Since Arizona voters approved Proposition 203 in November of 2010 I have talked to many people who were interested in obtaining a license to grow marijuana and sell it in an Arizona medical marijuana dispensary.  In general these people fall into two categories: (1) people whose primary goal is to provide medicine to patients, and (2) people who want to make a lot of money.  When I mention to the people in category 2 that all Arizona medical marijuana dispensaries must be operated on a not-for-profit basis they usually say I know, but I’m going to form one or more companies to provide services to the dispensary to move money from the dispensary to the for profit companies.

In theory this seems like a reasonable plan that could work, but I suspect that in practice most category 2 people will be “over paying” for services rendered by a for profit company to the category 2 person’s not-for-profit dispensary.  Let’s consider two scenarios and compare the results.

Scenario 1:  AZ Medical Marijuana Dispensary, LLC (“AMMD”), has a license to operate an Arizona medical marijuana dispensary.  It is owned equally by Homer Simpson and Ned Flanders.  The total cost for salaries, bonuses, employee benefits, payroll taxes and expenses for all of AMMD’s personnel for the first year of its business is $X, which amount can be deducted from AMMD’s gross income for the purposes of determining if AMMD is a not-for-profit dispensary as required by Arizona’s medical marijuana laws.  Whether any portion of this amount is deductible from AMMD’s federal income tax return depends on Internal Revenue Code Section 280E.

Scenario 2:  Same facts as Scenario 1 except Homer and Ned form Suck Off the Profits, LLC (“SOTP”), an employee leasing company that employs and leases to AMMD all personnel needed by AMMD to operate AMMD’s dispensary business.  SOTH bills AMMD $X times 3.  In computing its not-for-profit bottom line for Arizona medical marijuana dispensary requirements AMMD now can reduce its gross income by the cost of its leased personnel = $3X instead of $X.

In both scenarios AMMD must submit audited financial statements to the Arizona Department of Health Services.  These financial statements will disclose in the case of Scenario 1 that AMMD paid $3X to SOTP.  I suspect that ADHS will inquire into the ownership of SOTP and when it finds that Homer and Ned own both companies ADHS may claim that AMMD was not operated on a not-for-profit basis.  How will Homer and Ned explain why AMMD paid 3 times the actual cost of the employees to SOTP?  Homer and Ned may think ADHS is stupid, but if so, that would be a big mistake that could lead to the loss of AMMD’s license to operate an Arizona medical marijuana dispensary.

However, AMMD’s loss of its license to operate an Arizona medical marijuana dispensary might be the least of its worries.  Don’t you think that the federal law enforcement agencies will get copies of the audited financial statements of every Arizona medical marijuana dispensary and do their own investigations as to whether Arizona medical marijuana dispensaries are operated on a not-for-profit basis?  Evidence that a dispensary is a money making machine is a good way to entice the feds to bust your medical marijuana dispensary.

Read the post called “Feds Indict 6 California Medical Marijuana Dispensary Owners & Sue to Take Landlord’s Land” about a California dispensary called G3 Holistic that was very good at making money.  The story linked to in the preceding sentence said:

“In a civil forfeiture complaint, the government claimed that a forensic investigation by the IRS identified 19 bank accounts linked with G3 Holistic Inc. or individuals connected with it. The accounts had received $3.3 million in deposits during an eight-month period in 2011, with withdrawals nearly equaling that amount. The IRS concluded it was to make G3 appear to be a nonprofit organization.”

The Los Angeles Times has a detailed story about California medical marijuana dispensaries making big bucks called “Some Southern California ‘Nonprofit’ Pot Shops Make Big Money.”  This story says:

“Tax may be the biggest cudgel the feds have against medical pot. Increasingly, the IRS is applying an obscure provision of the tax code, 280E, which prohibits drug traffickers from claiming routine business deductions, for costs like wages and rent, when federal agents are trying to get back-taxes from them. Already dispensaries were in a quandary: Pay the IRS and literally document your federal crime to the federal government, or don’t report it and risk going down for tax evasion. Now they face 280E, and potentially crippling tax bills.”

