Are donor-restricted funds protected from general creditors, including judgments? Are they available to be used as collateral for a loan? How can an organization best protect its funds? What actions are recommended?
These are all questions of state law, but in general, donor-restricted funds are protected from creditors. There are two basic types of restrictions: (1) restrictions on the length of time the funds must be held, such as a restriction to hold the funds forever and use only the income for your charitable purposes, and (2) restrictions on the use of the funds, such as a restriction to use the funds only to fix the roof. Some gifts have a double restriction, such as hold the funds forever and use the income only to maintain the roof. Your accounting systems need to keep track of what amounts are available for what purposes.
Normally, you can’t use use-restricted funds as collateral for a loan. You can’t use permanently restricted funds as collateral for a loan either, but you may be able to pledge the income from the permanently restricted funds to support repayment of a loan taken to pursue your charitable purposes. You should check with an attorney in your state who is familiar with such laws.
These rules normally apply only to funds restricted by third-party donors to the charity. They don’t apply to funds that have been restricted by the charity’s board itself. Even if the board has restricted a portion of its surplus, or any gifts of more than a certain figure, such as $25,000, the legal theory is that the board can unrestrict the funds at any time and use them for its general purposes. They would generally be available to creditors of the organization.
Many nonprofits have created separate “foundations” to hold their reserve assets (particularly board restricted funds) so that they are not directly available to creditors of the organization. Larger organizations or “systems” that have multiple entities under common control have frequently set up separate entities to hold the reserve money, utilize it where most necessary within the scope of their operations, and hold it outside the areas of greatest risk. (See Ready Reference Page: “Charities Often Restructure to Protect Corporate Assets”).
Even single entity organizations have occasionally set up a separate asset holding company to protect the surplus assets from risk, although the protection may not be as great as it is within a larger system. But if the organization faces a claim for which it is uninsured or under-insured, having the funds in a separate entity which is not directly liable for the claim can significantly add leverage to reduce the amount that will be needed to settle the claim.