IRS denies exemption to a cannabis cooperative under IRC § 501(c)(16)

Plain-English summary

The IRS denied exemption to a proposed cooperative under IRC § 501(c)(16). The cooperative was not formed by a tax-exempt farmers' cooperative under IRC § 521, its corporate status had been suspended by the state, and its stated purposes included facilitating cannabis transactions. The IRS concluded that the cooperative failed the organizational and operational requirements for § 501(c)(16) and that its planned activities conflicted with federal controlled-substances law and public policy. The proposed adverse determination became final after no protest was received within 30 days.

Ruling snapshot

• Question: Did the proposed cannabis cooperative qualify for exemption as a crop-financing organization under IRC § 501(c)(16)?
• Outcome: Exemption denied.
• Key authorities: IRC §§ 501(c)(16), 521, 6110, and 7428; 21 U.S.C. §§ 802(16), 812(c), and 841(a); Treas. Reg. §§ 1.501(c)(16)-1 and 1.521-1.

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION

Release Number: 201333014 Contact Person:
Release Date: 8/16/2013

Date: May 20, 2013 Identification Number:

Contact Number:
Employer Identification Number:
Form Required To Be Filed:

Tax Years:

UIL: 501.00-00, 501.03-05, 501.16-00, 521.00-00

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)(16). 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. The
IRS Customer Service number for people with hearing impairments is 1-800-829-4059.

Sincerely,

Holly O. Paz
Director, Rulings and Agreements

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

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Date: March 27, 2013 Contact Person:
Identification Number:
Contact Number:
FAX Number:

Employer Identification Number:

LEGEND:

State = UIL: 501.00-00, 501.03-05,
Date1 = 501.16-00, 521.00-00
Date2 =

Dear

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)(16). Based on the
information provided, we have concluded that you do not qualify for exemption. The basis for our
conclusion is set forth below.

FACTS

You are a State nonprofit cooperative association formed on Datei. However, according to its
business website, State has classified your corporate status as “Suspended” since Date2.

You were incorporated by three individuals. Your Articles of Incorporation state that you were “formed
for the pleasure, recreation and other non-profit purposes authorized under § 501(c)(16) of the
Internal Revenue Code.” Your purpose is to form a cooperative that “will facilitate and organize
transactions between members who collectively cultivate and possess marijuana for medical
purposes.” This includes promoting, advocating, and financing “the safe and legal access of medical
marijuana for therapeutic and medical purposes as well as research.” You will limit access to any
marijuana you own or possess to your members who, pursuant to State law, are qualified medical
marijuana patients and/or primary caregivers.

Your incorporators are engaged in the production of cannabis and have associated themselves
together to form a nonprofit cooperative association. Your incorporators are not organizations exempt
from federal income tax under § 521 of the Code, or members of such organizations.

You will have no more than three directors on your board and they will serve four-year terms. The
directors must be qualified members to serve on the board. Directors receive compensation for their
services and are entitled to reasonable reimbursement for traveling and other expenses.

2

Any person or entity that is a qualified patient or caregiver, as defined by the State Code, may submit
a membership application to become a member of your association. Your Board of Directors may
admit or deny membership in its discretion. There is no fee to become a member, but the board may
require members to invest funds for effective corporate purposes.

You do not issue stock shares, and while the property interest of each of your members may be
unequal, the voting rights are equal with each member having one vote. You measure each
member’s property rights and interests by the member's total non-refunded contribution of funds,
property, or cannabis pro rata to your total retained funds.

To provide capital for your corporate purposes, you may retain funds from your net sales. You
classify the total funds that you retain as the “Revolving Fund,” and the amounts retained from each
member as “Revolving Fund Credits.” Revolving Fund Credits are evidence of your indebtedness to
each member. You do not plan to pay interest on the credits, but if the board provides for interest,
you will not pay more than eight percent per annum.

