2013 Tax Planning for Marijuana Dealers

7/16/2019 2013 Tax Planning for Marijuana Dealers

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TAX PLANNING FOR MARIJUANA DEALERS

Benjamin Moses Leff*

INTRODUCTION

In the past decade and a half, eighteen states and the District ofColumbia have legalized medical marijuana.1 Last November, Coloradoand Washington became the first states to legalize the sale and use ofrecreational marijuana, as well, and many more states are consideringfollowing their lead. The trend appears to be toward liberalization of statemarijuana laws not just for medical purposes, but to advance a number ofother state policy goals, including reducing crime, improving blightedneighborhoods, improving opportunities for youth currently impacted by the

drug trade, increasing safety for marijuana users, and raising revenue forstate and local governments.

These state and local policy objectives clash directly with federal law,since the sale of marijuana is a federal crime even when such activity isaffirmatively sanctioned under state law. While the conflict between stateand federal criminal law has garnered attention from legal academicsconcerned about federalism issues,2 marijuana industry insiders do not citefederal criminal law as the biggest impediment to the development of alegitimate marijuana industry. Instead, the lead trade publication for themarijuana industry reports that [t]he federal tax situation is the biggest

threat to [state-sanctioned marijuana] businesses and could push the entireindustry underground.3

To date, no extended scholarly attention has been

* Associate Professor, American University Washington College of Law. The authorwould like to thank Jonas Anderson, Lilian Faulhaber, Amanda Frost, Amanda Leiter,Lindsay Wiley and research assistance from Sean Griffin.

1 See 18 Legal Medical Marijuana States and DC, PROCON.ORG,http://medicalmarijuana.procon.org/view.resource.php?resourceID=000881 (last visitedFeb. 24, 2013).

2See, e.g., Sam Kamin, Medical Marijuana in Colorado and the Future of Marijuana

Regulation in the United States, 43 MCGEORGE L.REV. 147 (2012).

3 Marijuana Business Conference Wrapup: 36 Tips, Lessons & Takeaways for the

Cannabis Industry, Medical Marijuana Business Daily (Nov.15, 2012),http://mmjbusinessdaily.com/2012/11/15/marijuana-business-conference-wrapup-36-tips-lessons-take-aways-for-the-cannabis-industry/ (emphasis added)(hereinafter 36 Tips).


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2 DRAFT Please do not cite without permission[28-Feb-132013

paid to the federal tax situation faced by state-sanctioned marijuana sellers.

This paper proposes a novel tax strategy that solves the tax situation

for state-sanctioned marijuana sellers. The problem facing marijuana sellersis caused by a provision enacted by Congress in the early nineteen-eightiescalled 280E.4 Section 280E, which was enacted to punish drug dealers,5provides that sellers of controlled substances must pay taxes on their grossrevenue instead of their net incomea method of calculating income taxesthat some believe would drive almost all legitimate marijuana sellers out ofbusiness.

6The Internal Revenue Service has been vigorously enforcing

280E against state-sanctioned marijuana sellers,7

unlike the Department ofJustice, which has not generally pursued criminal charges against state-sanctioned marijuana sellers.8 It is this enforcement of 280E that has themarijuana industry so alarmed.

I argue that a properly organized and operated marijuana seller couldavoid the impact of 280E by qualifying as an exempt organization under

4 I.R.C. 280E.

5 The Senate Report explained, To allow drug dealers the benefit of business expensedeductions at the same time that the U.S. and its citizens are losing billions of dollars peryear to such persons is not compelled by the fact that such deductions are allowed to other,

legal, enterprises. S. REP.NO. 97-494, at 309 (1982).

6 See, e.g., Al Olson, IRS Ruling Strikes Fear in Medical Marijuana Industry,

NBCNEWS.com (Oct. 5, 2011) http://www.nbcnews.com/business/irs-ruling-strikes-fear-medical-marijuana-industry-1C7101112 (quoting an industry insider as saying, nobusiness, including ours, can survive if it is taxed on its gross revenue. The IRS is trying totax us out of business.).

7See Letters from IRS Deputy Assoc. Chief Counsel Andrew J. Keyso to U.S. Rep.Pete Stark, et al. (Dec. 16, 2010) available athttp://www.irs.gov/pub/irs-wd/11-0005.pdf(explaining that the IRS lack[s] the authority to publish guidance making an exception to280E for state-sanctioned marijuana sellers).

8 See, generally, Sam Kamin and Eli Wald, Marijuana Lawyers: Outlaws orCrusaders?, 91 OREGON L.REV. __ (forthcoming 2013)(describing the Attorney Generalscommunications about its enforcement policy); see also, Memorandum from David W.Ogden, Deputy Atty Gen., to selected U.S. Attys (Oct. 19, 2009)(urging U.S. attorneys tonot to focus federal resources in your states on individuals whose actions are in clear andunambiguous compliance with existing state laws). But see, Memorandum from JamesM. Cole, Deputy Atty Gen. to U.S. Attys (June 29, 2011)(explaining that [t]he OgdenMemorandum was never intended to shield [large-scale commercial marijuana] activitiesfrom federal enforcement action and prosecution, even where those activities purport tocomply with state law.).


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2-28-2013] Tax Planning for Marijuana Dealers 3

either 501(c)(3)which exempts charities from federal income taxesor under 501(c)(4)which exempts so-called social welfareorganizations.9 Both charities and social welfare organizations are exempt

from federal income taxthey pay no tax on either gross or net revenuesand so 280E does not affect them. Therefore, qualifying as a charity ofsocial welfare organization would solve a marijuana sellers federal taxproblem.

In order to qualify, a marijuana seller would have to meet a number oflegal requirements. First, it would have to be operated for a proper tax-exempt purpose. I propose that the marijuana seller have the purpose ofimproving the social and economic conditions of a neighborhood blightedby crime or poverty by providing job training, employment opportunities,and improved business conditions for commercial development in the

neighborhood. Many tax-exempt community development corporations runretail operations to accomplish these goals in neighborhoods all over thecountry.

In addition to having a tax-exempt purpose, a tax-exempt marijuanaseller would also have to meet a few other legal requirements. For example,it would have to refrain from distributing its profits to any managers orowners, it would have to restrict its political activities, and it may have to beoperated in a less commercial manner than ordinary for-profit marijuanasellers. These requirements would have a significant impact on how amarijuana seller was operated. For example, the fact that it cannot

distribute profits to owners or managers may have a significant impact onits ability to raise start-up capital. But if the business challenges could besurmounted, none of these legal requirements should pose a significantimpediment to qualifying as tax-exempt if the organization was properlyoperated.

Even once an organization has met these statutory requirements forexemption, however, the Supreme Court has held that a common-lawpublic policy doctrine prevents organizations from qualifying for tax-exempt status as charities if their charitable purposes are illegal or contraryto a well-established fundamental public policy. Because marijuana salesare still illegal under federal law, the public policy doctrine acts as anabsolute bar to exemption under 501(c)(3). However, this paper makesthe novel argument that the public policy doctrine applies only to charities,and not to social welfare organizations, and thus, marijuana sellers could

9 I.R.C. 501(c)(3), 501(c)(4).


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organize as 501(c)(4) organizations even if they were barred fromorganizing under 501(c)(3).

This novel argument is more than just a clever strategya taxloophole so to speakto avoid the impact of 280E. Rather, IRSrecognition of tax-exempt status for marijuana sellers together withenforcement of 280E could actually provide a mechanism to resolve thesubstantial federalism issues raised by the conflict between state and federalmarijuana laws. Many of the state policy goals identified by the recentlegalization movements relate to local issues, like crime reduction,neighborhood improvement, and state and local tax revenue. However, asthe state-sanctioned marijuana industry matures and states begin the processof creating regulations for the industry, it becomes more and more clear thatthere is the potential for conflict not only between the state and the federal

governments, but between states and their local governments andcommunities.10 A federal policy that incentivizes marijuana sellers to benon-profit, neighborhood-based organizations whose primary purpose isimproving the neighborhood in effect ties federal approval to localsupport.11 The federal tax laws, therefore, provide federal incentives toalign state and local policy objectives. The IRS could promote state andlocal policy harmonization by permitting community-based nonprofits tosell marijuana, but only when local community groups favored it in states inwhich it was legal. This would surely be better than its current role as alightning rod of the conflict between state and federal policy objectives.

I. THE PROBLEM:SECTION 280E

Generally, the federal income tax requires a business to pay apercentage of its taxable income in tax. In order to determine the businesss

10 See generally, Sam Kamin, supra note 2 at 162-65; Sam Kamin, Keynote:Marijuana at the Crossroads (2012) available at http://ssrn.com/abstract=2181443(describing conflict between states and localities over marijuana policy); Patricia E. Salkin

& Zachary Kansler, Medical Marijuana Meets Zoning: Can You Grow, Sell, and SmokeThat Here?, 62 PLANNING AND ENVIRONMENT LAW 3 (2010) (describing conflicts betweenstates and localities over marijuana policy).