If you are a category 2 person you should read about the G3 Holistic case, note in your mind that your dispensary will be giving ADHS a road map of how your dispensary spends its money (the audited financial statements) and then answer the question San Francisco Detective Harry Callahan asks a crook in the movie “Dirty Harry” after Callahan points his gun at the crook who must decide whether to go for his gun or give up.  Dirty Harry says:

I know what you’re thinking. Did he fire six shots or only five? Well, to tell you the truth, in all this excitement, I’ve kinda lost track myself. But being as this is a .44 Magnum, the most powerful handgun in the world, and would blow your head clean off, you’ve got to ask yourself one question: ‘Do I feel lucky?’ Well, do ya punk?”

If you are a category 2 person who is involved with an Arizona medical marijuana dispensary and you plan on siphoning profits from the dispensary, you must ask yourself “Do I feel lucky.”

For those category 2ers who are not familiar with the not-for-profit requirement of Arizona’s medical marijuana law applicable to all Arizona medical marijuana dispensaries I suggest you read the following text taken from my article called “Warning to Everybody Considering Becoming Involved with an Arizona Medical Marijuana Dispensary.”

Arizona Medical Marijuana Dispensaries Must be Operated on a Not-for-Profit Basis

A lot of people believe that owning an Arizona medical marijuana dispensary is a way to get rich despite the fact that all Arizona medical marijuana dispensaries must be operated on a not-for-profit basis.  Unfortunately neither Arizona’s medical marijuana laws nor the ADHS rules explain what that term means.  The only guidance with respect to the meaning of this term is found in Arizona Department of Health Services rule R9-17-304(D).8 that states that the Bylaws of a dispensary must contain “Provisions for the disposition of revenues and receipts to ensure that the dispensary operates on a not-for-profit basis.”  That’s it.  Nobody has a clue what the phrase means.

We do know, however, that all Arizona medical marijuana dispensaries must provide annual audited financial statements to ADHS.  Most businesses do not get audited financial statements, which are very expensive.  The fact every dispensary will be giving ADHS audited financial statements means that ADHS will be able to examine in detail how dispensaries are spending money, i.e., who the dispensaries pay and how much they pay.  I believe that all expenditures of money by a dispensary must be commercially reasonable or the dispensary is opening itself up to a claim that the dispensary is being operated on a for profit basis.

For example, if a member of the board of directors attends one two hour meeting of the board every quarter and provides no other services the board member may be paid for the reasonable value of the services rendered.  What is the value of 8 hours of time spent at a meeting of the board of directors?  Surely payments of $25, $100 or $250 hour may be justified since many professionals, plumbers and Xerox printer technicians charge those hourly rates.  However, if that board member is paid $100,000 for eight hours of time I submit that ADHS will have a problem with that and ADHS could refuse to renew the dispensary’s license.

Money dispensaries pay to employees and insiders will be scrutinized closely.  The dispensary must be able to justify the reasonableness of all payments to employees, insiders and affiliates.  Dispensaries should not agree to pay for any services provided by employees, insiders and affiliates without tangible evidence that the payments are commercially reasonable.  One way to do this is to follow the same rules used by bona fide tax exempt charities.  To learn more about this important topic a good start is to read “Nonprofit Payments to Insiders and Outsiders: Is the Sky the Limit?“  This article contains footnotes that refer to sources of information that can be used to justify payments to insiders of tax exempt charitable organizations.

Dispensary people must also understand that law enforcement and prosecutors will be able to access dispensaries’ audited financial statements given to ADHS for the purpose of determining if any dispensaries are not operating on a not-for-profit basis.  I am sure law enforcement and prosecutors will pay special attention to payments of large amounts of money to “management” companies or service provider companies owned by the owners, officers or board members of a dispensary.  It is a mistake to think you can make a dispensary operate on a not-for-profit basis by siphoning money from the dispensary to affiliated entities.

The bottom line with respect to the not-for-profit requirement is that Arizona medical marijuana dispensaries must actually operate a not-for-profit business so why would anybody want to invest the large amounts of money and time into a business that cannot pay profits that justify that risk?

June 23, 2012 Update:  Will Humble’s June 23, 2012, blog post confirms what I suspected, i.e., ADHS will investigate large payments by a dispensary to third parties.  Read “Will Humble Warns Arizona Medical Marijuana Dispensaries Not to Pretend to be a Not-for-Profit Business.”