You may enter into marketing, crop purchase, or other agreements with any member or patron. The
agreements may incorporate provisions relating to the harvesting, handling, packing, processing,
selling, shipping, delivery, or title transfer of cannabis produced by the member or patron. After
delivery, you may receive unqualified power to take title over and process, sell, dispose, or transfer
the cannabis.

APPLICABLE LAW

Section 501(a) of the Internal Revenue Code exempts from taxation organizations described in
§ 501(c).

Section 501(c)(16) of the Code describes corporations organized to finance the ordinary crop
operations of its members or other producers. The corporation must be organized by a § 521 farmers’
cooperative, or the cooperative’s members, and operated in conjunction with the § 521 farmers’
cooperative that organized it.

A § 501(c)(16) organization may issue capital stock, but if the stock has a dividend rate, it may not be
higher than the greater of the legal rate of interest in its incorporation state or eight percent (8%) per
annum on the value of the consideration for which the stock was issued.

If the § 501(c)(16) organization issues stock, the § 521 farmers’ cooperative must own substantially all
of it. Nonvoting preferred stock may be owned by others, but those stockholders must not participate,
directly or indirectly, in the profits of the § 501(c)(16) corporation, on dissolution or otherwise, beyond
the fixed dividends.

Section 501(c)(16) organizations may accumulate and maintain a reasonable reserve for any
necessary purpose or if required by state law.

Section 521 of the Code exempts farmers’ cooperatives from taxation, except as otherwise provided
in §§ 1381 — 1383. Farmers’ cooperatives include farmers’ associations, fruit growers’ associations,
or like associations organized and operated on a cooperative basis for one of two purposes. The
cooperative may organize to market its members’ or other producers’ products, then return the sales
proceeds, less necessary marketing expenses, based on either the quantity or the value of the
products furnished by the members or producers (“marketing association”). Alternatively, the farmers’

cooperative may organize to purchase supplies and equipment so its members or others may pay
cost rather than retail (“purchasing association’).

Treas. Reg. § 1.501(c)(16)-1 states that a corporation organized by a farmers’ cooperative, or its
members, is tax-exempt if organized for the purpose of financing its members’, or other producers’,
ordinary crop operations. The farmers’ cooperative that organizes the financing corporation must be
exempt under § 521 and operate the financing corporation in conjunction with itself. Further, the
provisions of Treas. Reg. § 1.521-1 relating to a reserve or surplus and to capital stock shall also
apply to § 501(c)(16) corporations.

Treas. Reg. § 1.521-1(a)(1) requires the § 521 marketing association to distribute the proceeds of the
business proportionally between members and nonmembers. It must also keep permanent records of
the business done with both members and nonmembers.

Treas. Reg. § 1.521-1(a)(2) specifies that an association may have capital stock, so long as the
stock’s dividend rate is not higher than the greater of the legal rate of interest in its incorporation state
or 8 percent (8%) per annum on the value of the consideration for which the stock was issued.
Additionally, the producers who market their products or purchase their supplies and equipment
through the association must own substantially all of the stock of the association.

Treas. Reg. § 1.521-1(a)(3) specifies that accumulation and maintenance of a reserve to either meet
state requirements or for any necessary purpose will not destroy the exemption.

Treas. Reg. § 1.521-1(b) expands the description of § 521 purchasing associations, defines the term
“supplies and equipment” as it is used in § 521, and states that the provisions in Treas. Reg.

§ 1.521-1(a) relating to a reserve or surplus and to capital stock applies to purchasing associations.
The value of the supplies and equipment purchases for nonmembers may not exceed the value of the
supplies and equipment purchased for members, and the total value of the purchases made for
nonmembers who are not producers must not exceed 15 percent (15%) of the value of all of the
association’s purchases.

Treas. Reg. § 1.521-1(e) requires an organization claiming exemption under § 521 to file a Form 1028
with the district director for the internal revenue district where the organization's principal place of
business or principal office is located.

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 (“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.