11 California already recognized this in its original 1996 legislation, which requires thatmarijuana dispensaries be operated either as nonprofits or as cooperatives. CAL.HEALTH &SAFETY CODE 11362.5 (West 1997) The argument is even stronger for recreationalmarijuana dispensaries, since the risk of them having an adverse social impact on theneighborhoods that house them is even greater.


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taxable income, we start with all of the money coming in to the businessits gross revenueand then we subtract out all of the expenses of thebusiness, expenses like salaries, rent, advertising, health insurance for its

employees, state and local taxes, license fees, bookkeeping, accounting andlegal services, and many other things.12 If the business is some sort of retailoperation, one expense will be cost of goods sold (COGS),13 whichconsists primarily of the wholesale price that the business pays its suppliersto get the goods that it then sells at a retail price. Only after all of theseordinary and necessary business expenses are subtracted from the grossrevenue can we know what the taxable income is.

To illustrate, take as an example someone whose business is the retailsale of marijuana. If she paid federal income taxes like every otherbusiness, she would perform the following calculations. Imagine that she

had gross receipts of $3,000,000 and paid $2,600,000 of cost of goods sold,the wholesale cost for the marijuana she sold.14 She then had the followingother expenses:

Advertising 5,000

Legal Services 45,000

Office 10,000

Rent/Utilities 21,000

Taxes/Licenses 9,000

Wages/Payroll 175,000

Equipment Depreciation 15,000

12See I.R.C. 61, 162. Obviously, this very brief explanation is a simplification ofbusiness taxation under the federal income tax.

13 This is actually a slight simplification. According to the Treasury Regulations,gross income consists of total sales less cost of goods sold. All other ordinary andnecessary business expenses are then deducted from gross income, so the subtraction of thecost of goods sold is actually a first step that precedes the subtraction of all other businessexpenses. See Treas. Reg. 1.61-3(a). (In a manufacturing, merchandising, or miningbusiness, gross income means the total sales, less the cost of goods sold). The end resultis the same: total revenue less gross income and all other ordinary and necessary businessexpenses results in taxable income.

14 This hypothetical is based loosely on the expenses provided by the petitioner inOlive v. Commr of Internal Revenue, 159 T.C. No. 2, 10-11 (Aug. 2, 2012), but I havesimplified the numbers and decreased the cost of goods sold slightly to reflect exerttestimony that suggested that the petitioner had overstated its cost of goods sold.


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Other 20,000

Total 300,000

To calculate the businesss taxes, she would subtract the $2,600,000 ofcost of goods sold and the $300,000 of other business expenses from hergross revenue of $3,000,000 to get a taxable income of $100,000. If weapply a hypothetical 35% tax rate to that amount, her federal income taxesfor the year would be $35,000 and she would take home an after-tax incomeof $65,000.

That is how the calculation would work if marijuana sales were taxedlike every other business in America. But marijuana sales are not treatedlike every other business under the federal tax code. Instead, the way thatstate-sanctioned marijuana sellers must calculate their taxes is dramaticallyaltered by a little-known provision enacted in 1982, which was codified as 280E of the Internal Revenue Code.

15Marijuana industry insiders believe

that 280E is the biggest impediment to the development of a legitimatemarijuana industry, and could drive all legitimate sellers out of business. 16

Under 280E, [n]o deduction or credit shall be allowed for anyamount paid or incurred during the taxable year in carrying on any trade orbusiness if such trade or business . . . consists of trafficking in controlledsubstance . . . which is prohibited by Federal law[.]

17Under federal law,

marijuana is a Schedule I controlled substance,18

and the Tax Court hasruled that sale of it constitutes trafficking even when such sale is legal

15 See, generally, Carrie F. Keller, Comment: The Implication of I.R.C. 280E inDenying Ordinary and Necessary Business Expense Deductions to Drug Traffickers, 47 ST.LOUIS U.L.J. 157 (2003).

16See 36 Tips, supra note 3; see, also,Sam Kamin & Eli Wald, supra note 2 at 11(This provision [280E] could decimate the industry; few businesses can afford to payincome tax on their gross receipts).

17 I.R.C. 280E.

18See 21 U.S.C. 812 Schedule I(c)(10); see alsoUnited States v. Oakland CannabisBuyers Coop, 532 U.S. 483, 489-90 (2001)(holding that the distribution of marijuanaprohibited under the Controlled Substances Act except for distribution pursuant to agovernment-approved research project exempt under 823(f)). The United States SupremeCourt has held that Congress is within its constitutional authority to impose criminalsanctions on possession of marijuana. SeeGonzales v. Raich, 545 U.S. 1 (2005).


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under state law.19

Thus, a marijuana seller cannot deduct her expenses priorto calculating her taxable income.

The situation is not quite as dire as it initially may seem. A marijuanaseller is not required to actually calculate her income tax strictly as apercentage of her gross income. The Tax Court has explained that COGSis not a deduction within the meaning of [the tax code] but is subtractedfrom gross receipts in determining the taxpayers gross income.20 Inaddition, when Congress enacted 280E, the Senate Report stated that [t]opreclude possible challenges on constitutional grounds, the adjustment togross receipts with respect to effective cost of goods sold is not affected bythis provision of the bill.21 In other words, while a marijuana seller cannotdeduct the ordinary and necessary expenses incurred in running herbusiness, at least she can deduct the wholesale cost of the marijuana itself

from her gross revenue before calculating how much tax she owes.Whether it is because of constitutional concerns or accounting principles,the IRS follows this interpretation of the law.

22

So, because of 280E, the tax calculation of the hypothetical marijuanaseller described above would be as follows: Gross revenue of $3,000,000less COGS of $2,600,000 leaves $400,000. Instead of deducting the$300,000 of legitimate business expenses, the taxpayer would be required tocalculate her tax based on the whole $400,000 of gross income. Again, atthe hypothetical rate of 35%, she would owe $140,000 in tax. But her pre-tax profit is still the same $100,000 it was in the original hypothetical. The

effect of 280E, then, is to turn this marijuana sellers $65,000 of after-taxprofit into a $40,000 loss. She owes more in federal income tax than herentire net income for the year. Presumably, if she has a negative profitmargin year after year, it will not be long before she has to shut down.23

19Californians Helping to Alleviate Medical Problems, Inc. v. Commrof InternalRevenue, 128 T.C. No. 14 (May 15, 2007) (hereinafter CHAMPS)at 14.).

20Olive v. Commr of Internal Revenue, 159 T.C. No. 2 (August 2, 2012)(at note 2).

21 S. Rep. NO. 97-494, at 309 (1982).

22See, e.g., Olive v. Commr of Internal Revenue, 159 T.C. No. 2 (August 2, 2012)(inwhich the IRS argued that the taxpayers cost of goods sold should be disallowed becauseof a substantiation failure, but did not argue that such expenses are disallowed under 280E).

23 I have purposely chosen a hypothetical that illustrates the worst-case scenario for amarijuana seller: total pretax profits of less than her federal tax bill. If the hypotheticalmarijuana seller wanted to avoid shutting down, she could always raise her prices. If she


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Currently, state-sanctioned marijuana sellers are employing two legalstrategies to minimize the impact of 280E, but neither provides a completesolution. In 2007, the Tax Court held that a business that both operated amarijuana dispensary and provided caregiving services to patients couldbifurcate its business expenses and deduct the expenses associated with thecaregiving activities even though 280E prevented it from deducting any ofthe expenses associated with its dispensary operations.

24In effect, the Tax

Court held that 280E only applied to expenses related to the activity ofselling marijuana, rather than to all expenses of any business that soldmarijuana. Following this case, marijuana sellers were advised to allocateas many expenses as possible to caregiving services, and deduct the

expenses associated with such services fully.

25

In addition, because COGS are deductible under 280E, a marijuanaseller can try to allocate as much of her expenses to COGS as possible. If amarijuana seller is vertically integrated, growing the marijuana she sells,then opportunities to shift expenses to COGS are multiplied, sincecultivation costs are properly classified as costs of goods sold. So, in thehypothetical above, costs such as advertising, legal services, taxes, andwages could all be allocated between retail operations and cultivationoperations using some reasonable method. Only those expenses allocated tothe retail operations would be disallowed under 280E. The rest would be

deductible as a part of COGS.

increased her prices by 10% and therefore had $3,300,000 of gross revenue, then she wouldhave $155,000 of after-tax profit (3,300,000-2,600,000=700,000X.35=245,000; 700,000-300,000-245,000=155,000). Whether she can raise prices or not depends on the elasticityof the demand for legal marijuana, which presumably depends to a large degree on theavailability and cost of illegal marijuana, which is a pretty close substitute for legalmarijuana. But, as discussed infra, the primary policy goal of legalizing marijuana formany states is driving illegal marijuana sales out of business, and the price of legalmarijuana is relevant to the question of whether that goal will be met.

