What Are Restricted Funds? Types, Endowment Rules, and Penalties

Restricted funds are contributions a nonprofit or government entity has accepted under conditions that limit how the money may be spent. The conditions come from outside the organization — a donor, a foundation, or a government agency — and they are legally binding from the moment the gift or grant is accepted. Under current accounting standards, every dollar on a nonprofit’s balance sheet sits in one of two buckets: net assets with donor restrictions or net assets without donor restrictions.¹

The restriction can be tied to a specific program, a future date, or the requirement that the principal never be spent at all. Whichever form it takes, the organization has to track the money separately, spend it only as directed, and report on it.

How Restrictions Get Attached to a Gift

Restrictions are created in writing by the person or entity giving the money. Individual donors express intent through pledge agreements, letters, or the response language on a fundraising campaign. Foundations and corporate funders use grant agreements that spell out the scope of work, allowable expenses, and reporting deadlines. Government agencies create restrictions through legislative appropriations and performance-based contracts, and federal awards carry the cost principles in the Office of Management and Budget’s Uniform Guidance, which decides what expenses are allowable under a given grant.²

Accepting the money is what binds the organization. There is no separate signing ceremony; once the funds are received under the stated conditions, the conditions apply.

The Types of Restricted Funds

Purpose Restrictions

A purpose restriction ties the money to a specific use. A donor might give $50,000 earmarked for laboratory equipment or a foundation might award a grant that can only cover direct program costs for a particular initiative. The restriction is satisfied when the money is spent on the designated activity, at which point an accounting entry moves the balance from “with donor restrictions” to “without donor restrictions.”¹

Time Restrictions

A time restriction ties access to a date rather than a use. A donor might specify that a $10,000 gift cannot be touched until the next fiscal year. Once the date arrives, the restriction lifts and the funds become available for general use, subject to any purpose restriction that also applies.

Permanent Restrictions and Endowments

A permanent restriction requires the organization to preserve the original gift amount — the principal — indefinitely. This is what most people mean by a donor-restricted endowment. The organization invests the principal and can spend only the investment income or earnings, and only for the donor’s stated purpose, such as funding a recurring scholarship. The principal itself is never spent.

Endowments create long-term stability and long-term rigidity in equal measure. They provide reliable income for the purpose the donor named, but they cannot be drawn down to plug a cash-flow hole. Nonprofits report their endowment holdings on IRS Form 990, Schedule D, Part V, broken into board-designated, permanent, and term categories that must total 100 percent.³

Board-Designated Funds Are Not Restricted Funds

Nonprofit boards often set aside money for a future need — a reserve fund, a building project, or seed money for a new program. These are called board-designated funds, sometimes quasi-endowments. They look earmarked on internal reports, but legally they are not restricted.

The difference is who imposed the limit. A board designation is internal and reversible: the board can vote to redirect the money at any time, so if a financial emergency hits, the board can move funds from a capital project reserve to cover operating costs. A donor restriction is external and cannot be changed by a vote; altering it requires either the donor’s consent or a court order. On the financial statements, board-designated funds are classified as net assets without donor restrictions, and they have to be disclosed in the liquidity footnotes so readers can see which assets are truly available.³

The Legal Standard for Managing Endowments

The Uniform Prudent Management of Institutional Funds Act (UPMIFA) is the main law governing how nonprofits manage and spend endowment assets. It has been adopted in 49 states; Pennsylvania operates under a different framework called Act 141. UPMIFA requires anyone managing institutional funds to act in good faith and with the care a reasonably prudent person would use in a similar role.

When a board decides how much to spend from an endowment in a given year, UPMIFA lists seven factors it must weigh:

How long the fund is expected to last and the need to preserve it
The mission of the organization and the specific goals of the fund
General economic conditions
The possible effects of inflation or deflation
The expected total return from investments
Other resources the organization has available
The institution’s investment policy

These factors force a balance between spending now and preserving the fund for later. Drawing down too aggressively, even for legitimate program purposes, can expose the board to scrutiny for failing the prudence standard.

