The IRS rules on restricted donations for nonprofits come down to a simple principle with strict enforcement: when a donor legally limits how a gift can be used, the organization takes on a binding duty to spend the money that way, track it separately in its books, and report it accurately on Form 990. Fail on any of those points and the consequences run from excise taxes on individual insiders to revocation of tax-exempt status. The donor’s side of the transaction is governed by the same Section 170 rules as any charitable contribution, but the paperwork burden climbs quickly once restrictions and noncash property enter the picture.
When a Gift Is Legally Restricted
A restricted donation is any contribution where the donor legally limits how the organization can use the money, whether by program, timeframe, or both. The restriction has to be established at the time of the gift, in writing: a gift agreement, a letter accompanying the check, or a formal pledge document. Casual language does not create a binding restriction. The words need to be mandatory rather than aspirational. If the gift instrument leaves the organization free to redirect the funds, the IRS won’t treat the gift as materially restricted.
The board’s formal acceptance is what locks the restriction in. Once accepted by resolution, the organization owes a fiduciary duty to honor the terms, and the board minutes documenting acceptance become the primary paper trail if the IRS asks questions later.
How Nonprofits Must Track and Manage the Money
Every materially restricted gift needs its own line in the organization’s books, separate from general operating revenue. Commingling restricted dollars with unrestricted funds is one of the fastest ways to trigger an examination and, in serious cases, put exempt status at risk.
The chart of accounts should label each restricted fund by donor and purpose. Internal reports need to show that every expenditure ties back to the stated purpose, supported by invoices, receipts, and expense documentation that connect to the underlying gift agreement. Monitoring is continuous until the restriction is fulfilled or formally released, not a one-time setup at intake.
Board involvement runs through the whole life of the fund. The board formally accepts the gift, authorizes expenditures (or delegates that authority with written guidelines), and approves the release of restrictions once the purpose has been met. Each of these actions belongs in the minutes. When auditors or the IRS come looking, minutes are the first document requested.
Current Net Asset Classifications
Nonprofit accounting standards classify net assets into two categories: “with donor restrictions” and “without donor restrictions.” Within the restricted category, some funds are time- or purpose-limited and will eventually be released, while others are permanent, most commonly an endowment where the donor requires the principal to be preserved indefinitely and only investment income can be spent. Both types sit under the same label on the financial statements, but the organization still has to track the nature of each restriction internally.
Reporting Restricted Funds on Form 990
Any tax-exempt organization subject to the annual filing requirement under Section 6033 has to report the status of its restricted funds on Form 990 or Form 990-EZ.1Office of the Law Revision Counsel. 26 USC 6033 – Returns by Exempt Organizations Part X (Balance Sheet) reports net assets on two lines: “net assets without donor restrictions” on Line 27 and “net assets with donor restrictions” on Line 28.2Internal Revenue Service. Instructions for Form 990 A mismatch between those balance sheet figures and the revenue categorization elsewhere on the return is the sort of discrepancy that draws IRS attention.
Organizations holding endowments must also complete Schedule D (Supplemental Financial Statements), which requires a detailed breakdown of endowment assets, changes during the year, and the use of investment income. Nonprofits receiving significant noncash contributions file Schedule M, describing the property and the valuation methods used.
Form 990 and its schedules are public documents. Anyone can request copies, and regulations require organizations to provide the return with all schedules and attachments on request.3eCFR. 26 CFR 301.6104(d)-1 – Public Inspection and Distribution of Applications for Tax Exemption and Annual Information Returns of Tax-Exempt Organizations Donors, journalists, and watchdog groups routinely review these filings to check how restricted funds are being handled.
What Happens When Restricted Funds Are Misused
The IRS treats fund misuse as a symptom of deeper governance problems, and it rarely stops at a single penalty. The consequences run from excise taxes on individuals up to revocation of the organization’s exempt status.
Section 4958 Excise Taxes
When a transaction between a tax-exempt organization and an insider (an officer, director, key employee, or other “disqualified person”) produces an excess economic benefit, Section 4958 imposes a 25% excise tax on the disqualified person who received it.4Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions Any organization manager who knowingly approved the transaction owes a separate 10% tax, capped at $20,000 per transaction. If the excess benefit isn’t corrected within the taxable period, the disqualified person owes an additional 200% of the excess benefit.
Redirecting restricted funds to benefit insiders or their family members is exactly the kind of transaction that triggers these taxes. The initial 25% is punishing enough; the 200% second-round tax for failing to fix the problem is where the numbers become catastrophic.
Revocation of 501(c)(3) Status
An organization that allows its income or assets to benefit insiders can lose 501(c)(3) status entirely.5Internal Revenue Service. How to Lose Your 501(c)(3) Tax-Exempt Status The IRS also expects organizations to pursue the exempt purposes described in their application for recognition. Systematically diverting restricted funds away from their stated purpose is arguably abandonment of those exempt purposes, which is independent grounds for revocation.