24SeeCHAMP, supra note 19.

25 See William Hoffman, Medical Marijuana Dispensaries Persist Despite TaxObstacles, TAX NOTES (May 14, 2012)(quoting attorney Henry Wykowski as saying, Oneof the things I encourage dispensaries to do now is to very carefully allocate their expensesbetween the services they are providing versus the sale of the medical cannabis). Thelimit of this strategy is illustrated in Olive v. Commr, supra note 20, in which the TaxCourt held that an organization could not allocate expenses to a caregiving business if all itwas really doing was selling marijuana.


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Either of these strategies could decrease federal taxes and thereforeincrease profits, possibly to the point where a seller could avoid going out

of business. But the primary point remains the same: 280E dramaticallyincreases the cost of operating a marijuana business that complies withfederal tax law, much more so than any other business taxes. When the costof running a legitimate business is raised, the financial benefit of running anillegal or quasi-legal business is increased. At a certain point, the costs oflegitimacy get too high, and the black-market providers thrive.

II. THE SOLUTION:TAX-EXEMPT STATUS

As discussed above, 280E imposes a tax regime that makes itextremely expensive to operate a state-sanctioned marijuana store. This

section offers a solution that relieves state-sanctioned marijuana sellers ofthe burden of 280E. It proposes that they operate as nonprofit tax-exemptorganizations. If state-sanctioned marijuana sellers could qualify as a tax-exempt organization, 280Ea provision that affects the calculation oftaxable incomewould not affect them because an organization that doesnot owe any income tax is unaffected by a provision that affects the way itcalculates income tax; no matter how many deductions it is denied, it stillowes no tax. Thus, some sort of tax-exempt status is the holy grail ofmarijuana dispensaries.

26Can they qualify?

Section 501 of the Code provides that any organization described in

subsection (c) (among others) is exempt from federal income tax.

27

Subsection (c) contains 28 numbered paragraphs each of which describes adifferent sort of exempt organization.28 The most familiar, probably, is 501(c)(3), which describes corporations . . . organized and operatedexclusively for religious, charitable, scientific, testing for public safety,literary, or educational purposes[.]

29Less known among the general

26 In some states, marijuana sellers are required by state law to be nonprofit orcooperative organizations. See, e.g., Mass. Gen. Laws Chapter 369, 2(H) (2012)(definingMedical marijuana treatment center as a not-for-profit entity, as defined byMassachusetts law only). Such organizations may be nonprofits under state law, but ifthey do not qualify as tax-exempt under federal law, their non-profit status does not helpthem avoid the impact of 280E.

27See I.R.C. 501(c).

28Seeid.

29 I.R.C. 501(c)(3).


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public, but very widely used by nonprofits is 501(c)(4), which describesorganizations not organized for profit but operated exclusively for thepromotion of social welfare.30

Both 501(c)(3) and 501(c)(4) have to meet a series of requirementsin order to qualify for exemption. First, each requires that an organizationbe organized and operated for certain purposes. In the case of 501(c)(3)organizations, those purposes are charitable.31 In the case of 501(c)(4)organizations, the purposes are the promotion of social welfare.32Second, both types of organizations are bound by the "commercialitydoctrine," which holds that the primary activity of a tax-exemptorganization cannot be one that has a direct counterpart in, or is conductedin the same manner as is the case in the realm of for-profitorganizations[.]

33Third, both 501(c)(3) organizations and 501(c)(4)

organizations must meet a statutory requirement that no part of the netearnings of such entity inures to the benefit of any private shareholder orindividual

34and they are restricted in the types or quantities of political

activities they may engage in.

In addition to all of these tests, however, the Supreme Court has heldthat 501(c)(3) organizations are also constrained by a doctrine called thepublic policy doctrine. The public policy doctrine holds that the purpose

30 I.R.C. 501(c)(4). For the purposes of this paper, I only consider whether a

marijuana seller could qualify under 501(c)(3) or 501(c)(4) of the Code, and not anyother paragraphs of subsection 501(c).

31 Section 501(c)(3) actually lists a number of possible purposes, including charitable.See I.R.C. 501(c)(3) (for religious, charitable, scientific, testing for public safety,literary, or educational purposes, or to foster national or international amateur sportscompetition (but only if not part of its activities involve the provision of athletic facilitiesor equipment), or for the prevention of cruelty to children or animals), However, theSupreme Court has held that in enacting both 170 and 501(c)(3), Congress sought toprovide tax benefits to charitable organizations[,] thus interpreting the term charitableto extend to all organizations exempt under 501(c)(3). Bob Jones University v. Commr,461 U.S. 574, 587-88 (1983)(emphasis added).

32 I.R.C. 501(c)(4).

33 Bruce Hopkins, THE LAW OF TAX-EXEMPT ORGANIZATIONS (10th 2011) at4.10(a)(i), p. 100.

34 I.R.C. 501(c)(4)(B). Almost identical language appears in 501(c)(3): no part ofthe net earnings of which inures to the benefit of any private shareholder or individual[.]


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of a charitable organization may not be illegal or contrary to fundamentalpublic policy.35 Because selling marijuana is illegal under federal law, thepublic policy doctrine disqualifies a marijuana seller from exemption as a

501(c)(3) organization. However, no court or federal agency has ever heldthat the public policy doctrine applies outside the confines of 501(c)(3),and there is good reason to believe that it does not. I argue that the publicpolicy doctrine, which is derived from the common law of charities, simplydoes not apply to 501(c)(4) social welfare organizations, which are notcharities. And so, a marijuana seller could qualify as tax-exempt under 501(c)(4) of the Code.

A. Purposes Test: Community Economic Development Corporations

If a marijuana seller wants to qualify as a 501(c)(3) charity or a

501(c)(4) social welfare organization, the first question it must ask iswhether it can be operated exclusively for proper purposes. I argue that iforganized and operated correctly, the answer is an unqualified yes.

Section 501(c)(3) requires that an organization be organized andoperated exclusively for religious, charitable, scientific, testing for publicsafety, literary, or educational purposes, or to foster national or internationalamateur sports competition , or for the prevention of cruelty to childrenor animals[.]

36The IRS has previously denied 501(c)(3) status to an

organization that sold marijuana.37

That organization argued that itadvanced charitable purposes by educating individuals about legal

marijuana use for medicinal purposes and by promoting health by providingserious ill individuals with safe, legal access to cannabis.38

Promotinghealth is a proper charitable purpose, as is education, but the IRSdetermined that the organization did not qualify as a 501(c)(3) organizationbecauseamong other things[d]istributing cannabis does not further

35See, e.g., Bob Jones University v. Commr, 461 U.S. 574, 591 (1983)(holding thatthe purpose of a charitable trust may not be illegal or violate established public policy).

36 I.R.C. 501(c)(3). As discussed supra note 31, the list is not intended to beexclusive, but is intended to represent a number of purposes that Congress considerscharitable.

37See I.R.S. Priv. Ltr. Rul. 201224036 (June 16, 2012).

38 I.R.S. Priv. Ltr. Rul. 201224036 (June 16, 2012); see, also, I.R.S. Priv. Ltr. Rul.201013062 (April 2, 2010)(revoking the tax-exempt status of an organization that primarilyruns clinics for potential medical marijuana patients, when such activities were notdescribed in its application for exempt status).


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any exempt purpose39

presumably at least partially because Federal lawdoes not recognize any health benefits of cannabis[.]40

But promoting health and educating individuals are not the onlypossible charitable purposes a marijuana seller could have. The TreasuryRegulations expand the statutory list of charitable purposes as follows:[s]uch term includes: Relief of the poor and distressed or of theunderprivileged . . . or (i) to lessen neighborhood tensions; . . . or (iv) tocombat community deterioration and juvenile delinquency.41 Could amarijuana seller be operated to provide relief to the poor, distressed, orunderprivileged? Could it be operated to lessen neighborhood tensions,combat community deterioration or combat juvenile delinquency? I arguenot only that a marijuana seller couldbe operated to meet those objectives,but that those objectives were important goals that are fueling the

movement by states to legalize marijuana sales.

42

One type of organization that has been long recognized to haveproper charitable purposes because it promotes social welfare by relievingpoverty and combating community deterioration is the communitydevelopment corporation (CDC), whose tax-exempt purpose generallyincludes economic development of a poor or distressed neighborhood.

43It

is quite common for CDCs to operate retail businesses in theirneighborhoods as a central, or even primary, activity.

44If a marijuana seller

could be organized asor operated as a project ofa CDC, then thepurposes test would presumably be met.

39Id.

40Id.

41 Treas. Reg. 1.501(c)(3)-1(d)(2).

42See infra Part II(3).

43 See generally, Robert Halpern, REBUILDING THE INNER CITY: A HISTORY OFNEIGHBORHOOD INITIATIVES TO ADDRESS POVERTY IN THE UNITED STATES (1995); SusanBennett et al., COMMUNITY ECONOMIC DEVELOPMENT LAW: A TEXT FOR ENGAGEDLEARNING (2012).

