Navigating Nonprofit Funding Restrictions: 3 Best Practices

When individuals or organizations give large amounts of money to your nonprofit, they often want some control over how you use those funds to further your mission. For example, a major donor may stipulate that you need to put their gift toward a certain project that aligns with their interests, or a business’s fiscal sponsorship agreement that promises funding in exchange for publicity might be centered around a specific fundraising event.

Contributions with these types of donor-imposed designations are known as restricted funds. Properly managing these funds and honoring their restrictions is critical not only for building trust with individual supporters, but also for ensuring legal compliance and maintaining your nonprofit’s positive reputation in its community.

In this guide, we’ll walk through three best practices for navigating nonprofit funding restrictions so your organization can experience all of these benefits and prevent associated risks.

1. Understand the Different Types of Restricted Funds

Your nonprofit can receive a wide range of restricted contributions. Besides these funds being designated for different initiatives and given by various funders (individual donors, businesses, foundations, etc.), you may also see variations in the restrictions themselves.

According to Jitasa, all nonprofit funding falls into one of the following three categories when it comes to restrictions:

• Unrestricted funds have no donor designations, so your organization can put them toward any area of its budget (including overhead!). Most small to mid-sized individual and corporate donations, investment returns, and earned income (e.g., membership dues or merchandise sales) are unrestricted.

• Temporarily restricted funds are bound by a specific purpose or time period. Once the purpose is fulfilled or the time passes, any remaining funds can be reallocated to other initiatives. This category includes most major and planned gifts, corporate sponsorships, and grants.

• Permanently restricted funds usually take the form of endowments, which your nonprofit doesn’t spend directly but instead invests. Then, you’ll spend the interest the endowment contributions generate on a donor-designated initiative as long as you have the investment.

Remember that you should only consider funds to be temporarily or permanently restricted if the contributor imposed the designation. If your nonprofit decides internally to allocate contributions to a specific initiative (e.g., letting donors know that all donations made on GivingTuesday will fund a program you’re planning to launch in the new year), that isn’t legally binding, so you’ll record those gifts as unrestricted revenue. However, it’s in your best interest to follow through on that promise since it impacts donor trust.

2. Note Restrictions on Financial Reports

Donor-imposed restrictions are legally binding—i.e., your nonprofit can face lawsuits from funders or fines from the IRS if you misallocate restricted funds. So, you need to demonstrate that you’re using those contributions correctly in financial reports, such as your:

• Financial statements. Your statements of activities and financial position both cover your nonprofit’s net assets, which you should split into restricted and unrestricted categories for transparency.

• Form 990. In addition to categorizing restricted and unrestricted net assets here as well, you’ll need to specifically report on endowment funding on your Form 990.

• Grant reports. Grantmakers typically want to see detailed breakdowns of grant expenditures to demonstrate that you’re managing the funding they provided as you said you would in your proposal.

Creating these reports and paying attention to funding designations also helps you get a better picture of your organization’s financial health and processes, since you’ll always know how much revenue you have available for each of your mission-critical initiatives (and for overhead).

3. Proactively Ensure Proper Restricted Fund Accounting

In addition to careful reporting, you also need to set up the front end of your accounting procedures to facilitate restricted fund management. Make sure to:

• Configure your accounting software to track funding restrictions as you record gifts (which may be built-in or require manual setup, depending on your platform).

• Budget restricted funds first so they go toward the right activities, then fill in the gaps with unrestricted funding.

• Conduct regular financial audits to check that you’ve allocated restricted funds correctly and receive recommendations for managing them more effectively.

Additionally, be strategic when pursuing restricted contributions in general. Check that any grant you apply for is a good match for your mission and current initiatives, and prioritize cultivating major donors who are likely to designate their gifts for your biggest funding needs. This upfront alignment helps ensure you can allocate restricted funds correctly once you receive them.

Restricted funds may seem tricky to navigate at first, but learning to manage them is critical to your nonprofit’s success. Use the best practices above to get started, and don’t hesitate to reach out to an accountant if you need help or have any additional questions.