Restricted Funds in Nonprofits: What Leaders Must Know
Restricted funds are gifts where the donor has legally specified how, when, or for what purpose the money may be used. That specification is not a preference. Under U.S. law, donor-imposed restrictions create enforceable legal obligations — misuse can trigger state attorney general enforcement, donor litigation, or IRS consequences. The single most important action your organization can take: honor every restriction, track it in a separate subledger, and reclassify it only when the restriction is genuinely satisfied.
Before you read further, take these three steps for any restricted gift you have received:
Log the gift in your accounting system under the correct net asset class (“with donor restrictions” per FASB ASU 2016-14).
Store the gift instrument — the award letter, grant agreement, or written donor correspondence — in a permanent file.
Tag the fund in your subledger so every expense coded to that fund can be traced back to the restriction.
Four governing authorities shape how restricted funds work in the United States: FASB (ASU 2016-14 sets the accounting classification), UPMIFA (the Uniform Prudent Management of Institutional Funds Act governs endowments), the IRS (Form 990 requires disclosure of net asset balances and endowment activity), and your state attorney general, who holds primary enforcement authority over charitable assets.
Key Takeaways
Restricted funds carry legally enforceable obligations that only a donor, a court, or a qualifying expense can release — and the organizations that manage them correctly do so through documentation, subledger discipline, and written policies reviewed by legal counsel.
| Point | Details |
|---|---|
| Donor restrictions are legally binding | Misuse can trigger state attorney general enforcement, donor litigation, or IRS consequences. |
| Two net asset classes under FASB ASU 2016-14 | Track “with donor restrictions” and “without donor restrictions” separately in your subledger and financial statements. |
| Restrictions release on the deemed spent rule | A restriction releases when a qualifying expense is incurred, not when the specific donated cash is spent. |
| UPMIFA governs endowment spending | Boards must apply the eight prudence factors and document the rationale for every appropriation from an endowment fund. |
| Chisholm Law Firm supports restricted-fund compliance | The firm drafts gift agreements, advises on spending policies, and guides nonprofits through AG inquiries and cy pres petitions. |
Table of Contents
What restricted funds are and the main types you will encounter
The U.S. legal framework: donor intent, enforcement, and when restrictions can change
How to record, report, and disclose restricted funds correctly
Day-to-day management of restricted funds: policies, systems, and controls
Worked example: a $60,000 three-year restricted grant from receipt through release
What nonprofit attorneys see most often: warnings and practical advice
Chisholm Law Firm helps nonprofits protect donor trust and stay compliant
What restricted funds are and the main types you will encounter
Restricted funds are contributions where the donor has attached conditions on use. Under FASB ASU 2016-14, nonprofit financial statements carry two net asset classes: net assets with donor restrictions and net assets without donor restrictions. The old three-bucket system (unrestricted, temporarily restricted, permanently restricted) is gone from the face of the statements, but the practical distinctions still matter for internal tracking and disclosure notes.
| Restriction Type | What It Means | Common Example | When It Releases |
|---|---|---|---|
| Purpose restriction | Funds may only be used for a specified program or activity | Grant restricted to after-school tutoring | When qualifying expenses are incurred |
| Time restriction | Funds may not be spent until a future date or period | Pledge payable in Year 2 | When the specified date arrives |
| Perpetual (endowment) | Principal must be held in perpetuity; only income/returns may be spent | Named scholarship endowment | Never (principal); income releases per spending policy |
| Combined (purpose + time) | Both layers must be satisfied independently | Two-year grant for capital equipment | When both the time period arrives and the expense is incurred |
Board-designated funds look like restricted funds but are not. When a board sets aside unrestricted net assets for a specific purpose — often called a quasi-endowment — it is an internal governance decision. The board can reverse it at any meeting. A donor restriction, by contrast, cannot be reversed by the board alone. That distinction matters enormously on your balance sheet and in conversations with auditors.