44 The Regulations state explicitly that [a]n organization may meet the requirementsof 501(c)(3) although it operates a trade or business as a substantial part of its activities,if the operation of such trade or business is in furtherance of the organizations exemptpurpose or purposes. Treas. Reg. 1.501(c)(3)-1(e)(1).


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CDCs have in common the fact that they are all located in, and aredevoted to improving the quality of life in, some poor or distressedcommunity. Indeed the fact that they are devoted to improving the

conditions in a poor or distressed community is the central factor justifyingtheir tax exemption. Thus, the beneficiaries of a CDC in a narrow sense arethe members of some poor or distressed community. The community ismost often a neighborhood in a city or town, but it can just as well be a ruralor even suburban community, so long as its members are poor or distressed.

The IRS has long recognized that retail operations that provide jobsfor residents who are hard to employ and to provide work-skills training forpeople from disadvantaged backgrounds can be exempt organizations.Work-skills training is a proper educational purpose, and training andemploying hard-to-employ persons is a proper charitable purpose.

45

Furthermore, job-skills training is not the only proper purpose for anotherwise commercial enterprise. The IRS has held that businesses can beoperated to provide other charitable benefits to beneficiary workers, like tohelp [emotionally disturbed] youths become responsible and self-supporting citizens, and thus able to be reintegrated back into thecommunity

46and to help residents of a halfway house for transitioning

alcoholics to develop regular work habits and sense of self discipline andindependence at a time when they are not able to cope emotionally with theoutside pressures of the everyday world.

47

45 See, e.g., Rev. Rul. 73-128, 1973-1 CB 22 (holding that an organization that

employs residents of a particular economically depressed community to make toys soldthrough regular commercial channels is exempt because it provides vocational training tounemployed or underemployed persons); Rev. Rul. 76-37, 1976-1 CB 148 (holding that anorganization that buys houses, renovates them, and sells them at a profit is tax-exemptbecause the renovations are performed by students learning the building trades); Rev. Rul.57-297, 1957-2 CB 307 (holding that an organization that rehabilitated older unemployedpersons is tax-exempt).

46 Gen. Couns. Mem. 36393 (Sept. 2, 1975) (holding that an organization that operatesa grocery store that employs emotionally disturbed adolescents as part of a residencefacility and therapeutic program for its workers is exempt even though running a grocerystore is not itself a proper tax-exempt purpose).

47 Rev. Rul. 75-472, 1975-2 CB 208 (explaining that [t]he work in the furniture shopis transitional employment, rather than occupational training. The instruction or trainingreceived at the shop is not intended to achieve a significant increase in saleable skills sincemost of the residents already have other saleable skills.).But see I.R.S. Gen. Couns. Mem.39752 (Sept. 6, 1988) (holding that a furniture manufacturing operation and a packagingservice are not related to the exempt purpose of a church school because it was onlyteaching the importance of the work ethic to its students).


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One example of a current organization that operates numerousbusinesses in order to train and rehabilitate formerly disadvantaged persons

is Homeboy Industries. Homeboy Industries is a 501(c)(3) organization thathires former L.A. gang members to run a silkscreen business, a bakery, acaf, a maintenance company, and a retail store.48 The organizationsmission is to assist[] at-risk and formerly gang-related youth to contributeto society through job placement, training and education.49 Some of theservices it provides include mental therapy for former gang members,housing assistance, job development counseling and tattoo removaltreatments.

50But the main thing Homeboy Industries does is provide good

honest jobs for former gang members.51 These former gang members arehard to employ in the regular economy, and Homeboy Industries provides ajob and is willing to train its workers and provide the services those workers

need to succeed. The retail operations, therefore, serve the purpose ofrelieving poor, distressed and underprivileged persons (the former gangmembers). In addition, by providing a legitimate way out of a life of crimewithin a gang, the organization combats juvenile delinquency. Finally, bothbecause the retail operations themselves provide a stabilizing commercialpresence in poor and distressed neighborhoods, and because they turn somegang members away from criminal activities that harm neighborhoods, theretail operations lessen neighborhood tensions and combat communitydeterioration.

If a retail marijuana operation were to seek to qualify for tax-exempt

status as a CDC like Homeboy Industries, there are several things it shoulddo. First, it should identify itself with a poor or distressed neighborhoodand direct its activities to improving the living conditions in thatneighborhood. Ideally, that neighborhood would be a place that hashistorically been negatively affected by the illegal marijuana market. Theorganizations case would be strengthened if the neighborhood had

48See James Flanigan, Small Businesses Offer Alternatives to Gang Life, New YorkTimes (March 20, 2008), available athttp://www.nytimes.com/2008/03/20/business/smallbusiness/20edge.html?pagewanted=all&_r=; see also Form 990 for Homeboy Industries (2011), available athttp://www.guidestar.org/FinDocuments/2011/954/800/2011-954800735-089eeb6c-9.pdf.

49 IRS Form 990 at Part III, Q. 1.

50 Flanigan, supra note 48.

51Id. (Homeboys emphasis is on putting gang members to work.).


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previously had insufficient retail operations, and would benefit from astrong retail presence that could encourage other legitimate retail operationsto locate nearby. Second, the organization should hire employees who are

hard to employ in ordinary commercial operation. For example, it couldhire former sellers of illegal marijuanaespecially youthtrain them inlegitimate retail operations and draw them away from the illegal marijuanaindustry. The jobs and job training provided to these former drug dealerswould advance the charitable purpose of providing relief to the poor anddistressed youth themselves, and of combatting the neighborhood tensionsand community deterioration of the neighborhoods in which their formerillegal drug activities took place. Finally, the organization would be wellserved to ensure that members of the community it seeks to serve areprominently placed on its board of directors, so they can ensure that theorganization serves the primary purpose of advancing the social welfare of

the local community. If the organization does these things, then it wouldpresumably qualify as having proper tax-exempt purposes even if itsprimary activity consists of operating a store-front retail marijuana salesbusiness.

Admittedly, it is controversial to suggest that locating a state-sanctioned marijuana seller in a poor and distressed neighborhood andhiring former illegal marijuana sellers to work in it is good for thecommunity. One could imagine a range of opinions on the matter, and itwould certainly not be unreasonable for a person to believe that theexistence of a state-sanctioned marijuana seller would negatively impact the

community in many of the same ways that criminal marijuana selling does.However, all that is necessary to meet the requirements of 501(c)(3) and501(c)(4) is a group of people who reasonably believe that their proposedactivities plausibly advance their proper tax-exempt purposes. The lawdoes not require any specific level of proof that such activities would havethe desired result. As is discussed below, the strength of my proposal is thatit incentivizes marijuana sellers to take an organizational form thatmaximizes their chances of promoting the social welfare of the community,and enables the IRS to defer to local community support of marijuanasellers in determining which to grant tax-exempt status to.52

If an organization has proper purposes to qualify as a 501(c)(3)organization, then its purposes are sufficient to qualify as a 501(c)(4)organization as well. Remember, a 501(c)(3) organization is one operatedfor certain charitable purposes and a 501(c)(4) organization is one operated

52See, infra at Section III.


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for the promotion of social welfare.53

The Treasury Regulations helpfullyexplain that [a]n organization is operated exclusively for the promotion ofsocial welfare if it is primarily engaged in promoting in some way the

common good and general welfare of the people of the community.

54

Social welfare purposes (proper for a 501(c)(4) organization) and charitablepurposes (proper for a 501(c)(3) organization) are in no way mutuallyexclusive. In fact, the Regulations further explain that a social welfareorganization will qualify for exemption if it falls within the definition ofcharitable set forth in paragraph (d)(2) of section 1.501(c)(3)-1.55 Thedefinition of charitable set forth in the named paragraph is the one wehave already seen, which states, [s]uch term includes: Relief of the poorand distressed or of the underprivileged . . . promotion of social welfare byorganizations designed to accomplish any of the above purposes, or (i) tolessen neighborhood tensions; . . . or (iv) to combat community

deterioration and juvenile delinquency.

56

In other words, an organizationthat qualifies as charitable because it relieves the poor, distressed orunderprivileged, lessens neighborhood tensions, combats communitydeterioration or combats juvenile delinquency also qualifies as a socialwelfare organization under 501(c)(4) of the Code.57 The leading treatiseon tax-exempt organizations law puts it like this: of greatest importance,the concepts of what is charitable and what constitutes social welfare can bevery much alike. Thus, the same organization may simultaneously qualifyunder both categories of tax exemption.

58An organization that ran a retail

marijuana establishment to provide jobs and job training to former drug

53

I.R.C. 501(c)(4).54 Treas. Reg. 1.501(c)(4)-2(i).

