The IRS rules on restricted donations for nonprofits come down to a single principle with several moving parts: once a 501(c)(3) accepts a gift earmarked for a specific purpose, the organization is legally bound to spend the money that way, account for it separately, and report it correctly on its annual return. Missing any of those steps can trigger excise taxes on insiders, loss of exempt status, and the loss of donors’ deductions along with it.
What Makes a Donation Legally Restricted
A restricted donation is a contribution the donor has limited in writing to a particular program, project, timeframe, or combination of the three. The limit has to be mandatory, not aspirational. A donor saying they “hope” the money helps the library does not create a restriction; a gift agreement, pledge document, or accompanying letter that directs the funds to a named purpose does.
The restriction attaches at the moment of the gift. If the gift instrument leaves the organization full discretion to redirect the funds, the IRS does not treat the gift as materially restricted, and the organization is free to spend it on any mission-related expense. Once the board formally accepts a restricted gift, the organization owes a fiduciary duty to honor the terms. Board minutes should record both the acceptance and the specific conditions, because that paper trail is the first thing an examiner asks to see.
Restrictions come in two broad flavors. Some are time-limited or purpose-limited and will eventually be released once the condition is met. Others are permanent, the classic example being an endowment where the donor requires the principal to stay intact and only investment income to be spent. Both are now reported under one net asset classification, but the organization still has to track their nature internally.
How Nonprofits Must Track and Spend Restricted Funds
Internal accounting is where most compliance problems start. Every materially restricted gift needs its own line in the books, separate from general operating revenue. Commingling restricted dollars with unrestricted money is one of the fastest ways to draw an IRS examination and, in serious cases, put exempt status at risk.
The chart of accounts should identify each restricted fund by donor and purpose. Internal reports have to show that every expenditure from that fund directly serves the stated purpose, with invoices, receipts, and expense documentation that ties back to the original gift agreement. This is not a one-time setup. The organization has to monitor compliance continuously until the restriction is satisfied or formally released.
Board involvement runs throughout. The board should accept the restricted gift by resolution, authorize expenditures from the fund (or delegate that authority with written guidelines), and approve the release of the restriction once the purpose is complete or the time period runs out. All of that belongs in the minutes.
How Restricted Funds Appear on Form 990
Every tax-exempt organization subject to the annual filing requirement under Section 6033 of the Internal Revenue Code has to report the status of its restricted funds on Form 990 or Form 990-EZ.1Office of the Law Revision Counsel. 26 USC 6033 – Returns by Exempt Organizations On Part X of Form 990 (Balance Sheet), net assets are split into two lines: “net assets without donor restrictions” (Line 27) and “net assets with donor restrictions” (Line 28).2Internal Revenue Service. Instructions for Form 990 Any mismatch between those balance sheet figures and how revenue is categorized elsewhere on the return is the kind of inconsistency that draws scrutiny.
This two-category framework replaced the older three-tier system of “unrestricted,” “temporarily restricted,” and “permanently restricted” under FASB Accounting Standards Update 2016-14, which took effect in 2018. Organizations still need to know the nature of each restriction internally, but the public-facing return rolls them up.
Organizations holding endowment funds also complete Schedule D (Supplemental Financial Statements), which calls for a detailed breakdown of endowment assets, changes during the year, and how investment income was used. Significant noncash contributions require Schedule M, describing the donated property and how it was valued.
Form 990 and its schedules are public documents. Anyone can request copies, and the regulation requires organizations to provide them, with all schedules and attachments, on request.3eCFR. 26 CFR 301.6104(d)-1 – Public Inspection and Distribution of Applications for Tax Exemption and Annual Information Returns of Tax-Exempt Organizations Donors, journalists, and watchdog groups use those filings to check whether restricted funds are being handled as promised.
Substantiating the Gift for the Donor
The nonprofit’s receipt is part of its own compliance picture, because a donor who cannot substantiate the gift loses the deduction and often takes the complaint back to the organization. For any single contribution of $250 or more, the donor needs a contemporaneous written acknowledgment from the receiving organization before filing the return for that year.4Office of the Law Revision Counsel. 26 USC 170 – Charitable, Etc., Contributions and Gifts A canceled check or bank statement is not enough once the gift crosses that line.5Internal Revenue Service. 6Internal Revenue Service. About Form 8283, Noncash Charitable Contributions
Penalties for Misusing Restricted Funds
The consequences of mismanaging restricted funds run from excise taxes on individuals to full revocation of exempt status. The IRS tends to treat fund misuse as a symptom of broader governance failure and rarely stops at a single penalty.