A combined restriction is the most common source of confusion. Suppose a foundation awards a two-year grant for a literacy program. The time restriction releases at the start of Year 2, but the purpose restriction only releases when you actually incur qualifying literacy-program expenses. Both layers must clear before the funds move to net assets without donor restrictions.
The U.S. legal framework: donor intent, enforcement, and when restrictions can change
Donor intent is the legal anchor of every restricted gift. Courts and regulators consistently hold that a nonprofit accepting a restricted gift takes on a fiduciary-like obligation to use it as the donor directed. Honoring that intent is both a legal and ethical obligation — and a gift acceptance policy is one of the most practical tools for managing the risk before a gift is accepted.
UPMIFA and the prudence standard
The Uniform Prudent Management of Institutional Funds Act, adopted in some form by most U.S. states, governs how nonprofits manage and spend endowment funds. UPMIFA replaced the older UMIFA standard and introduced a prudence-based framework: boards must consider the duration and preservation of the fund, the purposes of the institution, general economic conditions, expected total return, and the organization’s other resources when deciding how much to appropriate from an endowment.
Cy pres and court-ordered redirection
When a restriction becomes impossible or impracticable to fulfill, the cy pres doctrine allows a court to redirect the gift to a purpose as close as possible to the donor’s original intent. Courts apply two conditions: the original purpose must be impossible or impracticable, and the donor must have had a general charitable intent beyond the specific purpose. Cy pres is not a quick fix. It requires a court petition, which takes time and legal fees.
UPMIFA also provides a statutory alternative for small or old endowments. Many states allow the board to modify the restriction without a court order for qualifying funds that meet statutory age and size thresholds — provided the organization gives the state attorney general advance notice and the AG does not object within a specified period. This is faster and less expensive than cy pres for eligible funds.
State attorney general enforcement
The state AG is the primary public enforcer of charitable trust law. AGs can investigate misuse of restricted funds, compel an accounting, seek restitution, and remove officers or directors. In some states, donors and donor families now have direct legal standing to sue a nonprofit for diversion of a restricted gift — a significant expansion of enforcement risk beyond the AG’s office alone.
When to call legal counsel immediately:
You discover restricted funds were spent on an unrelated purpose.
A donor dies and the gift instrument is ambiguous or missing.
A grant funder demands return of funds you have already spent.
You are considering redirecting an endowment gift without court approval.
Pro Tip: Before accepting any gift with unusual or narrow restrictions, have legal counsel review the gift instrument. Gifts with overly specific restrictions can cost more to administer than they are worth — and declining a problematic gift is far easier than unwinding one.
How to record, report, and disclose restricted funds correctly
Correct accounting for restricted gifts starts at the moment of receipt, not when you spend the money. Under FASB ASU 2016-14, an unconditional contribution is recognized as revenue in the period received, classified as net assets with donor restrictions if the donor imposed a restriction.
Journal entry: receipt of a restricted gift
When a foundation awards a $60,000 two-year literacy grant:
Dr. Cash (or Grants Receivable) $60,000
Cr. Contribution Revenue — With Donor Restrictions $60,000
The full amount hits revenue in Year 1 even if the grant spans two years, because the contribution is unconditional. The time restriction simply means you cannot spend it yet.
Journal entry: releasing a restriction
When you incur $25,000 in qualifying literacy-program expenses in Year 1:
Dr. Net Assets Released from Restrictions $25,000
Cr. Net Assets Without Donor Restrictions $25,000
This is a reclassification, not a cash transaction. Cash moved when you paid the expense. The release entry reflects that the restriction has been satisfied.
The “deemed spent” rule
PwC’s accounting guidance explains the “deemed spent” (first-dollar) rule: once you incur an expense that satisfies a donor’s restriction, the restriction releases — regardless of which cash account you drew from. Management cannot manipulate the timing of releases by selectively choosing which dollars to spend first.
