...deductions incurred in the trade or business of trafficking in controlled substances that federal law or the law of any state in which the taxpayer conducts the business prohibits. For this purpose, the term “controlled substances” has the meaning provided in the Controlled Substances Act. Marijuana falls within the Controlled Substances Act.Since federal law hasn't been amended to exclude medical marijuana from the Controlled Substance Act, the IRS has to disallow any deductions that the providers have taken. These are deductions that any business would take as a matter of course - business expenses for example.
That is a huge tax burden and one that makes little sense. Moreover, the legal provision of medical marijuana at Harborside in Oakland has resulted in quite a tidy sum of tax revenues: $1.1 million in taxes to the city of Oakland, $2 million to the state of California and $500,000 to the federal government. The IRS ruling would increase the federal government tab to $2.5 million, but would end up killing the business. Other providers in a similar position would see a similar hit.
I don't fault the IRS for pursuing this particular case, as they are required to follow the law as in effect. It's up to Congress to fix this.