Update — 7p.m.: The IRS ruling described below may be the least of medical marijuana dispensaries’ worries. Federal prosecutors have sent warning letters to at least 16 shops in California to shut down in 45 days or face criminal charges for violating federal drug laws, the Associated Press reported this afternoon.  The state’s U.S. attorneys are scheduled to address the crackdown at a news conference Friday.

The federal government’s attempts to crack down on medical marijuana just got easier — thanks to an obscure section of the tax code.

In what observers say could be a “crushing blow” to the industry, the Internal Revenue Service has ruled that medical marijuana dispensaries cannot deduct standard business expenses, such as rent, employee health insurance, security, licensing fees or payroll, from their tax returns.

The ruling came in response to an audit of Oakland, Calif.’s Harborside Health Center, one of the country’s biggest dispensaries, which must pay $2.5 million in back taxes from 2007 and 2008.  The decision is grounded in a section of the tax code that prohibits these deductions for businesses that traffic in illegal drugs. The measure was passed by Congress in 1982, during President Reagan’s “war on drugs.”

“The very fact that we filed a tax return and told the IRS all the details of what we are doing proves we are not a drug trafficking organization,” Harborside’s CEO Steve DeAngelo told the Associated Press. He said he’ll appeal the ruling, telling MSNBC, “Either this IRS assessment has to change or we go out of business. There really isn’t a middle ground for us.”

The IRS did not comment on the audit, but in a series of letters [PDF] to members of Congress last December, the IRS’ deputy associate chief counsel wrote:

Section 280E of the Code disallows 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.

The news has struck fear in the medical marijuana industry, which has been anticipating a crackdown and lobbying Congress for a change in the law.  In May, Rep. Pete Stark (D-Calif.) introduced a bipartisan bill that would create a tax code exception “to allow businesses operating in accordance with state law to take tax deductions associated with the sale of medical marijuana.”

Sixteen states and the District of Columbia have passed medical marijuana laws, and more than a third of all states are experimenting with some form of legalization or decriminalization. In our July film, The Pot Republic, we went inside California’s attempts to regulate its booming medical marijuana industry — and the increasing push back states are facing from federal officials.