MARIJUANA DISPENSARIES ARE FACING NEW SCRUTINY

Medical marijuana dispensaries try hard to maintain the appearance
that they are nonprofit health centers. Customers are referred to as
"patients," and merchandise as "medicine." Yoga classes are often
available, along with health-related literature.

But the rivers of cash flowing in and out of these businesses are
attracting scrutiny from local and federal authorities who say they
are trying to distinguish between legitimate health practitioners and
sellers of illegal drugs.

"We're trying to get to a point where we get we can weed out - for
lack of a better word - to filter out the people that are really
perverting this law just to sell drugs," said Frank Carrubba, deputy
district attorney in Santa Clara County.

Last month, the four operators of New Age Healing Collective in San
Jose were charged with illegal marijuana sales and money laundering
after the police said they turned up two sets of books. The raid was
part of a series of recent investigations into San Jose dispensaries
by the Santa Clara Special Enforcement Team.

One ledger, kept at the tiny dispensary, showed New Age Healing
losing $123,128 since May, according to the police. Another, which
the police said had been discovered inside a cash-filled shoe box in
the home of the couple that operated the center, told a different
story: $222,238 in profits.

The couple said it was operating a legitimate marijuana dispensary
and had done nothing wrong, according to one of their lawyers.

In Oakland, Harborside Health Center, one of the largest dispensaries
on the West Coast and a model for the medical marijuana industry, is
being audited by the Internal Revenue Service, said Harborside's
chief executive, Stephen DeAngelo. An I.R.S. spokesman said the
agency neither confirmed nor denied audits.

Last month, officials in Oakland postponed plans to license
large-scale marijuana farms in the city after the Justice Department
and the city attorney warned separately that the businesses could
violate state and federal marijuana laws.

The medical marijuana industry has continued to flourish since a
state proposition to legalize cannabis was defeated in November.
Oakland finance officials estimate that the city's three dispensaries
generated $35 million to $38 million in revenue last year, up from
$28 million in 2009.

San Jose now boasts 98 dispensaries - four times the number of
7-Eleven convenience stories in the city.

State law allows collectives to cultivate medical marijuana, but the
law is less clear when it comes to selling the product, said William
Panzer, a lawyer who helped write California's seminal medical
marijuana law, Proposition 215. Under guidelines issued by the state
attorney general, dispensaries are advised not to profit from their
activities. But the guidelines are fuzzy, Mr. Panzer said, and there
is virtually no case law on the issue.

"Let's come out from under the shadows and say, 'Here are the rules,'
" Mr. Panzer said. "The law around distribution is very hazy, and we
need the Legislature to do something. We've fallen behind other
states on regulations for medical marijuana sales."

After staking out the New Age Healing Collective for eight months,
Santa Clara County narcotics agents raided it on Oct. 7. They found
marijuana and a black ledger listing sales and expenses, a police
report said. The ledger stated that the collective's $255,642 in
sales from May through September were offset by $323,170 in operating
expenses and $55,600 that the dispensary spent on rent and payroll.

The same day, officers raided the home of Jonathan Mitchell and
Sheresie Dyer, the operators of New Age Healing. In a clothes closet,
according to the police report, they found a Glock pistol, a pound of
marijuana and a shoe box containing $15,971 and a "cash book." The
ledger, the report stated, showed that New Age's gross receipts were
$601,008 for those five months, a $222,238 profit.

"Their described activity as a collective is nothing more than a
retail store," wrote Sgt. Dean Ackemann, who is now with the San Jose
district attorney's office. "Their only actions are providing
marijuana to customers at street-level prices."

The police say they also found state tax returns, listing $84,111 in
gross sales for the second quarter of 2010, which the report
characterized as "highly suspect."

Geoffrey Rawlings, Mr. Mitchell's lawyer, said that he would not
comment on the specifics of the case, but that his client was legally
providing medical marijuana to patients. Mr. Mitchell and the others
have all pleaded not guilty.

Mr. Rawlings noted that the police were not raiding pizza
restaurants, which are also cash businesses, but that the profile of
marijuana dispensary operators might play a role in attracting the
attention of the authorities.

"When you're dealing with medical cannabis and you see these blond,
dreadlocked corporate officers coming and going, it kind of agitates
law enforcement and raises their hackles a little more than the pizza
shop owner down the street," Mr. Rawlings said. "They are convinced
that these people are breaking the laws without any evidence in
advance that they're breaking the law."

Medical marijuana activists have loudly protested the raids on San
Jose dispensaries, which have proliferated without any city regulations.

"We are extremely concerned by the raids," said Paul Stewart,
executive director of the Medicinal Cannabis Collective Coalition,
which represents several San Jose dispensaries. "They are acting on
what could be considered a specious legal finding by the D.A.; their
finding is that all collectives are operating illegally because they
are making a profit."

Mr. Stewart said the dispensaries were easy targets since they were
out in the open, unlike methamphetamine labs or other illicit drug operations.

"There is a concern that it appears they are attacking the
low-hanging fruit," he said.

Because laws are murky, dispensaries increasingly operate in the gray
area between large-scale businesses and nonprofit health centers.

"It's almost a hybrid operation," said Betty Yee, the Bay Area's
representative on the Board of Equalization, which oversees state
taxes. "It's kind of difficult line to straddle for them, but a lot
of them are doing it."

Ms. Yee also said that although money was pouring into dispensaries,
that did not mean operators were making big profits.

"The cost of their product is so huge that there is sometimes a
perception that they're making a lot of money when in fact their
margins are pretty thin," she said.

Though federal authorities have halted raids on medical marijuana
dispensaries under the Obama administration, the I.R.S. has shown a
new interest.

Harborside officials said the I.R.S. was raising questions about a
section of the tax code known as 280E. That section, aimed at drug
kingpins, prohibits companies from deducting any expenses if they are
"trafficking in controlled substances."

Harborside, which serves 70,000 members, has been lobbying the
federal government to exempt medical marijuana dispensaries from the
law. It sent a letter to Senator Barbara Boxer, Democrat of
California, stating that it could be taxed out of business if the law
was not changed.

"Harborside Health Center currently employs approximately 80
individuals in Oakland, CA," the letter reads. "Unless we can change
this law, these jobs are in jeopardy."

Mr. DeAngelo, the Harborside chief executive, said that all the
profits were put back into the business - and that the dispensary was
not a drug dealer.

"Our contention is that what we're doing is legal and not
trafficking, and it's not appropriate to apply it to us," he said.
"This is an industrywide issue."