IRS denies exemption to a cannabis dispensary

Plain-English summary

The IRS denied a nonprofit corporation's application for exemption under IRC § 501(c)(3). The organization distributed cannabis to members who had medical referrals, and it also provided related information and products. The IRS concluded that the distribution of cannabis violated federal law, served a substantial nonexempt purpose, and did not further a public rather than private interest. The IRS also found that the organization's articles and bylaws failed the organizational test because they authorized cannabis distribution and allowed possible dividends to shareholders.

Ruling snapshot

• Question: Did the nonprofit corporation qualify for exemption under IRC § 501(c)(3)?
• Outcome: Denied, exemption not recognized
• Key authorities: IRC §§ 501(a), 501(c)(3), 170, 6110, and 7428; Treas. Reg. §§ 1.501(c)(3)-1(a)(1), (b)(1), (c)(1), (c)(2), and (d)(1)(ii); 21 U.S.C. §§ 802(16), 812(c), and 841(a)

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Number: 201224036 Contact Person:
Release Date: 6/15/2012
Identification Number:

Date: March 19, 2012
Contact Number:

Employer Identification Number:
Form Required To Be Filed:

Tax Years:
UIL: 501.00-00; 501.03-00; 501.03-05

Dear

This is our final determination that you do not qualify for exemption from Federal income tax as
an organization described in Internal Revenue Code section 501(c)( ). Recently, we sent you a
letter in response to your application that proposed an adverse determination. The letter

explained the facts, law and rationale, and gave you 30 days to file a protest. Since we did not
receive a protest within the requisite 30 days, the proposed adverse determination is now final.

You must file Federal income tax returns on the form and for the years listed above within 30
days of this letter, unless you request an extension of time to file. File the returns in accordance
with their instructions, and do not send them to this office. Failure to file the returns timely may
result in a penalty.

We will make this letter and our proposed adverse determination letter available for public
inspection under Code section 6110, after deleting certain identifying information. Please read
the enclosed Notice 437, Notice of Intention to Disclose, and review the two attached letters that
show our proposed deletions. If you disagree with our proposed deletions, follow the
instructions in Notice 437. If you agree with our deletions, you do not need to take any further
action.

If you have any questions about this letter, please contact the person whose name and
telephone number are shown in the heading of this letter. If you have any questions about your
Federal income tax status and responsibilities, please contact IRS Customer Service at

1-800-829-1040 or the IRS Customer Service number for businesses, 1-800-829-4933.
IRS Customer Service number for people with hearing impairments is 1-800-829-4059.

Sincerely,

Lois G. Lerner
Director, Exempt Organizations

Enclosure
Notice 437
Redacted Proposed Adverse Determination Letter
Redacted Final Adverse Determination Letter

The

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Date: December 5, 2011 Contact Person:
Identification Number:
Contact Number:
FAX Number:

Employer Identification Number:

We have considered your application for recognition of exemption from Federal income tax
under § 501(a) of the Internal Revenue Code as an organization described in § 501(c)(3).
Based on the information provided, we have concluded that you do not qualify for exemption
under that section. The basis for our conclusion is set forth below.

FACTS

You are a State nonprofit public benefit corporation formed on Date. Your Articles of
Incorporation provide that you are “organized for charitable, religious, educational and scientific
purposes within the meaning of § 501(c)(3),” and specifically, to dispense cannabis (also known
as marijuana) intended to be used for medicinal purposes. Your articles state that you are
organized for public purposes.

Your bylaws require the issuance of certificates of capital stock, and provide that the certificates
represent the interests of the shareholders. The bylaws further state that shareholders may be
entitled to receive dividend payments. Your shareholders elect your board of directors annually.

In your Form 1023 Application, you state that your formation followed the passage of State
legislation that allows for the cultivation and use of cannabis by seriously ill individuals upon a
physician’s recommendation. You explain that under State Attorney General guidelines issued
for this legislation, you are required to operate in the business form known as a “public benefit
corporation.”

You further describe yourself as a “clinic devoted to the care and nurturing of persons in medical
distress for various reasons.” You state that you are dedicated to educating eligible individuals
about their rights when using cannabis as a medical therapy, and to provide them safe, legal
access to cannabis.