Revocation is retroactive in effect. It disqualifies the entity from receiving tax-deductible contributions, which means donors who gave in good faith may lose their deductions. For an organization sitting on large restricted endowments or outstanding capital campaign pledges, revocation can unravel years of fundraising in a matter of months.
Modifying or Releasing a Restriction
Sometimes the original purpose of a restricted gift becomes impossible or impractical. The building gets blocked by zoning, the disease gets cured, the program gets discontinued. The law provides a path to redirect the money, but the bar is deliberately high, and cutting corners looks a lot like fund misuse to the IRS.
The cleanest route is a variance power clause in the original gift agreement, which lets the board redirect funds without going to court as long as the new use is consistent with the organization’s mission. The IRS respects variance power when the language is clear. Development offices with any sophistication include this language in their standard gift agreements for exactly that reason.
When the gift instrument is silent, most states offer a statutory framework through some version of the Uniform Prudent Management of Institutional Funds Act. UPMIFA lets an organization ask a court to modify a restriction that has become unlawful, impracticable, impossible to achieve, or wasteful, with the modified use aligned as closely as possible with the donor’s original intent. For smaller endowment funds (typically below a threshold between $25,000 and $100,000, depending on the state) that are at least 20 years old, many states allow modification with written notice to the attorney general and a 90-day window for objection, avoiding court entirely.
Larger or newer funds generally require a formal court petition applying the cy pres doctrine, a centuries-old principle meaning “as near as possible.” Rather than invalidate the gift when its original purpose fails, the court picks a new use that closely tracks the donor’s original charitable intent. A fund created to fight a specific disease, for instance, might be redirected to research on a related condition. Any modification of a permanently restricted gift needs legal counsel, notice to the donor when available, coordination with the state attorney general, and often a court appearance.
What the Donor Needs for the Deduction
The donor’s ability to claim a charitable deduction for a restricted gift runs on the same Internal Revenue Code Section 170 rules as any charitable contribution. The organization has to qualify, and the donor cannot receive a substantial personal benefit in return.6Office of the Law Revision Counsel. 26 USC 170 – Charitable, Etc., Contributions and Gifts A restriction that effectively guarantees the donor exclusive use of a facility, or channels funds back to the donor’s business, reduces or eliminates the deduction.
Where a donor receives something in exchange for the contribution, the deductible amount is reduced by the fair market value of what they got back. Organizations must provide a written disclosure statement for any quid pro quo contribution over $75, explaining how much is deductible and estimating the value of goods or services provided.7Internal Revenue Service. Charitable Contributions – Quid Pro Quo Contributions Token items bearing the organization’s logo, such as mugs or calendars, are treated as insubstantial and don’t reduce the deduction, provided they fall below the annually adjusted cost thresholds.
AGI Limits and Carryforwards
Cash gifts to public charities are generally capped at 60% of adjusted gross income, while donations of appreciated capital gain property to those same organizations are limited to 30% of AGI.8Internal Revenue Service. Publication 526, Charitable Contributions Gifts to certain private foundations face a 30% or 20% cap depending on the type of property and the foundation’s classification.9Internal Revenue Service. Charitable Contribution Deductions Contributions exceeding the applicable percentage in a given year aren’t lost; the excess carries forward for up to five additional tax years. The restriction on the gift doesn’t change how the AGI limits apply.
Substantiation and Form 8283
For any single contribution of $250 or more, the donor must obtain a contemporaneous written acknowledgment from the receiving organization before filing the return for that year.6Office of the Law Revision Counsel. 26 USC 170 – Charitable, Etc., Contributions and Gifts A canceled check or bank statement is not enough once you cross the $250 line.10Internal Revenue Service. Charitable Organizations – Substantiation and Disclosure Requirements The acknowledgment has to state the cash amount (or describe donated property), indicate whether the organization provided goods or services in return, and if so, give a good-faith estimate of their value. For restricted gifts, it’s smart to reference the restriction in the acknowledgment, though the IRS doesn’t technically require the restriction language to appear in the receipt.
Noncash property brings more paperwork. Form 8283 is required when total noncash contributions exceed $500.11Internal Revenue Service. About Form 8283, Noncash Charitable Contributions Section A covers items valued at $5,000 or less per item; Section B applies to items worth more than $5,000 and requires a qualified appraisal.12Internal Revenue Service. Instructions for Form 8283 Restricted noncash gifts like donated artwork or real estate with use restrictions often land in Section B and need both the qualified appraiser’s signature and the donee organization’s acknowledgment on the form.
Donor Advised Funds Are Not Restricted Gifts
Donors sometimes assume a donor advised fund is a way to place a legal restriction on how their gift is used. It isn’t. With a DAF, the donor gives money to a sponsoring organization and then recommends, but cannot require, how the fund distributes grants.13Internal Revenue Service. Donor-Advised Funds Legal control of the assets sits with the sponsoring organization. The donor’s deduction is taken in the year of the gift to the fund, but the trade-off is losing the ability to enforce how the money is spent.