ASU 2016-14 disclosure checklist
The following items are required or strongly expected in your financial statement notes:
Disaggregation of net assets with donor restrictions by type (purpose, time, perpetual).
Description of the nature and amounts of donor restrictions.
Endowment disclosures: spending policy, investment return objectives, and underwater fund status.
Amount of net assets released from restrictions during the period.
Board-designated net assets disclosed separately from donor-restricted net assets.
What auditors verify
Auditors will ask for the original gift instrument for every material restricted fund. They will trace restricted revenue to the subledger, verify that restricted expenses are coded to the correct fund, and confirm that releases from restrictions are supported by qualifying expenditures. A common audit finding: releases recorded at year-end without supporting expense documentation. Another: restricted cash commingled with operating cash in a single bank account.
Day-to-day management of restricted funds: policies, systems, and controls
Rules on paper mean nothing without operational systems to enforce them. The following practices translate legal requirements into daily workflow.
Gift acceptance policy
Every nonprofit that accepts restricted gifts should have a written gift acceptance policy. At minimum, it should address:
Review criteria: Who evaluates a proposed restricted gift before acceptance (executive director, finance committee, legal counsel for unusual gifts)?
Decline authority: Under what conditions will the organization decline a gift (restrictions that conflict with mission, gifts with unacceptable administrative burdens, gifts with conditions the organization cannot legally meet)?
Variance language: A clause reserving the right to seek donor consent or court modification if a restriction becomes impracticable — this is not a loophole, it is a standard protection.
Documentation requirements: What must be on file before a restricted gift is booked (signed gift agreement, award letter, pledge card)?
Subledger and fund coding
Good practice is to maintain a restricted subledger that reconciles to both the general ledger and the bank accounts. Each restricted fund gets its own code. Every revenue transaction and every expense charged to that fund carries the code. At month-end, the subledger balance for each fund should match the general ledger balance for net assets with donor restrictions.
Practical tip: if your accounting software allows project or class tracking (QuickBooks Nonprofit, Sage Intacct, or Blackbaud Financial Edge NXT, for example), use it. A fund code on every transaction is the single most effective control against accidental diversion.
Internal controls
Require a second approval for any expense coded to a restricted fund above a materiality threshold.
Reconcile restricted fund balances monthly, not just at year-end.
Keep restricted cash in a separate bank account when the gift instrument or grant agreement requires it — some federal grants and many foundation grants do.
Restrict access to the subledger so that only authorized finance staff can reclassify net assets.
Aligning development and finance
Development staff often receive gift instruments before finance staff see them. That gap creates risk. A simple fix: require development to route every signed gift agreement, award letter, and donor correspondence to finance within 48 hours of receipt. Finance then opens the fund code before any revenue is booked. This prevents the common problem of a grant being deposited and spent before anyone in finance has read the restrictions.
Pro Tip: Assign one staff member — not a volunteer — as the “restricted fund steward” responsible for reconciling the subledger, maintaining the gift instrument file, and flagging any fund where expenses are approaching the restriction limit. This single-owner accountability prevents the diffusion of responsibility that leads to accidental diversion.
What to do when you can’t follow a restriction
Discovering that a restriction cannot be met is stressful, but the path forward is clear if you act quickly and document everything.
Preserve all documentation. Pull the original gift instrument, all donor correspondence, and the fund’s transaction history. Do not delete or alter any records.
Pause spending from the fund. Until you know the legal path forward, stop incurring expenses against the restricted fund.
Map your obligations. Identify the total amount received, the amount already spent, the amount remaining, and any reporting deadlines in the grant agreement.
Assess the options below and choose the least risky path given your facts.
Option A: Seek donor consent
If the donor is living and reachable, written donor consent to modify or release the restriction is the cleanest solution. Get it in writing, signed, and dated. Attach it permanently to the gift instrument file.
Option B: Return the gift
If the restriction cannot be met and the donor will not consent to a modification, returning the unspent funds is often the safest option. It eliminates legal exposure and preserves the relationship better than a regulatory proceeding.
