Restricted Fund: Definition, Types, Legal Requirements

Restricted Fund

Investopedia / Matthew Collins

What Is a Restricted Fund?

A restricted fund is a reserve account that contains money that can be used only for specific purposes. Restricted funds provide reassurance to donors that their contributions are used in a manner that they have chosen. They most often appear in the context of funds held by certain nonprofits, universities, or insurance companies.

Key Takeaways

  • A restricted fund is any cash balance that has been earmarked for specific or limited use.
  • Often associated with funds held by donations to nonprofit organizations or endowments, restricted funds ensure that donors alone can direct the usage of those assets.
  • Failure to comply with restrictions or unauthorized use of restricted funds can result in legal action.

Types of Nonprofit Restricted Funds

When a donor gives money to a nonprofit organization, they may specify how a gift is to be used in three basic ways:

  • Unrestricted Fund—The money in it can be used for any purpose that the organization sees fit.
  • Temporarily Restricted Fund—The money must be used for a specific, stated purpose.
  • Permanently Restricted Fund—The donation is designated to be held in perpetuity as principal, on which interest can be earned, with only the interest allowed to be spent.

If a donor restricts a nonprofit organization to allocate funds to a specific purpose, it is required to do so by law. Failure to comply may result in the donor taking legal action and reporting the nonprofit to the Office of the U.S. Attorney General.

Endowments are usually permanently restricted funds. In most cases, their principal cannot be spent, and only a specified percent of the interest that they earn can be spent per year. Furthermore, there are restrictions on how the interest can be spent. For example, an endowment given to a university may be restricted to funding scholarships and professorships.

A donor of restricted funds to a nonprofit usually designates what the money can be used for in a written document called the gift instrument.

How Are Restricted Funds Designated?

The donor determines if the funds are to be restricted. Typically, fund designation is specified in writing in what is termed the gift instrument. Foundations that provide restricted funds often describe how they want their money allocated when they distribute the award.

Nonprofit organizations can avoid confusion about how they intend to spend a donor’s funds by offering a choice of designation. A cancer research nonprofit, for example, could give donors a choice to allocate their funds to any one of breast, skin, or brain cancer clinical trials.

Restricted Fund Management for Nonprofit Organizations

Typically, restricted funds are not required to be placed into a segregated bank account, but they must be accounted for separately in a nonprofit’s financial statements. When budgeting, nonprofit organizations should separate restricted and unrestricted funds so that they correctly allocate the money they have to spend. They may implement an internal system that alerts management when restricted fund obligations have been met. Once the donor’s wishes are satisfied, any excess money can be transferred to unrestricted funds.

Nonprofit employees should be trained to identify expenditures that require allocation to restricted funds. When the staff correctly allocates money, it keeps donors satisfied and helps avoid legal disputes.

What is a restricted fund?

A restricted fund contains money that a donor has decreed can be used only for a specific purpose. If the money is temporarily restricted, any excess can become unrestricted once the purpose is fulfilled. If the money is permanently restricted, it must be kept intact in the form of an endowment, usually in perpetuity, and only the interest earned by investing the endowment may be spent in service of the purpose.

Do restricted funds require their own bank accounts?

No. It isn’t necessary to separate the money by putting it in its own account. Instead, the separation should be dealt with by accounting practices on the nonprofit’s financial statement.

What happens if restricted funds are spent for a non-designated purpose?

The funds are restricted by law, so if they are not used for the designated purpose, a donor can initiate legal action and demand their return. The donor may also report the nonprofit to the Office of the U.S. Attorney General.

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