Bryan and Lanette Davies, center, lead a prayer every evening for staff and patients at Canna Care in Sacramento, Calif. The evangelical medical marijuna supplier is in a public battle with the IRS. The dispensary is shown in November 2012. (Paul Kitagaki Jr./MCT)

The Canna Care dispensary, an evangelical medical marijuana provider renowned for doling out buds with Bibles, is waging a public fight with the Internal Revenue Service over an $873,167 tax penalty sought under a tax code aimed at drug traffickers.

On Tuesday, the U.S. Tax Court in San Francisco is due to hear Canna Care’s challenge over whether the IRS can impose the hefty tax demand under a 1982 law intended to close a loophole that allowed a Minneapolis cocaine and methamphetamine dealer to claim tax deductions for a scale, his apartment rent and telephone expenses.

In the case of Canna Care, the IRS has refused to accept $2.6 million in business deductions for employee salaries, rent and other costs after auditing 2006, 2007 and 2008 federal tax returns for the north Sacramento dispensary. However, the IRS did allow the dispensary, which handles about $2 million in medical marijuana transactions a year, to deduct the costs of the marijuana itself.

The IRS has used the Reagan-era tax code, known as 280E, to seek tax penalties against numerous California dispensaries under the argument that their business expenses constitute support of drug-trafficking operations.

Those targeted have included the state’s largest medical marijuana provider, Harborside Health Center, which is negotiating with the IRS over the government’s demand for $2.5 million in back taxes for Harborside’s Oakland and San Jose dispensaries.

Samples of medical marijuana are displayed at Canna Care in Sacramento, Calif. The evangelical medical marijuna supplier is in a public battle with the IRS over a nearly $900,000 tax penalty. The dispensary is shown in August 2009. (Paul Kitagaki Jr./MCT)

The IRS also played a role in sweeping crackdowns on medical marijuana businesses that California’s four U.S. attorneys initiated in late 2011. IRS agents joined in the raids on the Oaksterdam University marijuana trade school and dispensary of Richard Lee as he was seeking to negotiate his tax debt under the 280E tax code. Lee was the architect of Proposition 19, an unsuccessful 2010 bid to legalize recreational marijuana use in California.

The agency also raided Sacramento’s former El Camino Wellness dispensary and seized its bank accounts under federal money-laundering statutes used to target narcotics traffickers. No charges have resulted in either case.

Canna Care director Lanette Davies said she and her husband, Bryan Davies, the dispensary’s chief executive, had no dispute with the IRS over any of the figures reported in their tax returns. She said the IRS made an offer of $100,000 to settle their tax case. But she said they decided to challenge the demand in court because they considered it a punitive tax against cannabis outlets that other businesses do not pay.

Davies, whose family-run dispensary runs radio ads inviting neighbors and medical marijuana patients for nightly prayer sessions, said the couple will not accept a settlement that calls for paying “a couple extra percent of your gross sales” to the government.

“To me, that’s buying protection money,” she said.

Davies said the dispensary operates as a not-for-profit business under California’s medical marijuana laws and declared a modest business loss on its taxes in 2006. She noted that the IRS allows deductions for the business costs of acquiring marijuana — the one item that is illegal under federal law — but will not let the dispensary claim routine business deductions.

“They don’t accept that I pay my employees well and that I provide them with full dental and medical insurance,” Davies said. “They don’t accept the rent of our place, our liability insurance, our workman’s comp insurance, our phones or our security, a big expense for us.”

The IRS does not comment on tax cases, but according to court papers the agency demanded that Canna Care pay $229,473 in additional income taxes for 2006, $304,090 for 2007 and $339,604 for 2008.

In a petition challenging the IRS finding of tax deficiencies for Canna Care, attorney Spencer Malysiak argued that the agency’s refusal to accept the dispensary’s routine business expenses violates the 14th Amendment’s equal protection clause. The petition argued that the IRS was “tacitly” working to enforce U.S. drug laws against the dispensary even as it allowed Canna Care to deduct its costs of goods, the marijuana.

The IRS action “amounts to a de facto prohibition against medicinal marijuana dispensaries, and is tantamount to a criminal prosecution,” Malysiak wrote in the petition.

Henry Wykowski, a tax attorney who is representing Harborside, said it is common for dispensaries to fight IRS tax claims in court with a goal of minimizing their financial burden. But he said Canna Care stands out by appearing to reject negotiations to reduce its taxes and penalties.

“I would say the big picture is they were offered the settlement, and for whatever reason they decided not to take it,” Wykowski said. “Now they’re set for trial with regards to the [tax] deficiency. I can’t give you any idea of what their chances of success are.”

Wykowski was one of the attorneys involved in a landmark 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. The 2007 case resulted in a court ruling that the dispensary’s biggest expense — the marijuana — was deductible because U.S. tax law allows businesses to deduct the cost of goods sold.

The tax court also ruled that the dispensary could deduct the majority of its employee costs as care-giving expenses, and the dispensary ended up paying a tax assessment of $4,905.

Davies said that Canna Care employs 12 people, her husband receives an average salary of $100,000 as the CEO, and she is paid $75,000 a year as the director and an advocate on medical marijuana issues. She said other employees make between $30,000 and $40,000, in addition to health benefits. She said the dispensary maintains its not-for-profit status in part by supporting charities, including cancer research and a community Christmas event in Sacramento.

“We’re hoping to bring awareness to this statute and the fact it’s unconstitutional,” she said. “All cannabis businesses in the United States should be treated as legitimate businesses.”

— McClatchy-Tribune