Restricted funds in a nonprofit are gifts or grants that an outside donor or funder has earmarked for a specific purpose, time, or perpetual endowment, and the organization has no legal authority to spend them on anything else. Accepting the money creates a fiduciary obligation to honor the conditions, and getting the rules wrong can trigger forced repayment, loss of tax-exempt status, or federal penalties worth several times the misused amount.
What Actually Makes a Fund Restricted
A restriction is a condition set by an outside source at the time the money is given. The donor, grantor, or agency states the limitation; the organization accepts the gift on those terms; the agreement binds the organization to follow them. That is the whole mechanism. The money may cover a scholarship, a research program, a public health initiative, or a corporate foundation’s social-responsibility goal, but once accepted with strings attached, it cannot be redirected to payroll, rent, or any other general expense no matter how urgent the shortfall.
Board-Designated Funds Are Not Restricted
This is the most common point of confusion in nonprofit finance. When a board voluntarily sets aside money for a purpose (sometimes called a quasi-endowment), the board can reverse that decision at any time. Because no outside party imposed the limitation, those funds are classified as “net assets without donor restrictions” on the financial statements and on IRS Form 990.
Schedule D of Form 990 makes the distinction explicit: Part V asks organizations to break their endowment balance into board-designated or quasi-endowment, permanent endowment, and term endowment percentages, and the three must total 100 percent.1IRS. Instructions for Schedule D (Form 990) Only the permanent and term categories reflect genuine donor restrictions. If your board sets aside $200,000 for a building project but no donor required it, that money can be redirected by a board vote and must be reported that way.
Types of Donor Restrictions
Donor restrictions fall into two broad categories based on how the donor defines the limitation.
- Purpose restrictions. The donor specifies what the money can be used for: a named scholarship, a specific program, a piece of equipment. The restriction lifts once the organization spends the money on that stated purpose.
- Time restrictions. The donor specifies that the money cannot be spent until a future date or event. A five-year pledge carries an implicit time restriction on each installment. Once the date passes, the funds can be reclassified.
Many gifts combine both. A donor might give $50,000 for a community garden project that must be completed within two years, restricting both purpose and timing. When the conditions are satisfied, the organization records a release from restriction and moves the funds from “with donor restrictions” to “without donor restrictions” on its books.
Permanent Restrictions and Endowments
Some donors require that the original gift, the principal, be preserved forever. These permanently restricted gifts are the backbone of most endowments. The organization invests the principal and can spend only the earnings it generates, such as interest, dividends, or capital gains. A $1 million endowed scholarship might produce $40,000 to $50,000 in annual investment returns that the organization can distribute, while the $1 million itself stays invested indefinitely.
Since 2018, all donor-restricted funds, whether time-limited or perpetual, are reported together under “net assets with donor restrictions.” FASB Accounting Standards Update 2016-14 replaced the older three-class framework (unrestricted, temporarily restricted, permanently restricted) with two classes.2FASB. Accounting Standards Update No. 2016-14 Organizations still disclose the nature and amounts of the different underlying restrictions in the notes to the financial statements.
Endowment Spending Rules
The Uniform Prudent Management of Institutional Funds Act, adopted in some form by a majority of states, governs how charities, universities, and similar institutions invest and spend from endowment funds. UPMIFA replaced an older model law that drew a hard line at “historic dollar value,” which prohibited spending below the original gift amount.3Uniform Law Commission. Prudent Management of Institutional Funds Act
Under UPMIFA, the standard is prudence rather than a fixed floor. Managers must act in good faith with the care an ordinarily prudent person in a similar role would exercise, and they must weigh several factors: the duration and preservation of the fund, its purpose, general economic conditions, the effects of inflation, expected total return, the institution’s other resources, and its investment policy. No single factor overrides the others.
Underwater Endowments
When an endowment’s market value falls below the original gift amount, say a $1 million gift now worth $850,000 after a market downturn, it is considered underwater. UPMIFA allows continued distributions from an underwater fund if the organization determines that spending is prudent after weighing the same factors. Some states add a rebuttable presumption of imprudence when spending exceeds 7 percent of the fund’s value in a single year. That is not a hard cap, but crossing it shifts the burden to the organization to justify the spending. In practice, most institutions reduce distributions, talk to the donor about alternatives, and wait for the portfolio to recover rather than invade principal during a downturn.
Private Foundation Minimums Are a Different Rule
Public charities with endowments are not subject to a federal minimum payout requirement, though many adopt voluntary spending policies in the 4 to 5 percent range. Private foundations face the opposite pressure. Federal tax law requires a private foundation to distribute roughly 5 percent of the average market value of its net investment assets each year. Fall short and the IRS imposes an initial excise tax of 30 percent on the undistributed amount, and if the shortfall persists past a correction period, an additional tax of 100 percent of whatever remains undistributed.4Office of the Law Revision Counsel. 26 U.S. Code 4942 – Taxes on Failure to Distribute Income
Vetting a Restricted Gift Before You Accept It
Not every restricted gift is worth accepting. Conditions that are impractical, misaligned with the mission, or expensive to administer can create more burden than benefit. A gift acceptance policy forces the organization to answer three questions before saying yes.