Changing a Restriction When the Original Purpose Becomes Impossible

Leadership cannot simply override a donor-imposed restriction. If the original purpose has become impossible or impractical to carry out, the organization generally has to petition a court to modify it. The doctrine that governs this is called cy pres, roughly meaning “as near as possible.” A court can redirect the funds toward a purpose that closely matches the donor’s original intent rather than invalidating the gift.

An endowment set up to fund a research program that no longer exists, for example, could be redirected by court order to a similar research initiative at the same institution. The organization has to show that literal compliance is no longer feasible, not merely inconvenient. Some states also recognize equitable deviation, a related doctrine that lets courts change the administrative terms of a gift — for instance, an investment restriction — while keeping the charitable purpose intact.

What Happens if Restricted Funds Are Misused

Spending restricted money on the wrong thing carries three kinds of exposure.

Loss of Tax-Exempt Status

The IRS can revoke a nonprofit’s 501(c)(3) status if the organization is no longer operating in accordance with its stated exempt purposes. Diverting restricted charitable contributions to unrelated uses can be treated as evidence that the organization is not operating exclusively for exempt purposes, which is the core requirement for keeping the exemption.

Civil Liability

Donors, their estates, and state attorneys general can sue an organization for misusing restricted gifts. A donor who kept a right of reversion in the gift instrument can seek the return of the full present value of the contribution if the restriction is not honored. Even without a reversion clause, state attorneys general have broad authority to enforce charitable trusts and restricted gifts on behalf of the public.

Criminal Penalties

When misuse involves fraud, individuals can face federal charges. There is no single federal “charity fraud” statute, so prosecutors typically bring wire fraud, mail fraud, or tax evasion charges. For organizations receiving more than $10,000 in federal program benefits in a given year, federal law makes it a crime for any agent to embezzle or misapply property valued at $5,000 or more, with a penalty of a fine and up to 10 years in prison.⁴ Wire or mail fraud charges can carry sentences of up to 20 years.

Who Can Actually Enforce a Restriction

Donors have real but limited tools. The strongest is a right of reversion written into the gift instrument, letting the donor reclaim the contribution if the organization fails to comply. Most donors avoid this route because keeping a reversion right can disqualify the gift from a federal charitable income tax deduction.

In practice, enforcement often falls to state attorneys general, who have standing to investigate and sue nonprofits that misuse charitable assets. Donors who did not retain a reversion right generally do not have standing to sue on their own, though courts have increasingly recognized donor standing where the gift agreement functions as an enforceable contract. A written gift agreement that documents the restriction clearly, and says what should happen if the original purpose becomes impractical, is the most reliable protection for donor intent.

Reporting Obligations You Will Encounter

FASB Net Asset Classification

Under Accounting Standards Update No. 2016-14, nonprofits report using two net asset categories: with donor restrictions and without donor restrictions. This replaced the older three-category system (unrestricted, temporarily restricted, and permanently restricted). Time-limited restrictions and permanent restrictions are grouped together in the restricted category; board-designated funds sit in the unrestricted category.¹

Form 990 Schedule D

Schedule D, Part V requires the organization to break endowment holdings into board-designated, permanent, and term categories and to describe the intended uses of those funds.³

Single Audit for Federal Awards

Organizations that spend $1,000,000 or more in federal awards during a fiscal year must undergo a Single Audit, which reviews both the financial statements and compliance with federal grant terms.⁵ Organizations below the threshold still have to keep records available for federal review.

Federal Grant Closeout

When a federal grant’s performance period ends, recipients must settle all financial obligations within 120 calendar days, and subrecipients within 90 calendar days.⁶ Any unspent funds the organization is not authorized to keep must be returned to the awarding agency. Records related to the award have to be retained for three years after the final closeout reports are submitted.⁷

1
Financial Accounting Standards Board (FASB). Accounting Standards Update No. 2016-14 – Presentation of Financial Statements of Not-for-Profit Entities
2
NIH Grants & Funding. 7.9 Allowability of Costs/Activities
3
Internal Revenue Service. Instructions for Schedule D (Form 990)
4
Office of the Law Revision Counsel. 18 USC 666 – Theft or Bribery Concerning Programs Receiving Federal Funds
5
eCFR. 2 CFR Part 200, Subpart F – Audit Requirements
6
eCFR. 2 CFR 200.344 – Closeout
7
Congressional Research Service. Federal Grant Closeout