Question:  My attorney put language in the Articles of Incorporation for my Arizona medical marijuana nonprofit corporation that say it will be operated as a 501(c)(3) charitable organization and that no part of the earnings of the corporation can go to insiders.  Is that a problem?

Answer:  Yes.  Big time!  If you want to operate a pure charity then the language is appropriate.  Here is some common language I have seen in Articles of Incorporation of Arizona nonprofit corporations:

“This corporation is organized exclusively for charitable purposes such as religious, educational, literary and scientific purposes, including, for such purposes, the making of distributions to organizations that qualify as exempt organizations under section 501(c)(3) of the Internal Revenue Code, as amended, or the corresponding section of any future federal tax code (the “Code”).

“The Corporation is not organized and shall not be operated for pecuniary gain or profits. No part of the net earnings of the Corporation shall inure to the benefit of or be distributable to its directors, officers, members, or any other private person; provided that the Corporation shall be authorized and empowered to pay reasonable compensation for services rendered and to make payments and distributions in furtherance of the purposes set forth herein.”

You definitely do not want the above language in the Articles of Incorporation for a corporation that intends to own and operate an Arizona medical marijuana dispensary.  The first problem with the above language is that it is used in Articles of Incorporation of nonprofit corporation.  You should not be using a nonprofit corporation to own your dispensary because Arizona nonprofit corporations do not have owners/shareholders.  See “Is It a Mistake to Form an Arizona Nonprofit Corporation to Operate an Arizona Medical Marijuana Dispensary?

The second problem is the above language is appropriate in the Articles of Incorporation of an Arizona nonprofit corporation only if the corporation intended to become a tax-exempt organization under the Internal Revenue Code.  If you intend for your nonprofit corporation that will own a medical marijuana dispensary to file an IRS Form 1023 or 1024 and apply for tax-exempt organization status with the IRS you should know that:

  1. Arizona Revised Statutes Section 36-2806.A states:  “A registered nonprofit medical marijuana dispensary need not be recognized as tax-exempt by the internal revenue service”
  2. The IRS will not grant an organization an exemption from federal income taxes if the activities of the organization involve the violation of federal criminal law.

The third big problem arises from the language in the second paragraph quoted above.  The language is used in the Articles of Incorporation of nonprofit corporations that want to become tax-exempt organizations because it is required by the IRS.  Tax-exempt organizations are prohibited by the Internal Revenue Code from paying excess benefits to insiders such as officers, directors and members.  Violations of the excess benefit rules are taxed at the rate of 100% of the excess amount for every year the excess is not repaid to the organization.

If the insiders of an Arizona nonprofit corporation that intends to own an Arizona medical marijuana dispensary want to be able to be paid more than reasonable compensation and most do, then the corporation’s basic governing document, its Articles of Incorporation, should not limit the insiders compensation to reasonable amounts.  Consider the insider who provides no services, but receives $5,000 a month from the corporation.  The payment is a violation of the corporation’s Articles of Incorporation and makes the directors and officers who are responsible for the payment liable to the corporation for exceeding their authority.

Bottom line:  Neither Proposition 203 nor the Arizona Department of Health Services rules require dispensaries to be nonprofit corporations.  The rules say that the entity must be operated on a not-for-profit basis, but do not require any specific type of entity. Dispensaries may be a for profit corporation (I don’t recommend this type of entity), a nonprofit corporation (ditto), a general partnership (the worst type of entity to form), a limited partnership (ok, but now obsolete in Arizona), a sole proprietorship (bad choice) or a limited liability company (yes – this is the one!).  See “Must an Arizona Medical Marijuana Dispensary be a Nonprofit Corporation?”  If you formed any type of entity other than an Arizona limited liability company to own an Arizona medical marijuana dispensary, you need to dump it and switch to an Arizona limited liability company.