How Much Can a Nonprofit Carry Over?

Nonprofit organizations often end their fiscal year with a surplus, leading to questions about how much of this “carryover” is permissible. The answer is not a single number but depends on the organization’s classification, financial health, and strategic goals. The principles governing how much can be retained are shaped by tax laws, donor expectations, and internal policy.

Understanding Nonprofit Net Assets

A nonprofit’s ability to carry over funds is tied to how its resources are classified on its financial statements. According to accounting standards under FASB ASC 958, a nonprofit’s net assets are divided into two primary categories based on donor stipulations. This classification determines which funds are available for discretionary use and which are legally earmarked for specific purposes.

The portion of a balance sheet representing discretionary or “carryover” funds is called net assets without donor restrictions. This category includes revenue from services, product sales, and contributions with no strings attached, as well as board-designated funds. The organization’s governing body decides how to use these unrestricted funds, which can be accumulated as an operating reserve.

Conversely, net assets with donor restrictions consist of funds legally bound to a particular purpose or time frame specified by the contributor. These might include a gift for a new building, an endowment to be held in perpetuity, or a grant for a specific program. These assets cannot be considered part of a general carryover because their use is predetermined.

Accumulation Guidelines for Public Charities

A common misconception is that the IRS imposes a cap on how much money a public charity can accumulate. In reality, no federal law or IRS rule dictates a maximum reserve amount for a 501(c)(3) public charity. The government encourages nonprofits to maintain a healthy reserve for financial stability and long-term sustainability.

The most significant regulatory consideration is the Public Support Test, which determines if an organization qualifies as a public charity rather than a private foundation. A public charity must receive a substantial portion of its funding from the public or government. If an organization consistently accumulates large surpluses from investment income or a few private sources, it could risk failing this test and being reclassified as a private foundation, which has more restrictive rules.

A widely accepted best practice is for a nonprofit to maintain an operating reserve equivalent to three to six months of its annual operating expenses. This range is seen as a reasonable buffer to cover unexpected shortfalls, manage cash flow, or bridge funding gaps. Holding reserves significantly above this level without a clear, documented reason can raise questions from donors and funders.

An organization’s accumulated surplus is reported on its annual information return, the Form 990. Schedule O provides a space for nonprofits to explain their financial practices. If an organization holds large reserves relative to its budget, it should use this section to describe the board’s rationale and reference a formal reserve policy to preempt concerns from the IRS and the public.

Distribution Rules for Private Foundations

Unlike public charities, private foundations face a specific rule regarding how much they must pay out each year. These organizations are subject to an annual minimum distribution requirement to ensure their assets are actively used for charitable purposes.

Under Section 4942 of the Internal Revenue Code, a private non-operating foundation must calculate its “distributable amount” each year. This amount is approximately 5% of the average fair market value of its non-charitable-use assets, like its investment portfolio. The foundation must then make “qualifying distributions” equal to this amount, which includes grants and certain administrative expenses.

Failure to meet this 5% payout requirement results in significant financial penalties. The IRS imposes an excise tax on any portion of the distributable amount not paid out by the end of the following tax year. This initial tax is 30% of the shortfall, and if the deficiency is not corrected, the penalty can increase to 100% of the undistributed amount.

Developing a Formal Reserve Policy

The most effective way for a nonprofit to justify its accumulated funds is to adopt a formal, board-approved operating reserve policy. This internal governance document provides a clear rationale for the organization’s savings, demonstrating strategic financial management to donors, grantmakers, and regulatory bodies.

A reserve policy should articulate the purpose of the funds. Common purposes include:

• Ensuring operational stability during economic downturns
• Covering unforeseen expenses
• Managing seasonal cash flow variations
• Accumulating capital for a future strategic initiative

The policy must also define the target size of the reserve. While a common guideline is a range, such as three to six months of the average operating budget, the target should be tailored to the organization’s specific circumstances. Factors to consider include the reliability of revenue streams, the presence of long-term contracts, and the potential for unexpected events. The policy should also specify the authority required to draw upon the reserve and outline a plan for how and when depleted funds will be replenished.