You indicate that only your members may purchase or receive a donation of cannabis because
the only recognized entities under the State Attorney General Guidelines are cooperatives and
collectives that allow members and caregivers to associate. You do not charge a membership
fee. To become a member, a person must be at least 18 years old, have a written referral from
a qualified doctor, and provide a picture identification card. You keep copies of the doctor's
referral and the member's identification for your records, noting the expiration date of the
referral. After determining the member's eligibility, you review your policies and procedures with
the member.

You represent that you run your clinic in a manner similar to a doctor's office. Members must
make an appointment to receive services and obtain the cannabis. You treat members in a
private area and allow only the member and caregiver into the dispensary during the
consultation. The consultation determines which variety and form of cannabis is appropriate for
each member. You distribute the cannabis only in amounts permitted by State law.

In addition, you provide information to members regarding how to ingest and use topicals; which
varieties are more effective; recipes that include cannabis; and instructions to grow your own
cannabis. You provide grading services for homegrown cannabis. You also discuss with your
members current legislation and laws regarding the legal use of cannabis in State, and provide
information and literature on a variety of subjects related to alternative medicine and different
treatment options.

You charge your members a “suggested donation price” per visit to cover the farmer's costs of
growing and providing the cannabis. Members may make the donation in cash or homegrown
cannabis in exchange for using the dispensary and obtaining information and periodicals related
to alternative medicine. You state that you will provide cannabis free of charge to members in
need of financial aid. You sell to your members cannabis provided by your members to raise
funds for this purpose. Your staff determines financial hardship. Besides the ingestible form,
you also sell cannabis raw and in other forms.

As indicated on your Form 1023 Application, your primary source of funds will be member
donations and some public donations. You plan to conduct quarterly cannabis raffles. In
addition to selling cannabis, you will sell items such as t-shirts, organic pipes, topicals, butter
and edibles, and pharmacy front-counter items, such as lighters.

APPLICABLE LAW

Section 501(c)(3) of the Code provides for the exemption from federal income tax of
corporations organized and operated exclusively for charitable or educational purposes,
provided no part of the net earnings inures to the benefit of any private shareholder or
individual.

Section 1.501(c)(3)-1(a)(1) of the Income Tax Regulations provides that, in order to be exempt
as an organization described in § 501(c)(3), an organization must be both organized and
operated exclusively for one or more exempt purposes. If an organization fails to meet either
the organizational test or the operational test, it is not exempt.

Section 1.501(c)(3)-1(b)(1)(i) of the regulations provides that an organization is organized
exclusively for one or more exempt purposes only if its articles of organization limit its purposes
to one or more exempt purposes and do not expressly empower it to engage, otherwise than as

an insubstantial part, in activities which in themselves are not in furtherance of one or more
exempt purposes.

Section 1.501(c)(3)-1(b)(1)(iv) of the regulations provides that in no case shall an organization
be considered to be organized exclusively for one or more exempt purposes, if, by the terms of
its articles, the purposes for which it is created are broader than the purposes specified in

§ 501(c)(3). The fact that the actual operations of such organization have been exclusively in
furtherance of one or more exempt purposes shall not be sufficient to permit the organization to
meet the organizational test.

Section 1.501(c)(3)-1(c)(1) of the regulations provides that an organization operates exclusively
for exempt purposes only if it engages primarily in activities that accomplish exempt purposes
specified in § 501(c)(3) of the Code. An organization will not be operated exclusively for exempt
purposes if more than an insubstantial part of its activities are not in furtherance of an exempt
purpose.

Section 1.501(c)(3)-1(c)(2) of the regulations provides that an organization is not operated
exclusively for exempt purposes if its net earnings inure in whole or in part to the benefit of
private shareholders or individuals. The words “private shareholder or individual” refer to
persons that have a personal or private interest in the activities of the organization. See

§ 1.501(a)-1(c).

Section 1.501(c)(3)-1(d)(1)(ii) of the regulations provides that an organization is not organized or
operated exclusively for one or more exempt purposes unless it serves a public rather than a
private interest. Thus, the organization must establish that it is not organized or operated for the
benefit of private interests such as designated individuals or shareholders of the organization.

Section 1.501(c)(3)-1(d)(2) of the regulations provides that the term “charitable” is used in

§ 501(c)(3) of the Code in its generally accepted legal sense. The promotion of health has long
been recognized as a charitable purpose. See Restatement (Second) of Trusts, §§ 368, 372
(1959); 4A Scott and Fratcher, The Law of Trusts, §§ 368, 372 (4th ed. 1989). However, a trust
is invalid if its purpose is illegal. Restatement (Second) of Trusts, § 377 (1959).

