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IRS ruling strikes fear in medical marijuana industry

John Brecher / msnbc.com

Steve DeAngelo of Harborside Health Center

In a potentially crushing blow to the burgeoning medical marijuana industry, the IRS has ruled that dispensaries cannot deduct standard business expenses such as payroll, security or rent.

Harborside Health Center, one of the nation's largest medical marijuana dispensaries and considered a model for the industry, is on the hook for $2.5 million in taxes from 2007 and 2008.  That is $2 million more than the Oakland, Calif.-based company paid for those tax years.

“I see only two outcomes here,” said Steve DeAngelo, director and chief executive of Harborside. “Either this IRS assessment has to change or we go out of business. There really isn’t a middle ground for us.”

DeAngelo says the ruling will likely be appealed. He has 90 days to respond to the ruling.

The IRS ruling is based on an obscure portion of the tax code -- section 280E -- passed into law by Congress in 1982, at the height of Reagan administration’s “war on drugs.” The law, originally targeted at drug kingpins and cartels, bans any tax deductions related to "trafficking in controlled substances."

Although 16 states and the District of Columbia have passed laws allowing medical use of marijuana, the federal government still considers it a Schedule I drug, the most restrictive category with the harshest penalties.

The Internal Revenue Service refused to comment on the specific case, but letters sent from Andrew Keyso, IRS deputy associate chief counsel, to some members of Congress spell out the official position:

“Section 280E of the Code disallows deductions incurred in the trade or business of trafficking in controlled substances that federal law or the law of any state in which the taxpayer conducts the business prohibits. For this purpose, the term “controlled substances” has the meaning provided in the Controlled Substances Act. Marijuana falls within the Controlled Substances Act.”

The news has spread rapidly through the cannabis community and is likely to have a chilling effect on businesses.

“We are all a bit nervous and frustrated,” said Ken Estes, owner of Patient To Patient Group Collective in San Jose, Calif. “We have tried to comply with every city, state and federal law. We ask for input from all the agencies. But we are still being punished for operating a legitimate business.”

Harborside, which celebrated its fifth anniversary Monday, serves 94,000 patients with 84 full-time employees and brings in about $22 million in annual revenue. According to DeAngelo, the center, set up as a not-for-profit business, pays about $1.1 million in taxes to the city of Oakland, $2 million to the state of California and $500,000 to the federal government.

“We have no complaint about the taxes we pay," DeAngelo said. "We are doing our part. All we ask is that we be treated like any other business enterprise. To treat us like criminals is simply wrong. Drug kingpins and cartels don’t file taxes. We do. But no business, including ours, can survive if it is taxed on its gross revenue. The IRS is trying to tax us out of existence.”

Keith Stroup, legal counsel and founder of NORML, the nation’s largest marijuana advocacy group, says the IRS ruling is likely to  stifle the quasi-legal industry and force people back onto the black market.

“You know, Al Capone was taken down by the IRS, not by the FBI or the police. And I can assure you that Steve DeAngelo is no Al Capone,” Stroup said.

Stroup believes the move also could make it more difficult for the medical marijuana industry to capture significant capital investment. Medical marijuana is now a $1.7 billion market, according to a report released this year by See Change Strategy, an independent financial analysis firm that specializes in new and unique markets. The figure represents estimated sales of marijuana through dispensaries in states with medical marijuana laws.

Although the IRS declined comment, Stoup says NORML has received e-mails from other dispensaries that are currently being audited and will likely receive similar rulings. “Harborside is one of the biggest, so that is why the IRS targeted them first,” Stroup said. “But there are other dispensaries that will suffer the same fate unless Congress acts.”

Some members of Congress have taken up the cause.

Reps. Pete Stark, D-Calif., Barney Frank, D-Mass., and Jared Polis, D-Colo., have introduced legislation to ensure the medical marijuana industry is treated like any other business.

Two Republican presidential candidates — Ron Paul and Gary Johnson — also support the legislation.

Stark’s bill, the Small Business Tax Equity Act, authorizes medical marijuana dispensaries to take the full range of business expense deductions.

“You’d think that a time of record budget deficits that the IRS would be happy that a legal business is doing the right thing and paying its taxes," Polis said. "Instead, the IRS seems intent on destroying a successful and legal business that creates jobs and strengthens our economy."

The confused legal situation is “an un-American  loop of nonsense,” says Jerome Handley, a tax attorney in Oakland who has more than 100 clients in the medical marijuana industry. “My advice to my clients is simple: Document everything … and stay out of the spotlight.”

William Panzer, an Oakland  tax attorney who helped author California’s medical marijuana law, Proposition 215, also successfully fought the IRS in a similar case in 2007.

In that case, U.S. Tax Court Judge David Laro declared that Californians Helping to Alleviate Medical Problems (CHAMP), a medical marijuana provider, could deduct the majority of employee costs as caregiving expenses. The IRS sought $426,000 in back taxes and penalties, but CHAMP ended up paying a tax assessment of less than $5,000.

“This law is not about protecting citizens from criminals. It is a concerted effort by the federal government to crack down on a legitimate business,” Panzer said.

DeAngelo points out the apparent craziness of the law. “The IRS allows me to deduct my cost of purchasing cannabis, which is the controlled substance they say is illegal. But I can’t deduct my payroll or my rent? That, clearly, defies logic and common sense.

"Besides," DeAngelo added, "have you ever heard of a drug trafficker that actually files a tax return? Me neither."