposite corollary on the income side.

Damien Martin: Yeah.

Tony Nitti: There's no deduction unless something specifically says you can.

Damien Martin: That's right.

Tony Nitti: And losses are covered by 165. And for an individual, losses are really limited to those things in 165(c)(1-3).

(c)(1) we already talked about: losses from a trade or business. (c)(2) is losses from an activity entered into for profit, so what we would call a 212 activity. That's why you get to deduct capital losses. If you sell an investment that went bad in your stock portfolio, you get to take it because of 165(c)(2).

Then there's 165(c)(3), which is more of the "act of God" section. Casualty loss, we've already alluded to.

Damien Martin: Yeah.

Tony Nitti: A shipwreck, we see that in there. Fire. Theft. Well, here he's saying theft is what matters. "I was robbed by this guy. So 165(c)(3), as an individual, allows me to only claim certain narrow types of losses, but one of them is for theft, and clearly I was robbed here." And this is such a difficult thing to establish.

Damien Martin: It really is.

Tony Nitti: You get to claim the theft loss in the year of discovery. And the timing of theft stuff has always tripped me up. I find it so — it puts the taxpayer claiming the theft loss in such a tough position. But yeah, what matters here is the year of discovery. And remember, he's claiming this loss in 2017, when the reality is, as we're going to see, he continued funding these businesses until well into 2018, in the case of the excavating business.

So the court looked at all the facts and said, "Look, bottom line is, we go over this a lot: If somebody wants to allege they've suffered a theft loss, it really would be helpful if we could see some criminal charges filed under state law. Because instead, everything you're doing here, it's just anecdotal. And you're telling us what this guy did, and we believe you what he did, but it doesn't look great that if he was ripping you off, you kept cutting checks to him, kept cutting checks to him."

So they actually said, "We view this more as a matter of incompetence or mismanagement by this guy than outright theft. So whether we question whether a theft existed or whether we agree that a theft existed, but it wasn't discovered in 2017 because you kept making payments in 2018, either way you're not getting the deduction in 2017."

Damien Martin: I love doing this, Tony, with you. We've got to thank Tax Notes, got to thank our listeners here for hanging with us, because I do think that it's conversations like these, it's reading the tax cases, the tax law, digging in, that's where the interesting part of the job — if you want to call it that, the profession — it lies.

So again, I guess we're getting a little bit of a tone here on why we love what we do so much and encouraging others. It certainly is — it's fascinating and really why I love what I do.

I don't know, any other closing thoughts you have there, Tony, to leave everyone with?

Tony Nitti: Well, I'll just close by echoing your sentiments. I think we very naturally found a home here at Tax Notes.

Damien Martin: Yes.

Tony Nitti: This is where people geek out on stuff like this. Very grateful to them.

Damien Martin: Yes.

Tony Nitti: I just count the days until we get to do it again next year.

Damien Martin: You've got it.