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What Are Restricted Funds?

Last modified: December 7, 2018
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Definition

Restricted funds are monies set aside for a particular purpose as a result of designated giving.  They are permanently restricted to that purpose and cannot be used for other expenses of the nonprofit.  By contrast, unrestricted funds may be used for any legal purpose appropriate to the organization.

Only Donors Can Restrict Funds

One of the most important points to understand about restricted funds is that they can only come about through designated giving.  A nonprofit is free to set aside a portion of general operating revenue for any number of reasons, and may even create policies to make it difficult for those funds to be used for any other purpose.  But even if that happens, those funds are not truly restricted in the legal sense.  Real restricted funds are the result of a donor giving with specific strings attached as to what the donation may be used for.  It may be the result of the nonprofit soliciting or fundraising for that purpose.  Donors can also designate that a gift be used for a purpose they choose, completely independent of any fundraising campaign.  It may or may not be for a legitimate purpose.  These gifts can be a challenge to deal with.

What To Do About Unsolicited Designations

In that last scenario, if a donor designates a contribution that isn’t a result of an “ask” for that purpose, the nonprofit has a choice to make.  If it accepts the gift with the strings attached, that money becomes restricted to that purpose.  Sometimes that’s fine.  If a church, for example, has a facilities fund that it uses to pay mortgage payments and building-related expenses, the church may be happy to accept donor-designated gifts for that purpose, even if they weren’t directly solicited.

But what about designations that don’t fall into that situation? The good news is that a charity is not obligated to accept designated gifts.  If a donor gives a donation with a designation that doesn’t make sense for the organization at that time, it can always ask the donor if the money can be used for other purposes.  Most donors are trying to help the organization, and such a request is usually granted.  If the donor is gracious enough to agree, the money isn’t restricted.  Rarely, a donor may have a personal agenda, or is seeking some type of influence, and is not willing to lift the designation.  At this point, the nonprofit can accept the donation and agree to the restriction, or it can refuse the gift altogether.

Restrictions Are Permanent (Usually)

Once money is restricted, that restriction is permanent.  The funds cannot be redirected to other purposes, even if the budget picture becomes bleak.  It is a difficult situation to be facing unpaid rent and utility bills, or an upcoming payroll, with nothing in the organization’s operating account, but you have $50,000 sitting unused in a Scholarship Fund.  It seems logical that the money could be moved in an emergency.  But, the IRS is serious about restricted funds.  Improper use can result in severe penalties, or even loss of exempt status.  Boards can be sued by donors for misuse of such funds.

There is a possible way out, but it isn’t always easy.  If a situation arises that is serious enough to necessitate re-purposing restricted funds, it is necessary to obtain permission from the original donor(s) to remove the restriction.  It’s best practice to get that permission in writing.  That is the only legal way to use the money for purposes other than the original restriction.

Avoiding Headaches When Fundraising

There are a few things you can do to keep from getting caught in these situations.  When it comes to soliciting donations for a particular purpose, it is often wise to provide the donor with some caveats prior to the gift.  You can set a budget for the campaign and inform donors that any money received above a predetermined cap will be redirected to the general fund.  You could also publicize a time limit after which unused money in the restricted account becomes available to the general fund.  And finally, you can always provide a general disclaimer that all donations received through a campaign are subject to redirection at the discretion of the organization.

Be careful with blanket disclaimers like that last one, however.  If donors don’t have confidence that their donation is really for the purpose advertised, you may handicap your campaign.  The important thing to understand is that if you use a disclaimer or caveat, it needs to be very clear to the donor prior to the gift.

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This Post Has 11 Comments

  1. I work for a church and the lead pastor approached me a few day ago with this statement and directive; the money in my designated account that I raised for purposes directly related to my department was not mine. I do not own it. It is money that belongs to the church. I never disagreed with this but here’s the problem I need clarity on. He then directed me to cover the salary of an assist for department using money from this designated account. Are there any legal issues that can come back to haunt us?

    1. He is correct that the money belongs to the church, but you obviously know that. His directive to spend the money for a purpose other than its designation could be a major problem, however. If this money was originally set aside from general donations, then it is not technically restricted. Nonprofits and businesses do that all the time, that is, set money aside for a project or other purpose, only later to realize that they need to use it elsewhere. Not a problem there. However, if the money was given by donors for a specific designated purpose, and assuming the donors were not told at the time of the gift that the money might be spent differently, then that money is cannot be repurposed without permission from the donors. This is a legal issue that could definitely come back to bite you. The IRS doesn’t get too involved in this fight, but state Attorney General offices definitely do. Just because the money is needed somewhere else doesn’t override its restriction. Tread carefully here.

