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In the philanthropic sector, restricted funds refer to a contribution of funds to a nonprofit organization where the donor places a restriction on the funds, such as stipulating that the nonprofit only use the funds for a specific project. Organizations sometimes prefer to receive unrestricted contributions to maximize flexibility in spending; however, restricted funds can be the critical component in a successful capital campaign or the implementation of a new program. Restricted donations also provide donors with a way to ensure that philanthropic funds are used to further their charitable and strategic objectives.

When a nonprofit accepts charitable donations, a duty arises on the part of the organization to use those donated assets for charitable purposes and abide by any restrictions set by the donor. Failing to abide by that duty can expose the organization to enforcement actions by state charity regulators, potential lawsuits from the donor, reputational damage, and the loss of a donor’s trust.

Accordingly, when accepting restricted donations, a nonprofit needs to understand the scope of any restrictions, the ramifications of its own communications with donors, and the strict legal requirements required to repurpose restricted funds.

Here are several points nonprofit organizations should keep in mind about restricted funding.

Nonprofits should consider whether donation restrictions align with their charitable purposes.

When a nonprofit considers accepting a restricted donation, both the donor and the nonprofit should consider whether the restriction aligns with the organization’s exempt charitable purposes and the strategic initiatives of the donor. Nonprofits’ expenditures, including expenditure of donated funds, must relate to their exempt purposes. Relatedly, the organization should evaluate whether it can abide by any restrictions, both from a programmatic and administrative perspective.

Many nonprofit organizations have a Gift Acceptance Policy to guide them through these types of questions. A nonprofit should refer to its policy, including any procedures for reviewing restricted donations, limitations on the types of acceptable restrictions, and procedures relating to gift management.

Nonprofits need to understand the nature of an endowment to avoid future disputes. 

Development staff need to understand what is meant by the term “endowment.” A true endowment is an institutional fund not wholly expendable on a current basis under the terms of the gift instrument. A nonprofit with a true endowment is restricted from spending the principal and also may be subject to donor-imposed restrictions on the use of the income earned from the principal.

An offer from a donor to “create an endowment” or “give to an endowment” should be discussed with the donor to ensure that the donor intends to create a restriction that the nonprofit can only use the income (and not the principal) of the donation. Staff should not carelessly use the term “endowment.” For example, if an employee were to send an email to a donor who thought she was making an unrestricted gift, thanking her for the “generous endowment,” that email could create confusion and tie up needed funding.

A nonprofit may not unilaterally remove donor-imposed restrictions or use principal in an endowment. 

The Uniform Prudent Management of Institutional Funds Act (“UPMIFA”) (adopted in every state except Pennsylvania) only permits a nonprofit to release or modify a restriction if the donor consents in writing. If the nonprofit cannot obtain the donor’s consent — for example, because the donor has since passed away — court approval will be required in most circumstances.

A court may only modify a purpose or use restriction if the restriction has become unlawful, impracticable, impossible to achieve, or wasteful. A court may only modify a management or investment restriction if it has become impracticable or wasteful, impairs the management or investment of the fund, or (if due to unforeseen circumstances) the release would further the purposes of the fund. In either case, the nonprofit must give notice to the state’s charitable enforcement agency, such as the attorney general in California, and hire an attorney to bring a petition in court.

The only time court approval is not required is for small and very old funds, but even then, advance notice to the state enforcement agency is required. For example, under California’s version of the UPMIFA, a nonprofit can release a restriction if the restricted fund is less than $100,000 in value, over 20 years old, and the nonprofit determines that a restriction is unlawful, impracticable, impossible to achieve, or wasteful. However, the nonprofit must first give 60 days’ advance notice to the attorney general and the donor at the donor’s last known address.

Meeting the UPMIFA standards to release restricted gifts can be complicated and costly. Accordingly, nonprofit organizations should seek the guidance of experienced legal counsel before changing any restrictions or using principal from an endowment.

Heather DeBlanc is a partner in the Los Angeles office of Liebert Cassidy Whitmore (LCW). Her practice focuses on representation of nonprofits and public entities in business, contracts, education, construction, and various business transactions. 

Casey Williams is an employment litigator and nonprofit business attorney, based in LCW’s San Francisco office. Her practice is focused on helping mission-driven organizations achieve their goals while staying compliant and working through complex disputes. 

Victoria M. Gómez Philips is an associate in the Los Angeles office of LCW. Victoria advises clients on business and transactional matters, including legal and business risks concerning strategic partnerships, contracts, employment, operations, and company policies.