Excise Taxes Under Section 4958
When a transaction between a tax-exempt organization and an insider (officer, director, key employee, or other “disqualified person”) provides an excess economic benefit, Section 4958 imposes a 25% excise tax on the disqualified person who received the benefit.7Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions An organization manager who knowingly approved the transaction faces a separate 10% tax, capped at $20,000 per transaction. If the excess benefit is not corrected within the taxable period, the disqualified person owes an additional tax of 200% of the excess benefit.
Redirecting restricted funds to benefit insiders or their family members is exactly the kind of transaction that triggers these taxes. The initial 25% hit is painful; the 200% second-round tax for failing to fix the problem is where it becomes catastrophic.
Revocation of Tax-Exempt Status
An organization that lets its income or assets benefit insiders can lose its 501(c)(3) status outright.8Internal Revenue Service. How to Lose Your 501(c)(3) Tax-Exempt Status The IRS also expects organizations to pursue the exempt purposes they described in their original application. Systematically diverting restricted funds away from their stated purpose can be read as abandonment of those exempt purposes, which is an independent basis for revocation.
Revocation reaches backward as well as forward. It retroactively disqualifies the entity from receiving tax-deductible contributions, which can mean donors who gave in good faith lose their deductions too. For an organization sitting on large restricted endowments or capital campaign pledges, revocation can unwind years of fundraising in months.
Changing or Releasing a Restriction the Right Way
Sometimes the original purpose of a restricted gift becomes impossible to carry out. A building gets blocked by zoning, a disease the research fund targeted is cured, a program is discontinued. There is a legal path to redirect those funds, but the bar is deliberately high, and an unauthorized change looks a lot like fund misuse from the outside.
Variance Power in the Gift Agreement
The cleanest route is a variance power clause in the gift agreement itself, giving the organization authority to redirect funds if the original purpose cannot be met, as long as the new use is consistent with the organization’s mission. The IRS respects variance power when the language is clear and unambiguous, and well-run development offices build these clauses into their standard templates for exactly that reason.
UPMIFA and the Cy Pres Doctrine
When the gift instrument has no variance power, most states offer a statutory path through some version of the Uniform Prudent Management of Institutional Funds Act. UPMIFA lets an organization ask a court to modify a restriction that has become unlawful, impracticable, impossible to achieve, or wasteful. The replacement use must track the donor’s original charitable intent as closely as possible.
Many state versions of UPMIFA include a streamlined process for smaller endowments. Funds below a threshold that typically falls between $25,000 and $100,000, and at least 20 years old, can often be modified with written notice to the state attorney general rather than a court filing. The attorney general usually has 90 days to object; silence allows the organization to proceed.
Larger or newer funds generally require a formal court petition under the cy pres doctrine, a centuries-old principle meaning “as near as possible.” Instead of voiding the gift when its purpose fails, the court picks a new use closely matching the donor’s original intent. A donor who gave to fight a specific disease might see the funds redirected to research on a related condition rather than returned. Modifying a permanently restricted gift calls for legal counsel, notice to the donor if available, notice to the state attorney general, and in many cases a court appearance.
What Donors Can and Cannot Enforce
One point regularly surprises donors and matters for how the organization structures gift agreements: once a completed charitable gift is made, the donor generally has no legal standing to sue the organization for misusing it. Enforcement of charitable gift restrictions traditionally belongs to the state attorney general, who represents the public interest in holding charities to their commitments.
Narrow exceptions exist. Some courts have recognized donor standing when the gift agreement expressly reserved oversight rights for the donor, or when the donor stayed actively involved in monitoring the fund. Those cases are the exception. Attorney general offices are also chronically understaffed on charity oversight and cannot police every restricted gift at every nonprofit.
The practical takeaway for both sides is that prevention beats enforcement. Donors who care about how their money is used should negotiate a detailed gift agreement, build in reporting requirements, and consider reserving explicit oversight rights in the agreement itself. Organizations, in turn, benefit from clear written agreements, documented board acceptance, segregated accounting, and consistent reporting on Form 990. That combination is what keeps restricted funds doing what they were given to do, and keeps the IRS from asking harder questions.