What Are Restricted and Unrestricted Funds for a Nonprofit?
Many charities dread restricted donations. But, all charities should understand what restricted and unrestricted funds are and also how to use them advantageously.
Charities, by and large, prefer unrestricted funds since they can determine how to use a donation. They also may believe that donors equate unrestricted funds with "overhead." That term generally applies to the money needed to keep the lights on, people employed, technology installed, and rent for office space.
The fear that people will not want to donate for these mundane and boring items, however, may be overblown. One study by GuideStar, BBB Wise Giving Alliance, and Charity Navigator found the "overhead myth" does not actually loom so large.
The Donor Loyalty Study found that most donors trust that the charities they give to will use their funds wisely. Furthermore, the most significant donors feel the most comfortable funding overhead expenses.
However, some donors, especially ones interested in leaving a legacy gift, do want to restrict their contributions to a particular purpose, especially big projects or infrastructure of some kind.
Since no charity wants to turn down a donation just because the donor wants it restricted, organizations must understand the legal ramifications and obligations that accompany restricted gifts.
Donors to a nonprofit organization may designate or "restrict" the use of their donations to a particular purpose or project. An example is a gift to a special scholarship fund at a university.
"Unrestricted" funds are donations the nonprofit may use for any purpose. Unrestricted funds usually go toward the operating expenses of the organization or to a particular project that the nonprofit picks.
How Are Restricted Funds Designated?
Only the donor can determine if a donation is restricted or not. The designation can be made by a letter from the donor or through an explicit agreement with the nonprofit.
Often grants from foundations are restricted to a particular program or purpose, and that restriction is set out in the documentation that accompanies the award.
Most nonprofits ask for unrestricted funds when they solicit donors by email or direct mail. A clause often states this on the donation form and in the gift acknowledgment. Exceptions could be when donors are asked to give to a capital campaign, a building fund, or a scholarship fund.
Nonprofits must be transparent when asking for gifts. Some charities have experienced donor backlash when it appeared that donors were donating for a particular purpose only to find out that the charity used their gift in an unrestricted way.
One way to avoid confusion is to give donors a choice of designation at the time of the donation. For instance, the American Red Cross on its online donation page offers several options for the donor to direct his donation, such as “Disaster Relief,” “Where it is needed most,” and “Your Local Red Cross.”
Most direct mail solicitations include a statement that implies the donor is giving an unrestricted gift. For instance, Partners In Health included this statement in its letter: “YES! I believe every child has a right to grow up happy and healthy. Here’s my gift to help end the senseless deaths of young children from malnutrition.”
What Are the Legal Obligations of a Restricted Gift?
There are good reasons to be entirely clear about how the charity plans to use the gift when making a solicitation. There is not only a moral obligation for nonprofits to honor a donor’s wishes, but they are also required by law to do so.
If a donor restricts a donation to a particular purpose and the nonprofit does not comply, the donor can demand a refund. The donor can take legal action if needed and report the charity to the Office of the Attorney General in the state where the charity resides.
The Types of Restricted Funds
Restricted gifts fall into two categories, specified in the “gift instrument.” That is the document that determines how the donated funds will be used. The gift instrument might be an award letter from a foundation or a letter from an individual donor.
Donors sometimes impose time-limited restrictions. Time-restricted means that the donation can be used for a particular purpose for a specified period, or it must support a specific program or campaign.
When the time is up, or the project is done, the funds become unrestricted or stopped. Examples include a grant, graduation of a scholarship recipient, or the completion of a building project.
Permanently restricted funds never expire. Usually, this means that the charity invests the gift and then uses the interest and investment returns in perpetuity. Permanently restricted funds often go into an endowment that supports a particular activity or the organization in general.
Whatever type of restricted fund is set up, the nonprofit must keep track of it and report it appropriately in its financial statements. Consult the Accepted Accounting Principles (GAAP) at the Financial Accounting Standards Board (FASB) for detailed information.
It's a good idea to revisit any restricted funds on your books. If many years have passed, the goals of the organization have changed, or the fund is no longer relevant, consider your options for changing the status of the fund.