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."