Option C: Cy pres petition
For charitable trust gifts where the donor is deceased or unreachable, a cy pres petition to the appropriate state court can redirect funds to a purpose as near as possible to the original intent. This requires legal counsel, a court filing, and typically notice to the state AG.
Option D: UPMIFA statutory modification
For small or old endowment funds that meet state statutory thresholds, UPMIFA may allow the board to modify the restriction after giving the state AG advance notice. Check your state’s specific UPMIFA enactment for the dollar threshold and notice period.
When to notify the state attorney general: Notify the AG proactively if you discover a material diversion of restricted funds, if you are pursuing cy pres, or if a donor family has threatened litigation. Proactive disclosure typically results in a more cooperative regulatory response than a complaint-driven investigation.
Pro Tip: If a donor sends an unsolicited check with a restriction written on the memo line, you are not automatically bound by it simply by depositing the check. However, cashing it without objecting in writing creates a strong inference of acceptance. Return unsolicited restricted gifts promptly if you cannot or will not honor the restriction, and document the return.
Endowments, UPMIFA, and building a prudent spending policy
An endowment is a fund where the donor has restricted the principal in perpetuity and authorized the organization to spend only the income or a portion of the total return. Managing an endowment correctly requires a written spending policy that satisfies UPMIFA’s prudence standard and meets ASU 2016-14 disclosure requirements for underwater funds.
UPMIFA’s eight prudence factors
When appropriating from an endowment, the board must consider: (1) the duration and preservation of the endowment fund, (2) the purposes of the institution and the fund, (3) general economic conditions, (4) the possible effect of inflation or deflation, (5) the expected total return from income and appreciation, (6) other resources of the institution, (7) the investment policy of the institution, and (8) where relevant, an asset’s special relationship to the purposes of the fund.
Spending policy elements
| Policy Element | What to Include | Why It Matters |
|---|---|---|
| Target spending rate | A percentage of a rolling average market value (commonly 4%–5%) | Balances current use with long-term preservation |
| Smoothing mechanism | Average market value over multiple quarters | Reduces volatility in annual appropriations |
| Underwater fund rule | Whether to suspend or reduce distributions when market value falls below historic gift value | Required disclosure under ASU 2016-14 |
| Minimum fund size | Dollar threshold below which the fund is not separately invested | Prevents administrative burden from small endowments |
| Board approval | Annual resolution authorizing the appropriation amount | Documents prudence standard compliance |
Underwater endowments
An endowment is “underwater” when its current fair market value falls below the original gift amount (the “historic dollar value”). Under ASU 2016-14, organizations must disclose the aggregate fair value of underwater endowment funds, the aggregate historic dollar value, and the board’s policy for spending from those funds. Some boards suspend distributions entirely when a fund is underwater; others continue spending at a reduced rate. Either approach is defensible if documented and consistently applied.
Pro Tip: Include a variance clause in your endowment spending policy that allows the board to deviate from the target rate in extraordinary circumstances — but require a supermajority vote and written documentation of the rationale. Auditors and the state AG will look for evidence that deviations were deliberate and governed, not accidental.
Worked example: a $60,000 three-year restricted grant from receipt through release
This example walks through the full accounting lifecycle of a three-year, $60,000 foundation grant restricted to a youth workforce development program.
Assumptions: Grant awarded January 1, Year 1. $20,000 is allocable to each of Years 1, 2, and 3. The grant agreement includes both a time restriction (funds for Year 2 may not be spent before January 1, Year 2) and a purpose restriction (workforce development program expenses only).
Step 1: Record the full grant on receipt
Dr. Grants Receivable $60,000
Cr. Contribution Revenue — With Donor Restrictions $60,000
The full $60,000 is revenue in Year 1 because the grant is unconditional. The time restriction does not defer revenue recognition; it defers spending.