- Does the purpose fit the mission? A wildlife conservation nonprofit offered a restricted gift for a community swimming pool has an obvious mismatch. Misalignment can be subtler: a scholarship fund restricted to such a narrow pool of eligible students that it sits unspent for years.
- Are the restrictions reasonable? Quarterly progress reports are a fair request. A donor who wants to approve every vendor is micromanaging. Ongoing operational control tends to create friction and administrative cost.
- Is there a net positive after costs? Real estate, specialized equipment, and gifts with ongoing maintenance obligations can cost more to manage than they generate. Property gifts should be conditioned on satisfactory inspections, clear title, and environmental compliance.
Building flexibility into the donation agreement matters as much as the initial vetting. Well-drafted language lets the board redirect the gift to a related purpose if circumstances change, for instance, if a funded program is discontinued. Without that language, the organization may need court approval to change course.
When a Restriction Becomes Impossible
Sometimes the original purpose outlives its usefulness or becomes impossible to carry out. A scholarship restricted to students in a degree program the university no longer offers, or a grant for a community center that has permanently closed, leaves the money stranded. The legal mechanism for resolving this is the cy pres doctrine, which allows a court to redirect restricted funds to a purpose “as near as possible” to what the donor originally intended.
Courts applying cy pres look for two things. The original purpose must be genuinely impossible, impractical, or wasteful to carry out, not merely less effective than a newer alternative. And the donor must have had a general charitable intent rather than an intent so narrow that only the exact stated purpose would do. If both conditions are met, the court redirects the funds. If either is missing, the money reverts to the donor or the donor’s estate. These cases are relatively rare because they require court proceedings, and judges are reluctant to second-guess a donor’s explicit wishes. That is why flexibility language in the original agreement matters so much.
What Happens If You Misuse Restricted Funds
Donor and Attorney General Enforcement
When an organization spends restricted money on unauthorized purposes, who can sue depends on the state. Traditionally, enforcement was left almost entirely to the state attorney general. A growing number of states have adopted statutes granting donors direct legal standing to enforce the terms of their gifts. Where donors cannot sue directly, they can file complaints with the attorney general’s office, which has authority to investigate, seek court orders compelling repayment, and in extreme cases, petition to remove board members.
Federal Grant Penalties
Misuse of federal grant funds triggers a separate and harsher set of consequences. Under the OMB Uniform Guidance, a federal agency can withhold payments, disallow costs, suspend or terminate the award, withhold future federal funding, and initiate debarment proceedings that bar the organization from receiving any federal awards.5eCFR. 2 CFR 200.339 – Remedies for Noncompliance
If the misuse involved false statements or fraudulent claims, the False Claims Act raises the stakes. Liability is set at three times the government’s actual damages plus a per-claim civil penalty, currently between $14,308 and $28,619 for each false claim.6U.S. Department of Justice. The False Claims Act An organization that diverted a $500,000 federal grant and submitted false expenditure reports could face $1.5 million in treble damages on top of per-claim penalties. The Act also allows private whistleblowers to file suit on the government’s behalf and share in the recovery.
Loss of Tax-Exempt Status
The IRS can revoke 501(c)(3) status when insiders benefit improperly from an organization’s assets. Diverting restricted funds to benefit board members or officers exposes those individuals to penalty excise taxes and puts the organization’s exemption at risk.7Internal Revenue Service. How to Lose Your Tax Exempt Status Without Really Trying Separately, any organization that fails to file its required Form 990 for three consecutive years loses its tax-exempt status automatically, whether or not funds were misused.
Accounting and Reporting
Fund Accounting
Organizations that hold restricted funds use fund accounting, which tracks each pool of restricted money separately from general operating funds. Every dollar received with restrictions is coded to a specific fund, and every expenditure charged against that fund must match the donor’s stated purpose. The money may sit in the same bank account as unrestricted cash, but on the books, it lives in its own column and cannot be borrowed against or commingled. The output is an audit trail. If an auditor cannot verify that funds were used for their intended purpose, the organization risks a qualified audit opinion, which can affect future giving and regulatory attention.
Form 990 and Schedule D
On IRS Form 990, organizations report two categories of net assets. Line 27 of Part X covers net assets without donor restrictions, including funds the board has internally designated. Line 28 covers net assets with donor restrictions, encompassing every gift subject to a donor-imposed purpose, time, or permanent restriction.8IRS. Instructions for Form 990 Return of Organization Exempt From Income Tax Organizations with endowment funds complete Schedule D, Part V, and break the current endowment into board-designated, permanent endowment, and term endowment as percentages totaling 100 percent. Donor-advised funds are reported separately in Part I of Schedule D.
Indirect Costs on Federal Grants
Federal funding adds a layer that trips up organizations new to it. When you receive a restricted federal grant, you can typically charge a portion of your overhead against the grant as indirect costs. If your organization has a negotiated indirect cost rate with a federal agency, you use it. If not, you can elect a de minimis rate of up to 15 percent of modified total direct costs without documentation.9eCFR. 2 CFR Part 200 Subpart E – Direct and Indirect Costs The rule that matters most is consistency. Every type of cost must be treated the same way across all your federal awards. If you charge accounting salaries as a direct cost on one grant, you cannot also recover those same salaries through your indirect cost rate on another. Double-charging is one of the fastest routes to a disallowance during a federal audit.