Image: Stephen DeAngelo
John Sebastian Russo  /  AP
Stephen DeAngelo, founder of Harborside Health Center, stands in the dispensary's marijuana nursery in Oakland, Calif., on July 30, 2010. Though IRS officials won't confirm it, Harborside has been subjected to a months-long audit, says D'Angelo, one of the most recognizable faces in the state's medical marijuana industry with his trademark fedora and braids.
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updated 2/27/2011 3:27:38 PM ET 2011-02-27T20:27:38

In Northern California, few cities have worked as long or as hard as Berkeley and Oakland to nudge medical marijuana into the mainstream. But life in the mainstream brings its own set of mainstream problems.

Even as fears of criminal crackdowns fade, the flagship pot dispensaries in each city are facing tax troubles that could cost them millions of dollars.

In both cases, the dispensaries' difficulties stem from the legal haze that still surrounds the drug in California despite being legalized for medical use here nearly 15 years ago. The cases also highlight the huge sums of money moving through the state's medical marijuana operations, which must operate as nonprofits under state law.

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Berkeley Patients Group started offering medical marijuana in 2000 and has long presented itself as a safe, law-abiding establishment focused on health. The dispensary serves thousands of patients from its current location in a one-time car dealership behind a tall metal security fence with a sliding gate.

In state tax documents, Berkeley Patients Group reported selling more than $51 million worth of medical marijuana between July 2004 and June 2007. The dispensary claimed it did not need to pay sales tax on any of that pot under state law exempting prescribed medicines.

State tax regulators disagreed. They slapped the dispensary with a bill for nearly $6.5 million in back taxes plus interest. Berkeley Patients Group appealed the audit but on Tuesday the state Board of Equalization ruled against them.

Elisabeth Jewel, a Berkeley-based lobbyist who represented the dispensary before the board, said murky regulations were to blame for the confusion.

"We do feel that medical cannabis is medicine, absolutely," Jewel said. At the same time, she said, "we're realists. We understand there is a lot of tax revenue at stake here and dispensary revenue is growing. Cities and state want that revenue."

Berkeley Patients Group and the board will now work out a plan to let the dispensary pay what it owes without being forced out of business.

Still, the board hopes the case serves as a cautionary example. In a statement on the decision, board officials said all dispensaries need seller's permits and must pay sales taxes. Anyone making sales without a permit faces scrutiny of the past eight years of business activity for back taxes, interest and penalties, the board said.

Board chairman James Horton said in the same statement that he was proposing legislation to license all marijuana in the state from the grower to the retailer. He said licensing would bring pot under the same tight controls as cigarettes and liquor in the state.

"The time is overdue for the state to provide leadership for this industry," Horton said.

About 10 miles down the freeway from Berkeley Patients Group, Steve DeAngelo operates Harborside Health Center in Oakland. Inside a nondescript industrial building along the city's waterfront, some 72,000 patients are assisted by professional "budtenders" as they choose from a vast selection of marijuana that in other circumstances would land its seller in federal prison.

But DeAngelo doesn't worry about the U.S. Drug Enforcement Administration, at least since the Justice Department under Obama decided to take a hands-off approach to dispensaries. His problem right now is the Internal Revenue Service.

Though IRS officials won't confirm it, Harborside has been subjected to a year-long audit, says DeAngelo, one of the most recognizable faces in the state's medical marijuana industry in his trademark fedora and braids. At issue, DeAngelo says, is a section of the federal tax code that prohibits those who sell controlled substances from claiming business expenses as a tax write-off.

While most businesses would tremble at the idea of such scrutiny, DeAngelo says he welcomes the attention as a chance to make his case that a regulation designed to target drug kingpins should not apply to medical marijuana purveyors operating in compliance with state law.

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"I think we still don't know exactly what the IRS is up to," DeAngelo told The Associated Press. "I hope what is going on is they're studying our industry, trying to understand it, so they can tax us appropriately."

The agency declined to comment, citing privacy and disclosure laws regarding audits.

The whole idea of a drug kingpin filing a tax return at all may seem ludicrous, but courts have found that illegal drugs are taxable, including a U.S. Supreme Court case that California regulators cite in collecting sales tax on medical marijuana.

Harborside has become a fixture in Oakland, where it pays an special business tax levied by the city on its four dispensaries on top of its regular tax bills. If the IRS finds Harborside does not deserve special consideration as a dispensary, the resulting federal tax bill would force the $22 million-a-year operation to close its doors, DeAngelo said.

In the meantime, Harborside is lobbying Congress and the IRS to clarify the section of the tax code, known as 280E, to exempt medical marijuana distributors. And the dispensary has gained some notable allies: In November, six members of Congress — including Democrats Pete Stark of nearby Fremont and Barney Frank of Massachusetts — wrote the IRS asking the agency not to apply 280E to businesses operating legally under state marijuana laws.

"We are in the process of bringing out of the shadows and into the light an industry that has been underground for seven decades, and it's not going to be an easy process," DeAngelo said. "I'm confident that this is all just part of building a new system of legal cannabis distribution."

Copyright 2011 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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