In general, gifts, grants and contributions must be used for the purposes for which they are given.  In Pennsylvania, a hospital CEO was convicted and sentenced to nearly two years in jail for taking funds which had been given for scholarships and research and using them for the general purposes of a group of hospitals before they filed for bankruptcy.   In other cases, directors and trustees have been surcharged and ordered to replace misused funds.

Your board member is absolutely right that you must replace the funds and use them for the intended purposes.  If you can’t replace them and spend them by the end of the year, you should talk with the donor to see if you can work out an appropriate arrangement to replace them and spend them later.  Many grantmakers are willing to extend deadlines for using their funds.  Even if you can replace them and spend them by the end of the year, you should probably talk with the donor and explain the situation, what you have done about it, and how you will prevent it from happening again so that you will be able to ask in good conscience for future gifts from the same donor.

If you file a Form 990 tax information return, you may be required to report “a significant diversion of the organization’s assets” in response to Part VI A question 5 and explain the nature of the diversion and what you have done to correct the situation.  You wouldn’t want your donor to learn about the situation when checking your 990 while considering a request for an additional grant.