One of the things that you learn quickly when starting and operating a 501(c)(3) organization is that you have to handle money wisely. A nonprofit is no different than any other business in that you must make ends meet. Otherwise, your charity will cease to exist. And, as many nonprofits soon learn, it doesn’t really matter whether the economy is in recession or is booming…being wise about your organization’s financial resources is essential.
But here’s a question you probably haven’t considered: In all of your efforts to keep your program running strong, could it be that you are misappropriating funds without knowing it? Is it possible that you committing a serious violation of the law? If you do not understand what the IRS and state regulations require regarding restricted funds, you might be.
Unfortunately, this is a situation where we frequently see nonprofits getting it wrong. Most of the time, it is an innocent attempt by a board or by an Executive Director to be good stewards of the money people have donated. With completely innocent and positive intent, they proceed to act in a manner that is totally against the rules.
For example, suppose things are really tight at the local homeless shelter. There isn’t enough cash in the general operating fund to buy all the food that is needed for the upcoming Christmas season. There is, however, a few thousand dollars sitting in the fund designated for building a new facility. And, in truth, the food shortage is a far more pressing need. It is unlikely a building project will be started for at least two years, maybe more. Is it OK to divert some of the building fund money to the food fund?
Maybe…or maybe not.
There are two types (or buckets) of funds, restricted and unrestricted. Let’s take a look at each:
Restricted Funds: These are funds that are set aside for a particular purpose. Sometimes it’s temporarily restricted, meaning that the restriction could end due to a specified time limit, or more likely, by the completion of a project, such as the construction of a facility. Funds that are permanently restricted are usually meant for projects or activities that are ongoing and have no time limit. Alternatively, a permanent restriction could also be tied to money that is to be saved or invested in an endowment fund, the interest earnings of which can be used for a particular activity or general operations.
And, restricted means RESTRICTED! This is not a trivial matter. Donors can take legal action against a nonprofit that it believes is misusing restricted donations. The last thing your charity wants is to be in the cross-hairs of the state Attorney General’s office.
Unrestricted Funds: As the name suggests, unrestricted funds don’t have strings attached and may be used by the nonprofit for whatever purpose it deems necessary. This money typically goes toward normal operating costs.
Only Donors Can Restrict Funds
Before we go any further, we have to talk about how money gets restricted. This point is key to the entire discussion: Only a donor can restrict funds by designating their contribution to a particular use.
We often see nonprofits set aside money to be used for a particular purpose, and then track those funds as restricted. That is fundamentally incorrect. It is perfectly fine to budget money for a purpose, and even move those funds into a protected account. But restricting the use of funds is not the same as restricted funds. I know it sounds like a game of semantics, but it’s not. That’s why it is so important for nonprofit leaders to understand legal definitions, not just learned lingo. Again, only a donor can apply restrictions to gifts. If you need to protect the future use of unrestricted funds the nonprofit already has in its general operating account, call it a set-aside, a protected fund, or a budgeted fund. Just don’t call it restricted.
So back to the real thing: truly restricted gifts. They can be received either in response to a specific solicitation campaign, or they could be offered by a donor without a prior targeted solicitation. Let’s look at an example of each.
Solicited designations. A solicitation means that your organization asked for donations for a particular cause. Maybe it was by letter, email, website, radio spot…it doesn’t really matter. What matters is that donations given in response to a direct solicitation are to be dedicated to that purpose. In our homeless shelter example, the board cannot simply redirect the use of the money from the facilities account to the food account, no matter how dire the circumstances, if those funds are the result of a solicitation.
Unsolicited designations. These are donated funds that the donor designates without having been solicited by the charity. For example, Bob decides to donate $100 to the shelter, but on his own decides to “designate” that those funds be used for future expansion. Is that also a restricted gift? Can the charity legally divert that money to its food fund?
If the organization agreed to the designation at the time of the gift, then it’s a restricted gift. One way to look at it is this: Donations become restricted when both parties agree to the restriction. In our example, we’re assuming the shelter accepted Bob’s designation. That makes it a restricted gift. However, there are way to avoid this problem in the future.
Provide a Disclaimer. Provide a disclaimer with your solicitation that the organization reserves the right to use money as it sees fit. Or, if it is a budgeted purpose, let your donor know that any funds received over and above the budget of the solicited purpose will be put into the general fund for operating expenses. Make sure your donation receipt reiterates that point.
Ask Permission From the Donor to Re-purpose Their Gift. In a situation where it’s too late for a disclaimer, you can go back to donors and ask permission to re-purpose their gift. Most of the time, donors will agree when it makes sense. Keep in mind that donors have the legal right to say no, and we have seen donors refuse to allow such. In these situations, charities may have to refund the donation if it cannot be used for its original intended designation.
By now, it should be clear that restricted funds is a serious subject. So too is the tracking of restricted funds. From an accounting perspective, it’s not a simple matter. Most accounting software packages are not specifically designed for nonprofit use. Very few have the ability to track restricted funds natively, including the most popular accounting software used by nonprofits nationwide. There are creative workarounds, but it isn’t easy to do.
Even if you happen to use accounting software that can track restricted funds, the accounting rules associated with it is complicated. We rarely see it done correctly by those nonprofits trying to track it on their own, even though accurate tracking and reporting is legally required. For that reason, most nonprofits with any restricted fund activity should seriously consider outsourcing their bookkeeping to a professional.
Handling the finances of a nonprofit is always a challenge. Knowing what constitutes restricted funds (and then handling them correctly) is crucial to staying out of trouble with your donors…and the law.
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