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Restricted donations are a crucial source of funding for many nonprofit organizations, but they come with specific rules and obligations. The IRS rules on restricted donations ensure that these donations are managed and utilized appropriately, aligning with both the donor’s intent and the organization’s tax-exempt status. This article delves into the IRS rules surrounding restricted donations, the consequences of not following them, and how nonprofits can navigate situations where the restrictions on a donation cannot be followed.

What Are Restricted Donations?

Restricted donations are contributions made to a nonprofit organization with specific stipulations on how the funds should be used. These restrictions are specified by the donor and can include (but are not limited to):

• Purpose: Funds may be restricted to certain programs, projects, or activities.

• Time: Donations may be used only within a certain timeframe.

• Investment: Some funds may be required to be invested, with only the income being used (e.g., endowments).

We have a full article on restricted donations if you’d like to read more about them.

IRS Rules on Restricted Donations

The IRS recognizes restricted donations as those that a donor has directed to be used for a particular purpose, and these must be managed separately from general, unrestricted funds. Nonprofits must track these funds meticulously to ensure they are used according to the donor’s wishes and in compliance with IRS rules on restricted donations.

Key IRS Rules on Restricted Donations

IRS Rules on Restricted Donations: #1 Tracking and Reporting

Nonprofits must track restricted donations separately from unrestricted funds. This requires robust accounting practices to ensure that restricted funds are not inadvertently used for other purposes. The IRS requires that nonprofits report restricted donations accurately on their annual Form 990, the informational return tax-exempt organizations must file annually.

Best Practice: Maintain separate accounting codes or ledgers for restricted donations to avoid co-mingling with unrestricted funds. Regularly reconcile accounts to ensure compliance.

IRS Rules on Restricted Donations: # 2 Use of Restricted Donations

The IRS rules on restricted donations mandate that restricted donations be used exclusively for the purposes specified by the donor. If a nonprofit uses these funds for any other purpose without the donor’s consent, it could jeopardize the organization’s tax-exempt status.

Best Practice: Before accepting a restricted donation, ensure that the organization can fulfill the donor’s conditions. If the conditions are too restrictive or impractical, it may be best to negotiate terms that are more feasible.

IRS Rules on Restricted Donations: #3 Documentation of Donor Restrictions (Gift instruments)

Nonprofits are required to maintain documentation of any restrictions placed on a donation. This documentation sometimes takes the form of a written agreement or a letter from the donor detailing the restrictions. But it can also be digital, via email or text. The IRS may request this documentation during an audit to verify that the organization is complying with the donor’s intent.

Best Practice: Always document donor restrictions in writing, preferably in a digital format, and back up the data securely. This ensures clarity and provides a reference if any disputes arise.

IRS Rules on Restricted Donations: #4 Modification of Restrictions (The Cy-Près Doctrine)

When the original restrictions on a donation become impossible or impractical to fulfill, the IRS allows for modification of those restrictions under the cy-près doctrine. This legal principle permits the modification of a charitable trust to more closely align with the donor’s original intent when the specified purpose can no longer be achieved. Because the process involves the court, most nonprofits need an experienced attorney to navigate through the process. If you are in need of a legal consultation regarding freeing up restricted donations permissibly, let us know.

Best Practice: If a restriction cannot be met, consult with legal counsel to petition a court for modification under the cy-près doctrine.

IRS Rules on Restricted Donations: #5 Spending Rules for Endowments

The IRS provides specific guidelines on how nonprofits should manage and spend endowment funds, a common form of restricted donation. Under the Uniform Prudent Management of Institutional Funds Act (UPMIFA), nonprofits are expected to manage these funds prudently, preserving the purchasing power of the principal while making distributions for the donor-specified purposes.

Best Practice: Develop a spending policy that aligns with UPMIFA and the IRS guidelines. Regularly review and adjust the policy to reflect changes in market conditions and the organization’s needs.

Consequences of Not Following IRS Rules on Restricted Donations

1. Loss of Tax-Exempt Status

One of the most severe consequences of not adhering to IRS rules on restricted donations is the potential loss of the organization’s tax-exempt status. This can happen if the IRS determines that the nonprofit has consistently mismanaged restricted funds or failed to comply with donor restrictions.

Impact: Losing tax-exempt status can result in the organization having to pay corporate income tax on its revenues, and donors will no longer be able to deduct their contributions. Many major donors and grants will cease funding of organizations that have lost their tax exempt status.

2. Penalties and Fines

Nonprofits that do not follow IRS rules regarding restricted donations may face penalties and fines. These can arise from inaccuracies on Form 990 or from using restricted funds inappropriately.

Impact: Fines can strain the organization’s finances, reduce trust with donors, and damage the nonprofit’s reputation.

3. Damage to Donor Relationships

Mismanagement of restricted donations can lead to strained relationships with donors. Donors expect their contributions to be used in the manner they specify, and failure to do so can lead to a loss of trust and future donations. Nonprofits also run the risk of being sued by donors for misusing restricted donations.

Impact: Misusing restricted donations increases the risk of litigation, which is often time-consuming and expensive. It can also damage the nonprofit’s reputation and jeopardize future donations.

IRS Rules on Restricted Donations: When Donation Restrictions Cannot Be Followed

1. Communicate with the Donor

The first step when a nonprofit realizes it cannot fulfill the restrictions on a donation is to communicate with the donor. In many cases, donors are willing to modify the restrictions if they understand the challenges the organization faces. For example, if a donor creates a scholarship fund for a certain major, but the university stops offering said major, reach out to the donor. If you can make a compelling case for similar majors, the donor might allow the gift to be used for a related field of study.

Best Practice: Approach the donor with a clear explanation of why the restriction cannot be met and propose alternative uses for the funds that align with the donor’s original intent.

2. Seek Legal Counsel

If the donor is unavailable or unwilling to modify the restrictions, the nonprofit should seek legal counsel. An attorney experienced in UPMIFA can help navigate the legal process, including potentially petitioning a court to modify the restrictions under the cy-près doctrine. If you are interested in finding an attorney who can assist with the process, contact us for a consultation.

Best Practice: Engage an attorney experienced in nonprofit law to ensure that any modification complies with IRS rules and preserves the organization’s tax-exempt status.

3. Document All Actions Taken

When dealing with restricted donations that cannot be used as intended, it is critical to document all actions taken, including communications with the donor. This documentation can be crucial if the IRS audits the organization or if there is a dispute over the use of the funds.

Best Practice: Maintain a detailed record of all steps taken, including meeting minutes, correspondence with the donor, and legal filings.

Conclusion

It’s crucial for nonprofits to understand and know IRS rules on restricted donations. By adhering to best practices, seeking legal counsel when necessary, and maintaining transparency with donors, nonprofits can manage restricted donations effectively while safeguarding their tax-exempt status.