Step 2: Year 1 release (after incurring $20,000 in qualifying expenses)
Dr. Net Assets Released from Restrictions $20,000
Cr. Net Assets Without Donor Restrictions $20,000
Step 3: Year 2 and Year 3 releases (same entry, repeated annually)
The same $20,000 release entry is recorded in Years 2 and 3 as qualifying expenses are incurred. The deemed spent rule means the restriction releases when the expense is incurred, not when the check clears.
Financial statement snapshots
Audit-pitfall callouts for multi-year grants
Missing grant agreement on file. Auditors will ask for the signed award letter. If it is not in the file, the release from restrictions has no documented basis.
Timing mismatch. Recording a Year 2 release in Year 1 because you “plan to spend it” is not permitted. Releases require actual qualifying expenditures.
Budget vs. actual variance. If you spent less than $20,000 in Year 1, the unspent balance stays in net assets with donor restrictions. Do not release more than you spent.
Commingled cash. If the grant agreement requires a separate bank account and you commingled funds, disclose it to your auditor immediately.
What nonprofit attorneys see most often: warnings and practical advice
The most common and costly mistake in restricted-fund management is not fraud. It is carelessness with documentation. Organizations accept a restricted gift, spend the money on what they believe is a qualifying purpose, and then cannot produce the original gift instrument two years later when the auditor or a funder asks for it. At that point, the release from restrictions has no documented basis, and the organization faces a potential restatement, a qualified audit opinion, or a funder demand for repayment.
The second warning is about donor intent drift. A program evolves, staff turns over, and the original restriction language gets reinterpreted to fit current activities rather than the donor’s actual words. Courts and regulators do not accept “we thought it was close enough.” The gift instrument controls, and if the restriction is genuinely too narrow to be useful, the correct path is donor consent or a formal modification — not a liberal reinterpretation.
The third warning is about public trust. Restricted-fund mismanagement is one of the fastest ways to lose donors and invite regulatory scrutiny. A single news story about diverted charitable funds can set back years of relationship-building. The legal risk is real, but the reputational risk is often worse and longer-lasting.
Legal counsel is most valuable at three points: when you are drafting or negotiating a gift agreement or grant award, when you discover a potential compliance problem before it becomes a regulatory matter, and when you are considering any modification to an existing restriction. Counsel can draft gift agreements with variance language that gives the organization flexibility, negotiate grant terms with funders before the award is finalized, and guide you through the UPMIFA statutory modification process or a cy pres petition when a restriction truly cannot be met. For organizations setting up a nonprofit to qualify for foundation funding, getting the legal structure and gift acceptance framework right from the start is far less expensive than correcting problems after the fact.
Chisholm Law Firm helps nonprofits protect donor trust and stay compliant
Restricted-fund compliance is exactly where legal counsel pays for itself. Chisholm Law Firm works with nonprofit leaders on the specific legal tasks that reduce restricted-fund risk: drafting and reviewing gift agreements with appropriate variance language, advising on UPMIFA-compliant spending policies, responding to state attorney general inquiries, and supporting grant compliance reviews before an audit or funder site visit.
When you reach out, bring the gift instrument or grant award letter, any donor correspondence, and your current subledger balances. That documentation lets Chisholm Law Firm assess your exposure quickly and give you a clear action plan. Whether you need a one-time gift agreement review or ongoing grant compliance and reporting support, the firm’s flat-fee structure means you know the cost before you commit. Schedule a consultation at Chisholm Law Firm to protect your organization’s restricted funds and the donor relationships behind them.
Sources
The sources below are the primary references for restricted-fund law, accounting, and practice in the United States.
What Are Restricted Funds: Nonprofit Rules and Reporting – LegalClarity
cy pres doctrine — Cornell Law School Legal Information Institute
Restricted Funds: Everything Your Nonprofit Needs to Know — OneAbacus Advisory
This article is general information, not a substitute for advice from a qualified lawyer. Consult a qualified legal professional about your own circumstances before acting on anything here.