55 Treas. Reg. 1.501(c)(4)-2(i).

56 Treas. Reg. 1.501(c)(3)-1(d)(2).

57 Some examples of community economic development organizations that wererecognized as tax-exempt under 501(c)(4) include the organization described in Rev. Rul.67-294 (industrial development to relieve unemployment in an economically depressedarea) and the organization described in Rev. Rul. 57-297 (rehabilitation and jobplacement).

58 Bruce Hopkins, supra note 33, at 13.4 (p. 363); see, also, Robert J. Desiderio,PLANNING TAX-EXEMPT ORGANIZATIONS (2009) at 23.02[1] (the cases and rulingsdefining social welfare in the context of IRC Section 501(c)(3) organizations should applywith equal force to social welfare organizations seeking exemption under IRC Section501(c)(4).).


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dealers and to improve the economic development of the neighborhood inwhich the illegal drug trade flourished would meet the purposesrequirement of 501(c)(4) of promoting social welfare at least as easily as

it would meet the purposes requirements of 501(c)(3) of being charitable.

B. No Inurement Requirement, Limited Lobbying, No Campaign Activities

In addition to the requirement that an organization have an exemptpurpose, there are a few other requirements under 501(c)(3) and 501(c)(4)that an organization must meet in order to qualify for exemption. First, both 501(c)(3) and 501(c)(4) of the Code explicitly require that none of theearnings of qualifying organization may not inure[] to the benefit of anyprivate shareholder or individual[.]59 Second, 501(c)(3) organizations areprohibited from devoting any substantial part of their activities [to]

carrying on propaganda[] or otherwise attempting[] to influencelegislation[.]60 This provision is generally called the lobbying limitation,since it limits but does not prohibit 501(c)(3) organizations from engagingin lobbying activities. Section 501(c)(4) organizations are not subject tothis limitation and may conduct unlimited lobbying. Finally, 501(c)(3)organizations are absolutely prohibited from participat[ing] in, orintervene[ing] in . . . any political campaign on behalf of (or in oppositionto) any candidate for public office.61 This campaign interventionprohibition does not apply to 501(c)(4) organizations, although campaignintervention cannot be the primary purpose of a 501(c)(4) organization.

62

These statutory requirements should not be a bar to marijuana sellers

qualifying for tax exemption, but they may well shape the way in whichsuch organizations operate.

The no inurement requirement presumably will have the mostdirect effect on a marijuana seller. It is what makes a nonprofit a nonprofit,and its basic requirement is that no profits can be distributed to any private

59 I.R.C. 501(c)(3), 501(c)(4)(B).

60 I.R.C. .501(c)(3).

61Id.

62See Treas. Reg. 1.501(c)(4)-1(a)(2)(ii)(the promotion of social welfare does notinclude direct or indirect participation or intervention in political campaigns on behalf of or

in opposition to any candidate for public office [but a] social welfare organization . . . mayqualify under section 501(c)(4) even though it is an action organization described in section1.501(c)(3)-1(c)(3)(ii)[.]).


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person. However, the nonprofit requirement is sometimes misunderstood.It does not require that the organization be operated so there are no profits.Quite the contrary, an organization may earn substantial revenue from its

exempt activities, so long as that revenue is used to advance theorganizations tax-exempt purpose.63 A tax-exempt non-profit organizationcan use revenue generated from its activities to advance its other non-revenue generating activities, or it can re-invest that revenue in the activitythat produced it, so long as the activity itself serves the tax-exempt purposefor which the organization as formed. So, for example, a tax-exemptuniversity or school generally makes significant revenue from the tuition itcharges its students. Its tax-exempt purpose is to provide that education,and so there is no impediment to it making more than it spends in anyparticular year and spending that excess revenue on improving its core tax-exempt function. The no inurement rule does not in any way require that

none of the activities a tax-exempt organization pursues produce netrevenues nor does it in any way second-guess the allocation of such excessrevenues as among the exempt purposes of the organization.

What the no inurement requirement does do is prevent anorganization from distributing any such profits to private persons. But theban on distributions of profits is also sometimes misunderstood. It does notmean that employees or managers or even suppliers of capital cannot becompensated for their labor or capital. It just means that when anorganization provides an economic benefit to a private person, theorganization cannot provide an economic benefit that exceeds the value of

the labor or capital provided by the private person. That is, the organizationcannot pay more than fair compensation to its managers and it cannot paymore than a fair-market rate for its capital. The no inurement requirementis not even as broad as that because it actually only applies when anorganization provides an economic benefit to a person who is in a positionto influence the organization. So, the no inurement rule does not apply tocompensation of ordinary (non-management) employees. It only applies tocompensation of managers who are in a position to influence theorganization.

The no inurement rule is supplemented by a statutory penaltyregime that enforces it, the so-called excess benefit transaction penalties.Under the penalty regime, an organization may be subject to verysignificant penalties if it provides an economic benefit to a person who isin a position to exercise substantial influence over the affairs of the

63See Treas. Reg. 1.501(c)(3)-1(e)(1).


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organization64

if the value of the economic benefit provided [by theorganization] exceeds the value of the consideration . . . received forproviding such benefit.65 Furthermore, even if the payment for capital or

labor was fair, it might result in penalties if it was directly tied to therevenues of the operation.66 So the penalty provisions and the no-inurementrule identify basically the same type of financial arrangements betweenmanagement or investors and the organizationand a nonprofit marijuanaseller should be sure to avoid those types of arrangements.

It would be very easy for a marijuana seller to operate subject to theno-inurement requirement and the excess benefit transaction rules. It wouldjust have to decide in advance that it would not pay its managers more thana fair-market wage for their services, and that it wouldnt pay them apercentage of its profits. Similarly, if it sought start-up funding, it would

not be permitted to pay above-market returns on such capital, and it wouldbe prevented from raising equity capital. That is, it could not sell sharesof itself to investors as a way of raising money. Instead, it would have toborrow its start-up capital in some sort of debt-like instrument. It isconceivable that these restrictions would be problematic for a marijuanaseller seeking management or capital due to the unusual risk associated withthe industry, but it is unlikely that they would be prohibitive. After all,there is no prohibition on paying its employees or its investors a fair returnfor their labor or capital.

The lobbying restriction and the campaign intervention prohibition

would only have minimal impact on a marijuana sellers operations. If itwas a 501(c)(3) organization, it would limit the amount of money it spenton lobbying,67 and refrain from endorsing candidates or otherwise

64 I.R.C. 4958(f)(1)(A).

65 I.R.C. 4958(c)(1)(A).

66 See 4958(c)(4) (To the extent provided in regulations prescribed by the Secretary,the term excess benefit transaction includes any transaction in which the amount of anyeconomic benefit provided to or for the use of a disqualified person is determined in wholeor in part by the revenues of 1 or more activities but only if such transaction results ininurement not permitted under paragraph (3) or (4) of section 501, as the case may be.).The Secretary has not prescribed any regulations on this topic, and so it is not clear whetherpenalties could apply to economic benefits that do not exceed fair market value but that aredetermined by the revenues of the operation.

67 Generally, most 501(c)(3) organizations are permitted to spend up to 20% of theirexempt purpose expenditures tax free, and they can spend 30% of such expenditures onlobbying before their tax-exemption could be at risk. See I.R.C. 4911(c)(2),


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attempting to influence their election. If it organized as a 501(c)(4)organization, it would not have to worry at all about the lobbyingrestrictions and could endorse candidates or attempt to influence elections,

so long as that was not its primary activity. Since the organizationsprimary activity would be related to the operation of its store, the fact thatits political activity would be limited would presumably not be a significantobstacle.

C. Scope of Commercial Operations/Commerciality Doctrine

In addition to the purposes requirement, the no-inurementrequirement and the political-activity restrictions, the IRS will also askwhether the scope of the retail operations is excessive in relation to theorganizations tax-exempt purposes and whether the operation,

notwithstanding its tax-exempt purpose, is overly commercial. Thus,even after a proper tax-exempt purpose is identified, tax exemption imposessignificant restrictions on the manner of operation of a marijuana seller whowishes to qualify for tax exemption under either 501(c)(3) or 501(c)(4).Nonetheless, these restrictions should not be an absolute bar to exemption ifthe organization is committed to promoting the social welfare of thecommunity.

When approving tax exemption for organizations that run a businessthat trains workers, one key consideration is whether the scope of thebusiness activities are excessive in relation to the tax-exempt purposes. The

IRS has held that the question . . . is whether the organization isconducting its [commercial] operation as an end in itself or as the means bywhich it accomplishes a charitable purpose other than through theproduction of income.68 Therefore, a legitimate job-training programcannot justify exemption for a commercial operation that is notcommensurate in scope to the exempt job training purpose. For example,an organization that ran a grocery store that provided job training forunemployed residents of a distressed neighborhood failed to qualify forexemption because the grocery store was conducted on a scale larger thanis reasonably necessary for the performance of the organizations training

501(h)(2)(B). That would be a substantial amount of money for an organization that wasprimarily devoted to operating a marijuana store for the purpose of providing jobopportunities, job training and neighborhood economic development.

