Marijuana, even of the medical variety, remains illegal at the federal level -- meaning that dispensary owners can't take business deductions on tax returns they submit to the feds. But since MMJ is legal in Colorado, shouldn't they be able to deduct legitimate business expenses on state forms? Mitch Woolhiser, co-owner of Northern Lights Natural Rx, thought so. But he was wrong.

Why are such deductions disallowed? It's complicated....

When Woolhiser and his wife filled out their state returns in 2010, they took business deductions for Northern Lights, and their submission sailed through without an apparent problem. So they did likewise for 2011, only to receive an unfriendly letter from the Colorado Department of Revenue -- a missive officially known as a notice of deficiency or rejection of refund.

"It's basically a statement regarding my individual tax return," Woolhiser says. "Because we're an LLC, it's on our individual taxes. They adjusted my return to reflect the actual gross adjusted income from my 1040 rather than what my accountant entered." As a result, his modest, $877 refund was transformed into a bill to the State of Colorado for well over $3,000.

To add insult to injury, the state reexamined his 2010 return and kicked back that form as well. Because Northern Lights was just getting started back then and wasn't making much if any profit, the amount he now owes for that year is much smaller: under $200. But combined with the 2011 amount and the $17,000 he had to pay to the federal government, the sum came to around $20,000 -- which just happened to be almost exactly the amount of net profit the MMC generated as measured by standard accounting practices.

"They took all the money we made," Woolhiser says. "It was a 100 percent tax rate."

This turn of events wasn't totally unexpected. "My accountant is an expert, and she warned me this might happen -- but I didn't believe it," Woolhiser concedes.

He sees this policy as patently unjust. "We have to pay for a state-issued license from the MMED (Medical Marijuana Enforcement Division)," he points out, "and now they're demanding that we pay them the fee right away, because they're broke. But at the same time, they're not allowing me to take standard legal deductions from a state legal business?"

Nope -- and that's been the case since the beginning of the MMJ industry in Colorado, according to Colorado Department of Revenue spokesman Mark Couch. "The basis for Colorado taxes is the federal taxable income plus or minus certain items specifically identified by Colorado law," he writes via e-mail. "Standard business deductions for medical marijuana dispensaries are not specifically allowed under Colorado law, so we do not allow the deduction beyond what is allowed at the federal level."

If that's the case, why wasn't Woolhiser's 2010 Colorado tax return flagged? "We have reviewed additional deductions this year, which is why we may have reviewed this particular taxpayer this year where we did not review the deduction last year," he allows, adding, "Plans are to expand this particular review more next year, not only for 'standard business deductions' but other improper deductions we have been seeing and disallowing."

Couch concedes that Woolhiser is not the only dispensary owner unhappy that such deductions aren't allowed at the state level. He describes the number of gripes on the subject as "not a huge number, but some. We get complaints about a lot of adjustments we make. Just part of the job."

Page down to read about the medical marijuana industry's response to the issue. Woolhiser's equally unhappy with various medical marijuana industry groups, who he faults for not addressing the situation. But Shawn Coleman, executive director of the Cannabis Business Alliance, stresses that the issue is indeed on the CBA's radar.

"We've known about this for a while, and we've been working on it for a while," Coleman says. "I think the reason it hasn't been a big story yet is because most of the businesses aren't profitable yet. This tax issue only becomes an issue once they're profitable. And since we're starting to see people getting profitable, the problem is going to get worse instead of better."

In Coleman's view, "the problem is the federal tax code, which says if you are engaged in a business that's against federal law, you can't claim business expenses. It's a law designed for interrupting international drug cartels, the crack house on the corner and things like that, which don't apply to this industry. So in a lot of people's opinions, this is a misapplication of the tax code."

Nonetheless, the Colorado Department of Revenue "follows federal tax law," Coleman goes on. "The idea is that you probably told the feds the truth, so we're going to charge you taxes based on what you told the feds. So people who say, 'We can't make these deductions on the federal level, but we can do it in Colorado, because it's legal here' are getting the rejection letter. And the Department of Revenue says that's because they haven't been specifically told in legislation to allow the deductions."

Does that mean a bill could be passed in Colorado instructing the Department of Revenue to allow business deductions for medical marijuana businesses? When asked, DOR's Couch refers the question to the state's Office of Legislative Legal Services. There, a source tells us the office hasn't studied the matter in detail yet, because no legislation has been submitted about it. However, he believes a state fix would be possible, albeit with potential federal repercussions.

One way around this dilemma would be for the U.S. Congress to pass a law to allow states more leeway when it comes to medical marijuana, and Coleman says there is already legislation on the subject: the Small Business Tax Equity Act, sponsored by Representative Pete Stark, a California Democrat. In Coleman's words, "It would clarify the federal tax code so that the language would not apply to state-legal businesses."

Trouble is, the Small Business Tax Equity Act has been languishing since being introduced in May 2011, and the likelihood that it will suddenly start rocketing through the process is slight, especially during an election year. And while pushing such a measure in Colorado might be simpler, no legislator has stepped forward to sponsor such a bill -- and even if someone does, the next legislative session doesn't start until January 2013. With that in mind, the CBA's Coleman wants to wait to start talking to legislators about taking up this cause until after the November elections.

In the meantime, Woolhiser is frustrated. He calls the stereotype of medical marijuana making entrepreneurs rich a "huge misnomer" and concedes that if he'd known all of the hoops through which he'd be made to jump simply to break even, he might never have gotten into the industry in the first place.

Regarding the current Colorado tax laws about medical marijuana, he believes "something's got to be done. It's just basic fairness: You shouldn't be penalized for following state law. I understand it on the federal level. But this is ludicrous."

More from our Marijuana archive: "Medical Marijuana Enforcement Division staff cuts big but likely temporary."