Section 1.501(c)(3)-1(d)(3)(i) of the regulations provides, in part, that the term “educational” as
used in § 501(c)(3) of the Code relates to the instruction of the public on subjects useful to the
individual and beneficial to the community.

21 U.S.C. § 802(16) defines marijuana as “all parts of the plant Cannabis sativa L. whether

growing or not; the seeds thereof; the resin extracted from any part of such plant; and every
compound, manufacture, salt, derivative, mixture, or preparation of such plant, its seeds or

resin.”

21 U.S.C. § 812(c), Sch. I(c)(10) lists marijuana as a hallucinogenic substance and includes it
on schedule I of the Schedules of Controlled Substances. A schedule I substance is a
substance that (1) has a high potential for abuse; (2) has no currently accepted medical use in
treatment in the United States; and (3) there is a lack of accepted safety for use of the drug
under medical supervision.

21 U.S.C. § 841(a), known as The Controlled Substances Act, states that it is illegal for anyone
to knowingly or intentionally manufacture, distribute, or dispense, or possess with intent to
manufacture, distribute, or dispense a controlled substance.

United States v. Oakland Cannabis Buyers’ Cooperative, 532 U.S. 483, 490 (2001), reiterates
that there is only one exception from the Act for cannabis: Government-approved research
projects. “It is clear from the text of the Act that Congress has made a determination that
marijuana has no medical benefits worthy of an exception.” Id. at 493.

In Better Business Bureau of Washington, D.C., Inc. v. United States, 326 U.S. 279, 283 (1945),
the Supreme Court held that the “presence of a single . . . [nonexempt] purpose, if substantial in
nature, will destroy the exemption regardless of the number or importance of truly . . . [exempt]
purposes.”

In Ould v. Washington Hospital for Foundlings, 95 U.S. 303, 311 (1877), the Court noted that “[a]
charitable use, where neither law nor public policy forbids, may be applied to almost any thing
that tends to promote the well-doing and well-being of social man.”

In Mysteryboy Inc. v. Commissioner, T.C. Memo 2010-13 (2010), the Tax Court held that the
organization failed the operational test partly because the organization proposed to promote
illegal activities.

In Bob Jones University v. United States, 461 U.S. 574 (1983), the Supreme Court held that
racially discriminatory education is contrary to public policy and the University therefore could
not be viewed as providing public benefit within the charitable concept.

In Harding Hospital, Inc. v. United States, 505 F.2d 1068, 1071 (6th Cir. 1974), the court held
that an organization has the burden of proving that it satisfies the requirements of the particular
exemption statute. The court noted that whether an organization has satisfied the operational
test is a question of fact.

In Federation Pharmacy Services, Inc. v. Commissioner, 72 T.C. 687 (1979), aff'd, 625 F.2d 804
(8th Cir. 1980), the Tax Court held that while selling prescription pharmaceuticals to elderly
persons at a discount promotes health, this does not entitle it to an automatic tax exemption
under § 501(c)(3) of the Code.

In B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352, 358 (1978), the court held that a consulting
organization whose sole service was to find individual researchers for their clients, only some of
which were exempt, did not qualify for exemption under section 501(c)(3) of the Code. The
court found that B.S.W. Group’s primary “activity constitutes the conduct of a consulting
business [that] is ordinarily carried on by commercial ventures organized for profit.”

Rev. Rul. 61-170, 1961-2 C.B. 112, holds that a nurses’ association, which maintains an
employment register primarily for the employment of its members, is not entitled to exemption
under § 501(c)(3). The organization is primarily engaged in the performance of personal
services by operating an employment service principally for the benefit of its members. Public
participation in the management and support of the organization is negligible. It draws its
support primarily from members, and a board of trustees composed of professional nurses
controls the organization without public participation of any kind. Therefore, the organization is
not free from substantial private benefit considerations in the operation of the nurses’ register.

Rev. Rul. 69-175, 1969-1 C.B. 149, holds that a nonprofit organization formed by parents of
pupils attending a private school that provides school bus transportation for its members’
children serves a private rather than a public interest. The organization’s income approximately
equals the expenses involved in its operations.

Rev. Rul. 73-349, 1873-2 C.B. 179, holds that an organization formed to purchase groceries for
its membership at the lowest possible prices on a cooperative basis is not exempt as a social
welfare organization described in § 501(c)(4) of the Code. The organization was a private
cooperative enterprise for the economic benefit or convenience of its members. Any benefit to
the community was incidental to the benefit received by the members.