68Rev. Rul. 73-128, 1973-1 CB 222.


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program . . . .69

In that case, the training program involved about fourpercent of the stores earnings.70 On the other hand, organizations thatqualified as exempt devoted a more substantial portion of their resources to

the job training or employment operations. For example, the toymanufacturing operations described above were commensurate in scope,largely because the non-management employees were all unskilledtrainees.

71The organization that rehabilitated buildings as a vocational

training program qualified partially because [a]pproximately 70 percent ofthe construction work on each home is performed by the students.72

Generally, the commerciality doctrine holds that an organizationthat conducts activities that are also conducted by for-profit commercialorganizations must conduct its operations in a way that is materiallydifferent from the for-profit organizations operating in the same market.

As one court described it, if an organization engages in an activity whichmight be carried on as a trade or business in competition with commercialenterprises, the organization must prove that its primary objective incarrying on the activity is an exempt purpose, and not the production ofprofits.73 The test of whether an organization is too commercial may be

69 Rev. Rul. 73-127, 1973-1 CB 221.

70Id.

71 Rev. Rul. 73-128, 1973-1 CB 222 (While some individuals hired for themanagement staff do possess managerial and technical competence, the organization hiresthese people only to insure the successful operation of the vocational training program. Inaddition, a substantial number of the management and administrative staff are unskilled

trainees.); see, also, I.R.S. Gen. Couns. Mem. 35074 (Oct. 11, 1972), (addressing thesame toy factory seeking exemption, and explaining that [t]he . . . division thatmanufactured the dolls had the stated policy of employing only the unskilled and theunemployed or under-employed residents of a particular depressed community[;] that itwas not [the organizations] policy to retain trained individuals as a permanent cadre butrather to move individuals into career positions with outside employees as soon aspractical[;] and that because of the constant turnover of employees, the toy division wasthought likely to continue to operate at a deficit.).

72 Rev. Rul. 76-37, 1976-1 CB 148; see, also, Gen. Couns, Mem. 36321 (June 26,1975) (noting that it is clear that the organization uses the home construction solely as ameans to provide on-the-job training in conjunction with public school vocational trainingin fundamental construction skills.)

73Greater United Navajo Enterprises v Commr, 74 T.C. 69, 78-79 (1980) (holdingthat an organization that primarily engages in leasing oil well drilling equipment with notax-exempt purpose does not qualify under 501(c)(3) even if it also engages in a smallnumber of activities that are charitable because they provide job training and employment


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very similar (or indistinguishable) with the test of whether the commercialoperation is commensurate in scope with the tax-exempt purpose.74 Butother factors may also be relevant.75 For example, in an organization that

provides job training and employment to hard-to-employ workers, thepercentage of workers who are needy may be relevant.

If the marijuana store were operated like Homeboy Industries andother CDCs, it should be able to establish that its retail operations arecommensurate in scope with its job training, employment, andneighborhood development purposes and that it is not too commercial to betax-exempt. Firstly, it should employ primarily youths who were eitherformerly employed in the illegal drug trade, or at risk of becomingemployed in the illegal drug trade, in its neighborhood of operation.Second, it should provide those youths with extensive vocational training in

the operation of s a small business, along with the fundamental skills thatare necessary to such operation, including customer service, marketing,bookkeeping, legal compliance, financial planning, etc. Third, it shouldprovide them with counseling and psycho-social rehabilitation whereappropriate, especially in situations in which they may be suffering frompost-traumatic stress disorder, or other stresses. Fourth, it should employ

opportunities for residents of the Navajo Reservation).

74 To complicate matters even further, an organization is permitted to conduct purelycommercial activities that are unrelated to its exempt purpose, so long as those commercialoperations are not its primary activity. But it must pay a tax on the income from those

operations under IRC 511. Under 511 of the Code, a tax is imposed on income from anunrelated trade or business, which means any trade or business the conduct of which isnot substantially related to the exercise or performance by such organization of [the]purpose or function constituting the basis for its exemption under section 501. IRC513(a). If an organization that conducted significant exempt activities began to operate amarijuana seller as a small part of its overall activities, the marijuana operation may notadversely impact its tax-exempt status even if the IRS held that it was unrelated to theorganizations tax-exempt purpose. However, in that case it would owe tax on its incomefrom marijuana sales, and that tax would be calculated in accordance with 280E. Theanalysis of what constitutes an unrelated trade or business is not necessarily identical tothe question of what type of activity could advance the tax-exempt purpose of anorganization sufficiently to qualify as tax-exempt, but it generally follows the samecontours. See, generally, Hopkins, supra note 33 at 24.4 (pp. 651-660). Thus, in order toavoid the impact of 280E, a tax-exempt marijuana seller must operate its sales activitiesin such a way that they are directly related to its accomplishment of its tax-exempt purpose.

75 In I.R.S. Priv. Ltr. Rul. 201013062 (4/02/2010), the IRS concluded that anorganization whose primary activity was running a clinic that sold medical marijuana wasnot tax-exempt under 501(c)(3) at least in part because [i]f it operates like a for-profitbusiness, the activities are like a for-profit, if the fees charged are like a for-profit, then it isa for-profit business.


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persons that are not from the target distressed group only where necessaryto accomplish its exempt purposes. Fifth, it should use its marijuana sellingoperations to engage directly with the community, fostering a safe

environment conducive to economic development. It should pursue thesegoals even when they are not directly in the financial best interests of theoperation. Finally, its board should always keep in mind in all of itsactivities that its goal is primarily to serve the neighborhood and the poorand disadvantaged youths that it employs, and not to operate an ordinarycommercial business in the pursuit of profits.

D. Public Policy Doctrine

1. Public Policy Doctrine and 501(c)(3) OrganizationsThe final impediment to organizing our marijuana seller as a tax-

exempt organization is the existence of a common-law doctrine generallycalled the public policy doctrine. In Bob Jones University v.Commissioner,76 the Supreme Court held that the IRS was within itsauthority to deny tax-exempt status to universities that had raciallydiscriminatory admissions or dating policies. It could deny them taxexemption not because they failed to have a proper educational purposeunder 501(c)(3), but because 501(c)(3) status requires not only that anorganization advance educational purposes, but also that it meet thecommon-law requirements for charities. The Court held that one of those

long-standing common-law requirements for charitable trusts was that thepurpose of a charitable trust may not be illegal or violate established publicpolicy.77 While not illegal, the Court held that having a raciallydiscriminatory policy about admissions or dating was contrary toestablished public policy, and so the public policy doctrine mandated thatBob Jones have its tax-exempt status revoked.

Finding a violation of a fundamental public policy can be difficult,but determining if the charitable purpose of an organization is illegal isrelatively straight-forward. For example, in Revenue Ruling 75-384 theIRS discussed an organization whose primary activity [was] the sponsoringof protest demonstrations and nonviolent action projects in opposition to

76 461 U.S. 574 (1982).

77Id. at 591. See, also, Bruce Hopkins, supra note 33 at 6.2 (pp. 156-157);Restatement (Second) of Trusts 377 (1959).


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war and preparations for war.78

These events are violations of localordinances and breaches of public order.79 Thus the organization inducesor encourages the commission of criminal acts by planning and sponsoring

such events.

80

There is no question that educating the general public aboutissues relating to war, even if the perspective is entirely negative, would bea legitimate educational purpose, and would qualify the organizations fortax-exempt status under 501(c)(3). Thus, an organization whose primaryactivity was sponsoring protest demonstrations that observed all localordinances laws would qualify for exemption under 501(c)(3).

However, the IRS determined that the organization in Rev. Rul. 75-384 could not qualify for tax exemption because its primary activity wasillegal. It reasoned that [a]s a matter of trust law . . . no trust can becreated for a purpose which is illegal. . . . Thus, all charitable trusts (and by

implication all charitable organizations, regardless of their form) are subjectto the requirement that their purposes may not be illegal or contrary topublic policy.

81

When it comes to marijuana sellers, the IRS has taken the positionthat the public policy doctrine prevents such an organization fromqualifying as exempt under 501(c)(3). In PLR 201224036 the IRSdiscussed an application for exemption under 501(c)(3) by anorganization that distributed medical marijuana in a manner legal in its stateof residence. The IRS first stated that [l]ike a trust, a 501(c)(3)organization cannot be created for a purpose that is illegal.82 It then went

on to observe that [y]our primary activity, the distribution of cannabis, isillegal. . . . The fact that [your state] legalized distribution of cannabis . . .is not determinative because under federal law, distribution of cannabis isillegal.83 Thus, the IRS has already taken the position that an organization

78 Rev. Rul. 75-384, 1975-2 CB 204.

79Id.

80Id.

