Nonprofit franchising and its impact on maintaining 501(c)(3) status 

The concept of expanding a successful nonprofit model through franchising—often referred to as “social franchising”—has gained significant momentum in recent years. For organizations that have recognized success in a local or regional environment, replicating their programs through a franchise-like structure can be an effective way to serve a broader population. As with any innovative approach, however, there are important legal and compliance considerations to keep in mind. In particular, nonprofits recognized as exempt under Section 501(c)(3) of the Internal Revenue Code should proceed cautiously to ensure that the franchising model does not jeopardize their tax-exempt status.

Below is an overview of key considerations for nonprofits exploring a franchising model.

• Maintaining the charitable purpose

A fundamental element of obtaining and retaining 501(c)(3) status is operating primarily for exempt purposes, such as charitable, religious, or educational activities. Any effort to franchise your mission must be aligned with the organization’s exempt purposes. This alignment includes structuring the franchise operations so that they further, rather than detract from, the nonprofit’s charitable objectives. While the desire to generate revenue for sustainability is understandable, the franchising arrangement should continue to promote the public good, not merely commercial interests.

• Avoiding private benefit and private inurement

The Internal Revenue Service strictly prohibits 501(c)(3) organizations from allowing their net earnings to benefit private individuals or shareholders. In a franchising arrangement, it is crucial to ensure that any license fees, royalties, or other payments flowing to the nonprofit do not result in undue benefit to insiders or private parties. Compensation terms for use of the nonprofit’s brand, training, or other resources must be reasonable and directly support the organization’s exempt function. If the IRS finds excessive benefits or an inflated fee structure that benefits an individual more than it benefits the charitable mission, the nonprofit’s exempt status could be placed in jeopardy.

• Complying with the operational test

Tax-exempt organizations must pass the IRS’s “operational test,” which evaluates whether the organization’s resources and activities are devoted to exempt purposes. When franchising, each affiliate location should operate under guidelines consistent with the mission originally recognized by the IRS. Well-crafted policies, procedures, and reporting requirements can help ensure that franchisees or chapters do not deviate from the core charitable activities of the parent nonprofit. Consistency of purpose and uniform standards throughout the network are vital factors in preserving the organization’s exempt status.

• Minimizing unrelated business income

Franchising can sometimes lead to new streams of revenue that the IRS may consider unrelated to the nonprofit’s exempt function, potentially resulting in unrelated business income tax (UBIT). If a substantial portion of the organization’s activities is deemed unrelated to its charitable purpose, its tax-exempt status may be at risk. Nonprofits should analyze how any licensing, royalties, or related business activities fit within the organization’s broader exempt mission. If they function primarily as a means to expand charitable outreach, they more likely will be viewed as related business activities. By contrast, aggressive franchising efforts primarily designed for profit may prompt a closer look from the IRS.

• Establishing clear governance and oversight

Strong governance mechanisms must enable a 501(c)(3) organization to maintain control over the brand, ensure prudent use of charitable assets, and uphold the nonprofit’s reputation for accountability.

• Balancing expansion with risk management

Although franchising offers powerful growth opportunities, nonprofits should be mindful of the potential risks. When franchisees operate under the organization’s name and charitable purpose, any legal or reputational lapses can quickly spread through the entire system. Proper vetting of prospective franchisees, training programs, ongoing compliance checks, and clear contract provisions around termination or non-renewal are important strategies to mitigate these risks.

• Seeking professional guidance

Finally, due to the overarching complexity of nonprofit tax laws and franchise regulations, it is advisable to consult with legal and tax professionals experienced in both franchising and exempt-organization law. Professional guidance will assist in structuring agreements, drafting manuals appropriate to the specific goals of the nonprofit, developing safeguards against private benefit, and ensuring compliance with both federal and applicable state regulations.

By taking these steps, nonprofits can explore social franchising while protecting their 501(c)(3) status. Thoughtful planning and legal coordination help ensure that the expansion model remains aligned with the organization’s charitable mission, achieving both greater reach and continued compliance with tax-exempt requirements.

If you have questions about the content in this article, reach out to attorney Scott Opincar.