Article VI, Clause 2 of the United States Constitution states that federal laws prevail over conflicting or
inconsistent state laws.

4

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 Bob Jones University v. United States, 461 U.S. 574, 103 S. Ct. 2017 (1983), the Supreme Court
held that racially discriminatory education is contrary to public policy, and therefore, the University
could not be viewed as providing public benefit within the charitable concept.

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.”

The court in Weingarden v. Commissioner, 825 F.2d 1027 (6th Cir. 1987), summarized how courts
interpret tax statutes. “The general canon of construction is that statutes imposing a tax are
interpreted liberally (in favor of the taxpayer). But provisions granting a deduction or exemption are
matters of legislative ‘grace’ and are construed strictly (in favor of the government).” Id. at 1029
(citations omitted).

In Harding Hospital, Inc. v. United States, 505 F.2d 1068, 1071 (6th Cir. 1974), the court held that an
organization seeking tax-exempt status “bears a heavy burden to prove that it satisfies all the
requirements of the exemption statute.” The court noted that the “Tax Court has stated consistently
that a statute creating an exemption must be strictly construed and any doubt must be resolved in
favor of the taxing power.” Id. (citations removed).

The court in Green v. Connally, 330 F. Supp. 1150, 1161-62 (D.C. Cir. 1971), discussed multiple
cases that limited tax benefits such as the dependency deduction, the business expense deduction,
and the charitable deduction due to violation of federal or state laws. “Before considering the more
particular subject of charities, we refer to the general and well established principle that the
Congressional intent in providing tax deductions and exemptions is not construed to be applicable to
activities that are . . . illegal.” Id. at 1161.

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

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 it urged demonstrators 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. See Restatement
(Second) of Trusts, § 377 (1959); see also Restatement (Third) of Trusts, § 29 (2003). The purpose is
illegal if the trust will use the trust property for an object that is in violation of the criminal law, if the
trust tends to induce the commission of crime, or if the accomplishment of the purpose is otherwise
against public policy. IV Scott on Trusts § 377 (3d. ed. 1967); see also Restatement (Third) of Trusts,
§ 29 (2003).

The Restatement (Third) of Trusts, § 29 (2003) states that an intended trust or trust provision is invalid
if its purpose is unlawful, its performance calls for the commission of a criminal or tortious act, or it is
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)(16)
as a crop financing organization.

Section 501(c)(16) Requirements

“[P]rovisions granting . . . [an] exemption are matters of legislative ‘grace’ and are construed strictly (in
favor of the government).” Weingarden v. Comm’r., 825 F.2d at 1029. Organizations exempt under

§ 521 form crop-financing organizations to provide financing to their member farmers so they may
cultivate their crops and livestock. The crop-financing organization may be recognized as exempt
under § 501(c)(16) if it proves it is both organized and operated according to the requirements of the
statute. See Harding Hospital v. U.S., 505 F.2d at 1071.

A crop-financing organization must be a corporation. § 501(c)(16). The organization must have been
organized by either a farmers’ cooperative exempt under § 521, or by the members of a farmers’
cooperative exempt under § 521. Id. The crop-financing organization's purpose must be to finance
the ordinary crop operations of its members or other producers, and it must operate in conjunction
with the § 521 farmers’ cooperative that formed it. Id. Finally, Congress stated that the IRS may not
deny exemption solely because the crop-financing organization issues capital stock or maintains a
reserve. Id.; Treas. Reg. § 1.521-1(a).

Although you appear to satisfy the provisions relating to capital stock and a reserve, you do not satisfy
the other organizational requirements of § 501(c)(16). State has suspended your corporate status;
therefore you do not meet the first organizational requirement of § 501(c)(16). You also have not
shown that you were created by a § 521 farmers’ cooperative or that your incorporators were
members of a § 521 exempt farmers’ cooperative, and as such, do not meet the second
organizational requirement. Finally, your articles of incorporation state that you were “formed for the
pleasure, recreation and other non-profit purposes authorized under § 501(c)(16).” As ‘pleasure’ and
‘recreation’ are not exempt purposes listed under § 501(c)(16) or the accompanying regulations, you
do not completely satisfy the third organizational requirement. Id. Because you do not meet each of
the organizational requirements of § 501(c)(16), you are not considered to be organized as a crop-
financing organization.

