California Weed

Millions at stake in IRS audit of Oakland medical marijuana dispensary

Harborside Health Center proclaims itself the world's largest marijuana dispensary. For certain, it is California's most ambitious – a holistic care center with a naturopathic physician, acupuncturist, chiropractor, yoga instructors and therapists in "universal life force energy."

Its Oakland facility handles $22 million in annual medical marijuana transactions.

Now Harborside is attracting scrutiny from the Internal Revenue Service. Since last year, the IRS has been auditing 2008 and 2009 federal tax returns for the Oakland location, one of two outlets Harborside operates for 70,000 medical marijuana users. The other facility is in San Jose.

The outcome may eventually establish whether U.S. tax authorities treat medical marijuana as a legitimate enterprise or illicit drug trafficking.

IRS tax code passed during the Reagan administration to keep drug dealers from making business deductions could cost Harborside millions of dollars in tax deductions for salaries, overhead and the expenses of buying and furnishing medical pot.

Steve DeAngelo, Harborside's director, said the IRS has been examining the nonprofit dispensary's books for months and has informed him it is being audited for compliance with IRS code 280E, which covers rules for "expenditures in connection with the illegal sale of drugs."

While the IRS would not confirm or deny the audit, Harborside is lobbying Congress to change the code for dispensaries in states where medical marijuana is legal. Marijuana remains an illegal narcotic under federal law.

"We're ... objecting to the fact that something designed for cocaine kingpins is being applied to licensed medical cannabis facilities following state law," DeAngelo said.

He said Harborside and other California dispensaries – which currently pay more than $100 million in state sales taxes in addition to local fees – may be in peril if the IRS rigidly enforces its tax code.

Donald Heller, a former Sacramento federal prosecutor of narcotics cases, said DeAngelo has cause to worry.

"I'm sure the IRS is going to aggressively pursue this," he said. "Because, under federal law, you cannot deduct something that is illegal."

Center cites 2007 California case

Harborside is banking on the precedent of another California case, in which the IRS tried – and failed – to win a $426,000 judgment for back taxes and penalties against a San Francisco medical marijuana provider, Californians Helping to Alleviate Medical Problems Inc.

In that 2007 case, U.S. Tax Court Judge David Laro declared that the organization, known as CHAMP, was both a marijuana provider and a "caregiving" service offering counseling, food and other support for AIDS patients. He ruled that CHAMP could deduct the majority of employee costs as caregiving expenses.

In court documents, Laro said the IRS conceded that tax code 280E didn't apply to "the costs of goods sold." CHAMP's attorney, Matthew Kumin, said that meant its biggest expense – $575,000 for marijuana – was deductible.

He said CHAMP ended up paying a tax assessment of $4,905.

Kumin argues the IRS can go after the costs of speed boats or airplanes of drug traffickers but not marijuana at California dispensaries if the outlets document what they pay to acquire or cultivate pot for medical users.

"You can deduct the costs of the medicine so long as you show the IRS you paid for it," Kumin said.

But he said the Harborside tax probe highlights "the continuing incongruity between federal and state law" for marijuana.

Heller said the IRS is under no restrictions in auditing dispensaries, even as Attorney General Eric Holder declares the U.S. Justice Department won't prosecute legal marijuana operations in states permitting medical use.

"He (Holder) can decide what to prosecute and not prosecute," Heller said. "On the other hand, he cannot tell the IRS how to discharge its responsibilities."

The Harborside tax probe comes as Oakland draws federal attention over a city proposal to license industrial-scale cultivation warehouses for medical marijuana. The Oakland City Council is revamping its plan after warnings it could have violated California laws governing distribution of medical marijuana and triggered federal raids.

The IRS would not discuss how it views medical marijuana. "Any official comment that is made is going to be perceived as a confirmation (of the Harborside audit)," said IRS spokesman Jesse Weller in Oakland. "That's why we're not going to comment."

Center seeks Congress' help

Last November, Harborside's chief financial officer, Luigi Zamarra, wrote U.S. Sen. Barbara Boxer, arguing for changes in federal tax law for medical marijuana.

"The Internal Revenue Service has begun to audit the tax returns of cannabis dispensaries that are legally operating," Zamarra wrote. He said the IRS was seeking to "disallow many ordinary and necessary business expenses. This is simply unfair."

It is unknown how many California dispensaries file federal tax returns. Under state law, they must operate as nonprofits but pay state sales taxes. Some cities, including Oakland, have imposed local pot taxes as well.

Allen Davenport, an analyst for the California Board of Equalization, said the tax agency has conducted audits of about 40 dispensaries and notified hundreds more they must have proper sellers' permits and sales tax records.

DeAngelo, who said Harborside pays more than $2.3 million a year in state and local taxes on marijuana transactions, said there was never a question about filing federal tax returns.

"The whole idea of Harborside is to be a model of legitimacy and transparency," he said.

Heller said legal disputes over tax deductions for delivering medical marijuana may reach America's highest court.

"I have a good idea what the Supreme Court would do," Heller said. "It would uphold the IRS code that it is an illegal deduction."

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