81Id. On several other occasions the IRS has determined that organizations whosepurposes are illegal cannot qualify for exemption under 501(c)(3). See, e.g.,Mysteryboy,Inc. v. Commr, TC Memo. 2010-13 (2010)(holding that an organization that seeks to studyand promote sex between adults and children cannot be tax-exempt).

82 I.R.S. Priv. Ltr. Rul. 201224036.

83 I.R.S. Priv. Ltr. Rul. 201224036.


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whose primary purpose is the distribution of marijuana cannot be exemptunder 501(c)(3) because by breaking federal laweven if it complieswith all state and local lawsthe organization violates the public policy

doctrine.

Thus, the public policy doctrine may well disqualify a marijuanaseller from qualifying for exemption under 501(c)(3). But 501(c)(3) is notthe only paragraph in 501. Perhaps an organization that was barred fromtax-exempt status under 501(c)(3) could still be tax-exempt under anotherparagraph, like 501(c)(4). The relevant question is whether the publicpolicy doctrine applies to 501(c)(4)

2. Public Policy Doctrine and 501(c)(4) OrganizationsWhile it seems clear that the public policy doctrine would prevent anorganization that sold marijuana from being recognized as exempt under

501(c)(3), the answer is not nearly as clear with respect to 501(c)(4).There is no existing guidance from any court addressing the question ofwhether the public policy doctrine applies to 501(c)(4) organizations. Butthe public policy doctrine is derived from the common law ofcharities, anda 501(c)(4) organization, unlike a 501(c)(3) organization, is not a charity.Therefore, the common law of charities does not apply to 501(c)(4)organizations. There is one example of IRS guidance in which the IRS heldthat a specific organization whose primary activity was breaking the lawcould not be exempt under 501(c)(4).84 But, as discussed below, in

holding that the organization could not be exempt under 501(c)(4), the IRSfocused on facts that distinguish that case from the situation faced byproperly operated nonprofit marijuana sellers.85

First, in Bob Jones the Supreme Court made very clear that theorigin of the public policy doctrine is the common law of charities, and thatthe common law of charities applies to 501(c)(3), since that is the tax-exemption category that applies to charities. It stated, [t]he origins of such

84 Rev. Rul. 75-384, 1975-2 CB 204. In addition, in Mysteryboy, Inc., the IRSrejection letter concluded that your organization would not be exempt under either IRC

501(c)(3) or 501(c)(4). Mysteryboy, Inc., supra note 81. But the organization hadapparently not applied for tax-exempt status under 501(c)(4), and the court made nomention of 501(c)(4) in its opinion., holding only that the organization could not qualify asexempt under 501(c)(3).

85See infra text accompanying note 102.


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exemptions [for 501(c)(3) organizations] lie in the special privileges thathave long been extended to charitable trusts.86 These special privileges areaccompanied by a caveat, that a gift for charitable uses creates a

charitable trust provided the same is consistent with local laws and publicpolicy.87 The Court nowhere suggests that a 501(c)(4) organization is acharity or that it is bound by the common law of charities.

The idea that the common law of charitable trusts applies to 501(c)(3) but not 501(c)(4) is supported by another line of reasoningadvanced in the Bob Jones case. To support its holding that the commonlaw of charities applies to 501(c)(3) of the Code, the Court pointed outthat 170 of the Code uses the term charitable contributions to describeall contributions to organizations described in 501(c)(3) of the Code.Section 170 is the provision that makes contributions to 501(c)(3)

organizations tax deductible. This deduction provision is different from theexemption provision found in 501. The exemption provision relieves theorganization from paying tax on income that it earns while pursuing its tax-exempt purpose. The deduction provision permits a person making acontribution to a tax-exempt charity to deduct the amount of thatcontribution from her gross income before calculating her income taxes.The Court pointed out that [o]n its face, therefore, 170 reveals thatCongress intention was to provide tax benefits to organizations servingcharitable purposes. Thus, the fact that all contributions to 501(c)(3)organizations are deductible charitable contributions according to 170suggests that Congress intended that the common law of charities

including the public policy doctrineshould apply to all organizations thatare exempt under 501(c)(3).

But 501(c)(4) organizations are another matter. Section 501(c)(4)describes organizations operated exclusively for the promotion of socialwelfare[.] The word charity or charitable appears nowhere in theparagraph. Furthermore, the term charitable contribution as used in 170excludes contributions to organizations that qualify for exemption under 501(c)(4) rather than 501(c)(3) of the Code.

88In fact, it is fair to say that

the primary distinction between a 501(c)(3) organization and a 501(c)(4)

86Bob Jones, supra note 76 at 588.

87Id. (citingPerin v. Carey, 24 How. 465, 501 (1861)).

88See I.R.C. 170(c) (repeating the list of organizations described in 501(c)(3) butnot those described in 501(c)(4)).


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organization is that the (c)(3) can receive tax-deductible charitablecontributions while a (c)(4) organization cannot.89 The Supreme Court hasheld that organizations that receive the tax subsidies provided in

501(c)(3) and 170 are charities, and therefore are subject to the commonlaw of charities, which holds that they may not be organized or operatedprimarily to conduct activities that are illegal. But 501(c)(4)organizations are not charities, and the common-law public policy doctrinesimply does not apply to them.

The IRS implicitly recognized that the public policy doctrine doesnot apply to 501(c)(4) organizations in its only ruling addressing anorganization with illegal purposes seeking tax exemption under 501(c)(4).In Revenue Ruling 75-384, discussed above,90 the IRS denied tax-exemptstatus to an organization whose primary activity was conducting civil

disobedience campaigns against war. As discussed above, the IRS held thatthe organization could not qualify as tax exempt under 501(c)(3) becauseof the public policy doctrine. But the organization had actually soughtrecognition as tax exempt under either 501(c)(3) or 501(c)(4). The IRSstarted by citing the sections of the Code and Regulations that apply to 501(c)(3), discussing the public policy doctrine and its origin in charitabletrust law, and concluding that the organization could not be exempt under 501(c)(3). It concluded its public policy analysis by stating, [a]ccordingly,the organization is not operated exclusively for charitable purposes anddoes not qualify for exemption from Federal income tax under 501(c)(3)of the Code.91

It then turned its attention to the qualifications for tax exemptionunder 501(c)(4), citing the Code and regulations applicable to thatsection.92 Without any mention of the public policy doctrine or thecommon law of charities, it then concluded in a single two-sentenceparagraph:

Illegal activities which violate the minimum standards

89See Robert Desiderio, supra note 58 at 23.01 ([t]he primary disadvantage of asocial welfare organization is that contributors may not deduct contributions if theorganizations tax-exempt status derives from IRC Section 501(c)(4)).

90Seesupra text accompanying note 78.

91 Rev. Rul. 75-384, supra note 84.

92Id.


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of acceptable conduct necessary for the preservation ofan orderly society, are contrary to the common goodand the general welfare of the people in a community

and thus are not permissible means of promoting thesocial welfare for purposes of 501(c)(4) of the Code.Accordingly, the organization in this case is notoperated exclusively for the promotion of socialwelfare and does not qualify for exemption fromFederal income tax under 501(c)(4).93

In other words, the organization at issue could not promote socialwelfare because it plans to engage in [i]llegal activities which violate theminimum standards of acceptable conduct necessary for the preservation ofan orderly society.

94

The intended meaning of that sentence is ambiguous, however. Itcould mean that all illegal activities violate standards of acceptable conduct,and so an organization whose primary purpose is to conduct any illegalactivities could not have the purpose of promoting social welfare. It couldalso mean that some illegal activities violate the minimum standards ofacceptable conduct, and only those organizations that conduct activities thatviolate minimum standards of acceptable conduct cannot possibly promotesocial welfare, but not all illegal activities do so.

The punctuation of the sentence arguably resolves the ambiguity. If

there was a comma following the words illegal conduct, then the phrasethat followed would be a restrictive relative clause, which means it couldbe removed without altering the meaning of the sentence.95 In that case, theimplication would be that any illegal conduct, if it was the primary purposeof an organization, would disqualify the organization for tax exempt statusunder 501(c)(4). However, without the comma, the phrase is anonrestrictive relative clause, in which case the implication is that not allillegal conduct would disqualify an organization for 501(c)(4) status, butjust that subcategory of illegal conduct that violates the minimum standards

93Id.

94Id.

95 See, e.g., THE CHICAGO MANUAL OF STYLE ONLINE at 6.22, available athttp://www.chicagomanualofstyle.org/16/ch06/ch06_sec022.html.


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of acceptable conduct.96

In that case, it would be necessary to determine ifselling marijuana should be included in that subcategory of illegal activitiesthat violate the minimum standards of acceptable conduct necessary for the

preservation of an orderly society. As discussed below, I think it is not.

This discussion of grammar may seem hyper-technical, but theRevenue Ruling is the only existing discussion of whether an organizationthat conducted illegal activities could be exempt under 501(c)(4).97 Whatthe Ruling makes clear is that even the IRS takes the position that the publicpolicy doctrine only applies to 501(c)(3) organizations, since it discussesthat doctrine and its origin in the common law of charities exclusively in thesection of the Ruling addressing the claim for 501(c)(3) status.