You also fail to satisfy the operational requirements of § 501(c)(16) and the accompanying
regulations. See Treas. Reg. § 1.501(c)(16)-1. You cannot operate in conjunction with the § 521
farmers’ cooperative that formed you, as you were not formed by a § 521 farmers’ cooperative, as
defined by the Code and accompanying regulations, or by the members of such a farmers’
cooperative.

legality

As noted above, exemptions are not a right, but a matter of legislative ‘grace.’ Weingarden v.
Comm’r., 825 F.2d at 1029. Congress grants various organizations exemption from federal income
tax. In exchange for this favorable tax treatment, the organization must adhere to certain laws and
doctrines. This general and well-established principle is not limited to exemptions for charitable
organizations, but applies to all deductions and exemptions from federal tax. Congress did not intend
to provide tax deductions and exemptions to activities that are illegal. See Green v. Connally,

330 F. Supp. at 1161.

6

The common law of trusts specifies that a charitable trust is invalid if its purpose is unlawful, or if its
performance calls for the commission of a criminal or tortious act. See Restatement (Third) of Trusts,
§ 29. Evaluating the same common law, the Supreme Court noted, “[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.” Ould v. Washington Hospital for Foundlings, 95 U.S. at 311.

The general principle that tax deductions and exemptions are not applicable to activities that are
illegal is well established, and the courts and the IRS have consistently applied this general principle
to organizations seeking exemption. See Green v. Connally, 330 F. Supp. 1150 (D.C. Cir. 1971);
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); Rev. Rul. 75-384, supra. Therefore, similar to other exemptions and deductions, if a

§ 501(c)(16) organization commits illegal actions, or encourages others to commit illegal actions,
while performing its activities, it will not receive Congress’ “legislative grace” of exemption from federal
income tax. See Weingarden v. Comm’r, 825 F.2d at 1029.

Your activities violate this general principle. Your primary activity, facilitating and organizing
transactions between members who cultivate and possess cannabis, is illegal under Federal law. You
enter into agreements that give you title to the cannabis grown by your members. Once you obtain
title, you process, sell, and otherwise dispose of it as you decide. 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.

Federal law always prevails over conflicting or inconsistent state law. See U.S. Const. art. VI, cl. 2.
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 Oakland Cannabis
Buyers’ Coop., 532 U.S. at 493-94. The fact that State legalized distribution of cannabis to a limited
extent is not determinative because distribution of cannabis is illegal under federal law.

You operate in a manner that promotes activities that federal law prohibits, “violate[s] public policy as
reflected in those laws, and tends to promote illegal activities.” Mysteryboy Inc. v. Comm’r, T.C.M.
2010-13, 19. Because you advocate and engage in activities that contravene federal law, you failed
to prove that you satisfy the requirements of § 501(c)(16) and the related regulations. See Harding
Hospital, Inc., 505 F.2d at 1071.

CONCLUSION

Based on the facts and information submitted, you are not currently a legal corporation and you were
not organized by a § 521 exempt farmers’ cooperative, or by the members of such a cooperative.
Therefore, you cannot operate in conjunction with such a cooperative and are not described in

§ 501(c)(16) of the Code. Additionally, your primary purpose of facilitating and organizing
transactions involving cannabis not only violates federal law and public policy, but also promotes
illegal activities.

Accordingly, you do not qualify for exemption as an organization described in § 501(c)(16) of the
Code and you must file federal income tax returns.

7

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 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

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 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,

Holly Paz
Director, Rulings and Agreements