Rev. Rul. 75-384, 1975-2 C.B. 204, holds that a nonprofit organization, whose purpose was to
promote world peace, disarmament, and nonviolent direct action, did not qualify for exemption
under §§ 501(c)(3) or (c)(4). The organization’s primary activity was to sponsor antiwar protest
demonstrations in which demonstrators were urged to violate local ordinances and commit acts
of civil disobedience. Citing the law of trusts, the ruling stated that all charitable organizations
are subject to the requirement that their purposes cannot be illegal or contrary to public policy.

ANALYSIS

Based on the information you provided in your application and supporting documentation, we
conclude that you are not organized and operated exclusively for exempt purposes under

§ 501(c)(3) of the Code. An organization can be recognized as exempt under § 501(c)(3) only if
it shows that it is both organized and operated exclusively for charitable, educational, or other
exempt purposes. If an organization fails to meet either the organizational test or the
operational test, it is not exempt. Treas. Reg. § 1.501(c)(3)-1(a)(1).

You do not satisfy the operational test of § 1.501(c)(3)-1(c) of the regulations. Whether an
organization operates exclusively in furtherance of an exempt purpose is a question of fact. An
organization seeking tax-exempt status under § 501(c)(3) carries the burden of proving that it
satisfies the requirements of the statute. See Harding Hospital, 505 F.2d at 1071. Only an
insubstantial portion of the activity of an exempt organization may further a nonexempt purpose.
As the Supreme Court held in Better Business Bureau of Washington, D.C., Inc. v. United
States, 326 U.S. at 283, the presence of a single nonexempt purpose, if substantial in nature,
will destroy the exemption regardless of the number or importance of truly exempt purposes.

The common law of trusts specifies that a charitable trust cannot be created for an illegal
purpose. See Restatement (Second) of Trusts, § 377. Similarly, the Supreme Court noted in
Ould v. Washington Hospital for Foundlings, 95 U.S. at 311, that “[a] charitable use, where
neither law nor public policy forbids, may be applied to almost any thing that tends to promote
the well-doing and well-being of social man.” Like a trust, a § 501(c)(3) organization cannot be
created for a purpose that is illegal. See Rev. Rul. 75-384, supra; Mysteryboy Inc. v. Comm'r,
T.C. Memo 2010-13 (2010) (organization that encouraged sexual activity with minors with the
goal to repeal child pornography and rape laws was not exempt from federal income taxation;
activities of the organization violated public policy as reflected in Federal and state laws).

Your primary activity, the distribution of cannabis, is illegal. Federal law does not recognize any
health benefits of cannabis and classifies it as a controlled substance. 21 U.S.C. § 812.
Federal law prohibits the manufacture, distribution, possession, or dispensing of a controlled
substance. 21 U.S.C. § 841(a). Congress has “made a determination that marijuana has no

medical benefits worthy of an exception” to the general rule that the manufacture and
distribution of cannabis is illegal. Oakland Cannabis Buyers’ Coop., 532 U.S. at 493.

Current federal law prohibits the use of cannabis except in limited circumstances; those limited
circumstances do not include the use of cannabis for medicinal purposes. See Id. The fact that
State legalized distribution of cannabis to a limited extent is not determinative because under
federal law, distribution of cannabis is illegal. Because you advocate and engage in activities
that contravene federal law, you serve a substantial nonexempt purpose.

You also operate for private purposes rather than the public interest. An organization that
operates primarily for the benefit of its members serves the interests of a select group of
individuals rather than the community’s or the public's interest. A business or other activity that
assists the community incidentally and only provides benefits to a limited number of members of
the community more than incidentally is not charitable. See e.g., Rev. Rul. 61-170, supra,

Rev. Rul. 69-175, supra, and Rev. Rul. 73-349, supra.

Your Form 1023 Application and supporting material indicate that you are a cooperative
organization and only distribute cannabis to your members. In State, a cooperative must
conduct itself primarily for the mutual benefit of its members as patrons of the organization. The
organization uses its earnings for the general welfare of its members or it equitably distributes
its earnings or services to its members.

You state that you sell or give cannabis to members based on their financial need. The Tax
Court in Federation Pharmacy Services, Inc. v. Comm'r, 72 T.C. at 692, stated that selling health
items at a discount “is not, of itself, a charitable deed. Many profitmaking organizations sell at a
discount. Nor does the fact that [Federation Pharmacy] seeks to sell its drugs at cost alter the
result; so does an old-fashioned cooperative, yet it is not entitled to classification as charitable.”
Id. (citations excluded). As a cooperative, your activities benefit private interests more than
incidentally, which precludes exemption under § 501(c)(3). Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii).