The Ruling is less clear about whether an organization could qualify

as tax-exempt under 501(c)(4) even though its primary activity wasillegal. The grammatical discussion above suggests that it is not the IRSsposition that an organization whose primary purpose was illegal wouldnecessarily be disqualified from exemption under 501(c)(4). Instead, itappears that the IRS has taken the position that an organization could notpromote social welfare if it primarily conducts activities that violate theminimum standards of acceptable conduct necessary for the preservation ofan orderly society and that at least some illegal activities do just that.Specifically, the organization at issue in the Revenue Ruling could notsuccessfully promote the social welfare because it planned to engage in

96

One could argue that the grammar is still ambiguous because the transition word tothe clause in question is which rather than that. Generally, [r]estrictive relativeclauses are usually introduced by that . . . [while] [n]onrestrictive relative clauses areusually introduced by which[.] Id. Thus, the lack of a comma suggests that the IRSintended the clause to be restrictivemeaning that not all illegal purposes disqualify a501(c)(4) organizationwhile the use of which implies the opposite. However, thisargument is unpersuasive, since The Chicago Manual of Style suggests how thegrammatical ambiguity should be resolved. It states, which can be substituted for thatin arestrictive clause (a common practice in British English)[.] Id. In other words, the use ofwhich to signal a nonrestrictive relative clause is optional, while the use of a set of commasto signal a restrictive relative clause is not. Therefore, the lack of a comma isdeterminative, and the phrase which violate the minimum standards of acceptable conductnecessary for the preservation of an orderly society is restrictive, meaning that there ispresumably some sort of illegal activity that does not violate the minimum standards ofacceptable conduct. This illegal activity could constitute the primary purpose of a proper501(c)(4) organization, so long as it otherwise promoted the social welfare.

97 As discussed supra note 84, there is one passing reference to 501(c)(4) status in acase denying 501(c)(3) status to an organization because of the public policy doctrine,but the reference provides no guidance on either the law or the IRSs interpretation of thelaw.


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protest activities in violation of local laws and for the purpose of disruptingthe peace of the localities in which it operated. This seems like the rightquestion to ask: do the activities conducted by the organization in question

promote the social welfare notwithstanding the fact that they are illegal, ornot? In the following section, we will turn to that exact question.

3. Would a 501(c)(4) Marijuana Seller Promote Social Welfare?As discussed above, since the public policy doctrine does not apply

to 501(c)(4) organizations, the central question for a nonprofit marijuanaseller would be: (i) do its activities promote social welfare; or (ii) do theyfail to do so because they are contrary to the common good and the generalwelfare of the people in a community[?]98

Obviously, one possible approach would be to infer a federal policyfrom the fact that the federal government has identified marijuana as aSchedule I controlled substance. Under that approach, the federalgovernment has in effect already concluded that sale and use of marijuanaare contrary to the common good and general welfare of the people in acommunity. That approach is arguably supported by the reasoningemployed by the Supreme Court in United States v. Oakland CannabisBuyers Cooperative, in which the Court found that there is no exception tothe Controlled Substances Act for state-sanctioned medical marijuana.

99

One could plausibly argue that the Controlled Substances Act states afederal policy about what is or is not beneficial for people and the

communities in which they live, and that the IRS need go no further thanthat in determining whether a marijuana seller could promote the socialwelfare.

That reasoning, however, negates the possibility that an organizationthat promoted any illegal act could be tax-exempt under 501(c)(4), andtherefore would read out of existence the distinction between charities andnon-charities in the application of the public policy doctrine. Both commonsense and the grammar of Rev. Rul. 75-384 suggest that the public policydoctrine is not that broad. Thus, there must be at least some class oforganizations whose primary activity is illegal that nonetheless promotesocial welfare.

98 Rev. Rul. 75-384, supra note 84.

99 532 U.S. 483 (2001).


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If federal law is not the definitive guide to what promotes socialwelfare, then it seems proper to look to state law. In legalizing marijuanasales, the states appear to have made a determination about what is in the

best interests of their communities. The most recent legalization initiativessuggest that a growing number of voters and legislators are becomingconvinced that legalizing and regulating marijuana sales serves the purposenot only of enabling seriously ill people to benefit from marijuana use, butthat legalization could serve other social goods. For example, one benefit isthat legal marijuana could play a major role in ending the illegal sale ofmarijuana. The benefits of using legal marijuana sales to run illegaloperations out of business are dramatically focused in the neighborhoodsthat are currently plagued by concentrations of illegal marijuana sales.Illegal drug sales negatively impact bystanders, who are directly affected byincreased levels of violence and whose neighborhoods are prevented from

developing economically due to safety concerns. But a vibrant illegal drugmarket also negatively impacts the young people who are driven to takejobs in it . . . young people who are primarily poor and living in thesedistressed neighborhoods. Running illegal marijuana sellers out of businesscould have a significant effect on decreasing the chances that anentrepreneurial young person would find him or herself involved in theillegal drug trade. In other words, the trend among states to legalizemarijuana is driven to a large extent by a growing belief that permitting thelegal sale of marijuana could have the effect of providing relief to the poor,distressed, and underprivileged, lessening neighborhood tensions,combating community deterioration and combating juvenile delinquency.

In addition, states that have legalized marijuana are more and morepointing to other social benefits. Voters in states that have legalizedmarijuana have argued that legalization will increase security by permittingpolice to prioritize more dangerous illegal activity; that it will help keepyouths who are tempted to participate in the illegal drug trade out of jail andout of dangerous gangs; that it will help neighborhoods develop; that it willprotect innocent bystanders, often young, who are impacted by the drugtrade. The states that have enacted legislation based on these argumentshave made policy decisions of their own about what promotes socialwelfare, and these policy choices are important.

If a state has determined that an activity is in the best interests of itsneighborhoods and communities, it is hard to argue that it violates theminimum standards of acceptable conduct necessary for the preservation ofan orderly society. Indeed, the states have made a determination thatregulating sellers of marijuana is more likely to preserve an orderly society


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than not doing so. The federal governments decision to continue tocriminalize all marijuana selling has significantly less weight as adetermination of what conduct is necessary for the preservation of an

orderly society, since the states are closer to the communities andneighborhoods they represent, and have primary and plenary sovereigntyover decisions regarding community order.

Finally, if states have made a determination that legal marijuana ispotentially beneficial to a community and the federal government has madea determination that legal marijuana is harmful to a community,municipalities, localities, and neighborhoods may have their own views onthe matter.100 These views may be expressed in local zoning laws andregulations, but they may also be expressed through participation in localorganizations. Surely, these local determinations of what potentially

promotes social welfare should be given significant deference in makingdeterminations about what type of organization promotes social welfare.101

In Revenue Ruling 75-384, the IRS determined that anorganization that conducted civil disobedience to protest war could not be a501(c)(4) organization because it engaged in conduct that violated theminimum standards of acceptable conduct necessary for the preservation ofan orderly society.102 Without conceding that the IRS was right in thatdetermination, it is possible to distinguish that organization from acommunity economic development corporation that operated a marijuanastore. In the case of the organization conducting civil disobedience

campaigns, such campaigns would violate local laws, and therefore would

100 Many municipalities have passed ordinances to prevent marijuana from being soldin their jurisdiction, causing conflict between state and local governments. See, generally,Salkin and Kansler, supra note 10(discussing conflict between states and localities overmarijuana policy); see, also,Peabody Bans Medical Marijuana Dispensaries, available athttp://masscann.org/action-center/action-alerts/peabody-bans-medical-marijuana-dispensaries; Steve Elliott, Judge Tosses L.A. Pot Dispensary Moratorium, New JunkiePost (12/11/2010), available athttp://newsjunkiepost.com/2010/12/11/judge-tosses-l-a-pot-dispensary-moratorium/.

101See, e.g., Sam Kamin, supra note 2 at 162-165 (discussing tension between statesand localities and the federalism issues caused by this type of intergovernmentalconflict). The IRSs evaluation of whether a marijuana seller promotes social welfarecould well take into account the views of the local government as well as other communitystakeholders or leaders in the impacted neighborhood. Indeed, that would be the purposeof selling marijuana from a community economic development organization to ensurecommunity participation.

102See Rev. Rul. 75-384, supra note 78.


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violate norms established by both state and local communities. Theorganization was organized to purposely provoke local law enforcement byengaging in conduct that such authorities perceived to be a breach of the

peace and therefore a threat to the preservation of an orderly society.

The same could not be said about a nonprofit marijuana seller.Indeed, the opposite is the case. A nonprofit marijuana seller is organizedand operated specifically to preserve the order of the society in which itoperates. It seeks to combat illegal unregulated marijuana selling and makeopportunities for the neighborhoods and youth formerly impacted by it. Ineach case, the state in which it would operate had