The Internal Revenue Service has told one of the largest California marijuana dispensaries that it cannot deduct business expenses such as rent, payroll, interest and insurance, which could have implications for all dispensaries.

Harborside Health Center of Oakland was told it owes $2.5 million in back taxes as the IRS cited section 280E of U.S. Code that disallows any tax deductions for business expenses involved in trafficking controlled substances, and marijuana is classified as a Schedule I drug under the federal Controlled Substances Act.

The IRS taxes income from all sources — even illegal sources such as fraud, embezzled funds, bribes and gambling — so it can collect taxes from dispensaries even if the federal government considers them illegal, according to attorney Fernando Velez of Reicker, Pfau, Pyle & McRoy. He said states and cities can collect taxes for activities considered illegal by the federal government.

“I can’t think of any claim the federal government could make related to this taxing authority,” Velez said. “I could see the federal government using other means — for example, withholding of federal funds — to assert its authority over local decisions.”

IRS media relations specialist Anabel Marquez said she couldn’t comment since the move involved private taxpayer information. She did say an IRS audit can include six years of returns, but usually only goes back that far if “a substantial error” is found.

Sixteen states and the District of Columbia have passed laws allowing medical marijuana for qualified patients with a doctor’s recommendation, and California’s law has been in effect since 1996.

The State Board of Equalization decided to make medical marijuana sellers get seller’s permits and pay sales taxes in October 2005, “regardless of the fact that the property being sold may be illegal, or because the applicant for the permit did not indicate what products it sold.”

Santa Barbara County has been struggling with the contradictions of federal and state law for years. The City of Santa Barbara allows “medical marijuana storefront collectives” through an ordinance that establishes guidelines for location and operation, and the county Board of Supervisors decided to pursue banning them.

Santa Barbara-area dispensaries are tiny in comparison to the larger dispensaries such as Harborside, which has 94,000 patients and about $22 million in annual revenue, but owners sounded off Thursday about the IRS decision.

“We’re not drug dealers,” Santa Barbara Patients Group manager Heather Poet said. “It’s hugely prejudiced and they’re going to have to change that assessment.”

The Santa Barbara Patients Group has about 1,000 patients and has been permitted by the city for several years, and Poet has been paying sales tax since the state implementing the rules.

Another Santa Barbara dispensary owner, who spoke on the condition of anonymity, said the IRS ruling targets people who try to provide medical marijuana the legal way, by abiding with the Compassionate Use Act.

“People who are doing deliveries out of trucks have no overhead, no permits and no security guards,” he said.

He said his establishment pays sales tax as well, but says any business would bankrupt itself if it pays the taxes the IRS is asking of Harborside.

The Associated Press reported Thursday that federal prosecutors are cracking down on California dispensaries, warning at least 16 of them through U.S. attorney letters that they have to shut down in 45 days or face criminal charges and property seizure — even if they are operating legally under Proposition 215, the Compassionate Use Act.

The Department of Justice sent a policy memo to federal prosecutors in June saying that dispensaries and licensed growers could face prosecution for violating federal drug laws, a move that comes after two years of indicating prosecutors wouldn’t pursue dispensaries that complied with state laws, according to the AP. 

— Noozhawk staff writer Giana Magnoli can be reached at gmagnoli@noozhawk.com. Noozhawk staff writer Lara Cooper contributed to this report. Follow Noozhawk on Twitter: @noozhawk, @NoozhawkNews and @NoozhawkBiz. Connect with Noozhawk on Facebook.