  2. A donor gave a multimillion $ donation to a 501 c(3) non profit. The only restriction was that the non-profit’s CEO remain “employed” for a minimum of five years.

    A year later, the new CEO terminated the former CEO. Can the SEC or other agencies investigate this abuse of restricted funds. The funds had been invested in a separate “foundation” governed by the SEC.

    What other agencies can be notified for investigation?

    1. Several red flags with this. For one, why would the SEC be involved in a foundation? Secondly, truly restricted funds are restricted by purpose, not by requiring specific actions of a nonprofit. A donor has no right to dictate the employment practices of the charity they give to. It doesn’t sound like an abuse of restricted funds…more like a misunderstanding of what a restricted donation actually is, by one or both parties.

  3. If a church membership establishes a savings account for a specific purpose and it is funded with transfers from the general fund to grow it, is that savings account considered a “restricted” fund or a dedicated fund?

    1. Hi, Mike. Sorry for the response delay. No, that scenario does not create a “restricted account” in the legal sense. Your church may wish to treat it as a protected set-aside, which is perfectly fine. But, restricted funds can only be created at the time of the donation based solely on donor intent.

  4. Why don’t you submit a request with backup invoices for a reimbursement to your organization for the $5k?

    The invoice you paid can be from more than $5k and it should readily be a bonafide expenditure that benefited the intended recipient of the original restriction.

    You don’t have to be short on cash in order to request this and as long as it meets the intended purpose of the original restriction it would be pretty hard to substantiate why they didn’t grant approval.

  5. We are structured in St. Vincent de Paul as a pyramid. Our National Council at the top, District/Diocesan Councils beneath, and local Conferences at the bottom. In most instances Conferences use the EIN/501C3 of the District/Diocesan Council. As a member of an existing Conference a Donor donated $10K to my new Conference. My new Conference had not been established when the donation was made, so no bank account existed for my new Conference. Rather than holding the $10K as the end of the year approached, the Donor and I agreed to identify the donation as a Restricted Donation, and have our Diocesan/District Council hold the funds in a checking account, separate from the general funds of the Diocesan/District Council. The control of the funds were relinquished at that point. Three months later…….. I requested that the Diocesan/District Council release the funds to my new Conference as we has established an EIN, our own 501C3, and a bank account. The Diocesan/District Council refused to do so, stating that the funds were in their bank account, so belonged to them. Through intermediaries from our National Council, we negotiated with the Diocesan/District Council to get $5K of the $10K. We agreed to allow the Diocesan/District Council to have use of the $5K they would not provide for a 6-month period to resolve attorney fees with lawsuits they’re involved with – imagine that! No documentation was created as they refused to sign anything. However I’ve retained emails that cover everything. The time has passed, and they continue to refuse to provide the remaining funds. At what point did the original Donor’s authority to direct the funds end? What IRS laws is the Diocesan/District Council breaking by not providing the $5K in restricted funds? Although, we don’t have need of the funds, at this point, I want to ensure we’ve complied with IRS regulations from our perspective. What recourse might we have ?

    1. This is tricky. From your description, it sounds like the District Council agreed to be a fiscal sponsor until your organization was established. That allows the donor to give immediately and receive donation acknowledgement from an established charity. If the donor explicitly intended all of the $10,000 to go to your organization, the entire $10,000 should be considered restricted to your nonprofit by the District. The question is whether or not the District understood that donor restriction at the time they took custody of the funds. Even if they didn’t fully understand, they’re obligated to the donor as the recipient charity to honor the designation and restrict the funds.

      As for recourse, you need to press your case. If the District won’t acquiesce, your only recourse may be legal. Before filing suit, contact your AG’s office or state Dept of Charities to see what they say.

  6. Where is the actual reference in the IRS code to the requirement to honor (as opposed to “account for”) a donor restriction? I can find it in state codes, but have not seen anyone cite the actual requirement from either the US code or current IRS forms, pubs, etc. What penalties can/will the IRS impose, and where is that documented?

    1. This is one of those issues that is governed more by state law and accounting regulations than by IRS code. Generally Accepting Accounting Principles, GAAP, represents the standards of accounting practice in the US. GAAP details how restricted funds should be accounted for. Also, the Financial Accounting Standards Board (FASB) is the group who establishes the rules recognized under GAAP. State law is the jurisdiction for enforcement of restricted funds rules, as boards of accountancy are governed at the state level. Finally, the IRS follows GAAP/FASB requirements, requiring a breakdown on Form 990 balance sheets of restricted and unrestricted funds. Penalties aren’t generally levied by the IRS for restricted funds violations, but state AG’s offices will aggressively enforce these rules.

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