To satisfy the organizational test, an organization’s Articles of Incorporation must limit its
purposes to those listed in § 501(c)(3). Additionally, the Articles must not expressly empower
the organization to engage, more than insubstantially, in activities that are not in furtherance of
those exempt purposes.

You do not satisfy the organizational test described in Treas. Reg. § 1.501(c)(3)-1(b)(1). Your
specific purpose is to dispense medicinal cannabis. Distributing cannabis does not further any
exempt purpose. Your Articles of Incorporation therefore do not limit your purposes to one or
more exempt purposes under § 501(c)(3). Instead, your Articles empower you to engage, other
than as an insubstantial part of your activities, in activities not themselves in furtherance of an
exempt purpose.

You also fail the organizational test because your bylaws allow for the issuance of capital stock
to shareholders who vote on the members of the board of directors. The bylaws state that
shareholders may be entitled to receive dividend payments. Thus, your bylaws allow your net
earnings to inure to the benefit of private shareholders or individuals, contrary to Treas. Reg.

§ 1.501(c)(3)-1(c)(2).

CONCLUSION

Based on the facts and information submitted, you are not organized and operated exclusively
for exempt purposes. Your primary purpose of distributing cannabis not only violates federal
law, but also furthers a substantial nonexempt purpose. You also operate for private purposes
rather than the public interest. An organization that operates primarily for the benefit of its
members serves the interests of a select group of individuals rather than the community’s or the
public’s interest. A business or other activity that assists the community incidentally and only
provides benefits to a limited number of members of the community more than incidentally is not
charitable. In addition, your bylaws state that shareholders may be entitled to receive dividend
payments. Thus, your bylaws allow your net earnings to inure to the benefit of private
shareholders or individuals. Therefore, you are not described in § 501(c)(3) of the Code.

Accordingly, you do not qualify for exemption as an organization described in § 501(c)(3) of the
Code and you must file federal income tax returns.

Contributions to you are not deductible under § 170 of the Code.

You have the right to file a protest if you believe this determination is incorrect. To protest, you
must submit a statement of your views and fully explain your reasoning. You must submit the
statement, signed by one of your officers, within 30 days from the date of this letter. We will
consider your statement and decide if the information affects our determination.

Your protest statement should be accompanied by the following declaration:

Under penalties of perjury, I declare that I have examined this protest statement, including
accompanying documents, and, to the best of my knowledge and belief, the statement
contains all the relevant facts, and such facts are true, correct, and complete.

You also have a right to request a conference to discuss your protest. This request should be
made when you file your protest statement. An attorney, certified public accountant, or an
individual enrolled to practice before the Internal Revenue Service may represent you. If you
want representation during the conference procedures, you must file a proper power of attorney,
Form 2848, Power of Attorney and Declaration of Representative, if you have not already done
so. For more information about representation, see Publication 947, Practice before the IRS
and Power of Attorney. All forms and publications mentioned in this letter can be found at
www.irs.gov, Forms and Publications.

If you do not file a protest within 30 days, you will not be able to file a suit for declaratory
judgment in court because the Internal Revenue Service (IRS) will consider the failure to protest
as a failure to exhaust available administrative remedies. Code § 7428(b)(2) provides, in part,
that a declaratory judgment or decree shall not be issued in any proceeding unless the Tax
Court, the United States Court of Federal Claims, or the District Court of the United States for
the District of Columbia determines that the organization involved has exhausted all of the
administrative remedies available to it within the IRS.

If you do not intend to protest this determination, you do not need to take any further action. If
we do not hear from you within 30 days, we will issue a final adverse determination letter. That
letter will provide information about filing tax returns and other matters.

Please send your protest statement, Form 2848, and any supporting documents to this address:

Internal Revenue Service
SE:T:EO:RA:T:4

1111 Constitution Ave, N.W.
Washington, DC 20224

You may also fax your statement using the fax number shown in the heading of this letter. If
you fax your statement, please call the person identified in the heading of this letter to confirm
that he or she received your fax.

If you have any questions, please contact the person whose name and telephone number are
shown in the heading of this letter.

Sincerely,

Lois G. Lerner
Director, Exempt Organizations