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If you’re like most people, managing your clients’ funds is unfamiliar territory. Most of us don’t have an accounting background, and accounting isn’t a subject that’s included in law school curriculums.
You can’t just tuck your clients’ settlement funds in with the rest of your law firm’s general funds, and you certainly can’t stuff those crisp dollar bills in a pillowcase for safekeeping. To establish trust with your clients and ensure your law firm upholds its ethical responsibilities, you need to learn some accounting principles.
In this guide, we’ll give you a quick overview of the basics of attorney trust accounts and describe how you should manage settlement proceeds and other funds on behalf of a client.
(Note: your state will have its own rules governing how you handle client funds. We encourage you to read those too.)
Simply put, you need to know about your firm’s financial performance. But, you also need to be able to meet your legal, regulatory, and ethical obligations, such as preparing your federal and state income tax returns and managing your clients’ money. Accounting practices enable you to prepare financial statements, capture expenses, and create budgets and forecasts. The better you understand your law firm's finances, the easier it will be to make smart decisions for your business and to avoid legal and ethical headaches.
Let’s start by reviewing some common accounting terms that you should know.
There are two main reasons that lawyers should keep their clients’ funds separate from their personal or business operating accounts and from other fiduciary accounts. First, lawyers have a fiduciary responsibility to their clients. Second, it’s essential that the public have confidence in the trustworthiness of the legal profession.
That's where trust accounts come in. Trust accounts are designed to safeguard client and third-party funds from loss. These separate accounts protect clients’ funds from being used to satisfy the firm’s financial obligations and from being seized by the firm’s creditors.
Not all client funds need to go into a trust account. A general rule of thumb is that if funds are for tasks that aren’t yet completed, they should go into the trust account. But if the funds have already been earned, they should go into the firm’s operating account.
Here is a list of common client funds that you should place in a trust account:
It’s equally important to know what funds shouldn’t go into a trust account. By depositing the wrong funds into a trust account, you change the nature of the account, opening it to the risk that it could be raided by firm creditors.
Here is a list of funds to avoid depositing in a client trust account:
IOLTA, which stands for interest on lawyers’ trust accounts, is a type of trust account that raises money for charitable purposes, primarily for providing legal services to indigent people. IOLTA programs came to be in 1981 after Congress passed laws allowing checking accounts to earn interest and after the Supreme Court and state court rules created IOLTA programs.
All 50 states, plus the District of Columbia, Puerto Rico, and the U.S. Virgin Islands, operate IOLTA programs. The majority of states require lawyers to participate, though two programs are voluntary and four others allow lawyers to opt-out.
When lawyers receive a large sum of money that belongs to a client, such as a settlement payment or advanced fees, they should deposit the money into a trust account, where the funds can earn interest for the client. However, if the amount of money is small or if the lawyer only holds the money for a short time, the costs of collecting interest might outweigh the amount of interest the funds can earn.
However, an IOLTA account allows lawyers to deposit smaller funds from one client into a pooled, or combined, trust account with other short-term client funds. IOLTA trust accounts are typically checking accounts to facilitate fund access.
Because it is unethical for lawyers to benefit financially from funds that belong to their clients, lawyers can't earn interest on these accounts. With IOLTA, the interest that the funds accumulate is passed on to each state’s IOLTA program to fund charitable causes.
The goal of an IOLTA is to offer access to justice for individuals living in poverty without taxing the public or charging lawyers and their clients. The interest generated in IOLTA accounts supports civil legal aid and improvements in the justice system.
More specifically, IOLTA programs use the interest generated to fund free, non-criminal legal assistance for low- and middle-income people. The assistance includes helping provide access to health care, housing, government benefits, employment, and educational services. These services are provided by lawyer volunteers on a pro bono basis and by legal aid attorneys.
IOLTA funding also supports self-help and other educational resources, such as legal information websites and legal assistance hotlines. Other programs supported include alternative dispute resolution programs, public service projects, victim services programs, court-appointed special advocate programs, pro se assistance resources, minority lawyer recruitment initiatives, and law school scholarship programs.
IOLTA programs work with financial institutions to maximize their revenue, requiring banks to pay interest rates comparable to non-IOLTA accounts and negotiating to increase interest rates and lower service charges.
To find the IOLTA program in your jurisdiction, visit the National Association of IOLTA Programs directory.
Trust accounts are governed by state rules of professional conduct. Most of these rules are based on the American Bar Association’s Model Rules of Professional Conduct. Model Rule 1.15, titled “Safekeeping Property,” sets forth lawyers’ obligations with respect to client and third-party property:
(a) A lawyer shall hold property of clients or third persons that is in a lawyer's possession in connection with a representation separate from the lawyer's own property. Funds shall be kept in a separate account maintained in the state where the lawyer's office is situated, or elsewhere with the consent of the client or third person. Other property shall be identified as such and appropriately safeguarded. Complete records of such account funds and other property shall be kept by the lawyer and shall be preserved for a period of [five years] after termination of the representation.
(b) A lawyer may deposit the lawyer's own funds in a client trust account for the sole purpose of paying bank service charges on that account, but only in an amount necessary for that purpose.
(c) A lawyer shall deposit into a client trust account legal fees and expenses that have been paid in advance, to be withdrawn by the lawyer only as fees are earned or expenses incurred.
(d) Upon receiving funds or other property in which a client or third person has an interest, a lawyer shall promptly notify the client or third person. Except as stated in this rule or otherwise permitted by law or by agreement with the client, a lawyer shall promptly deliver to the client or third person any funds or other property that the client or third person is entitled to receive and, upon request by the client or third person, shall promptly render a full accounting regarding such property.
(e) When in the course of representation a lawyer is in possession of property in which two or more persons (one of whom may be the lawyer) claim interests, the property shall be kept separate by the lawyer until the dispute is resolved. The lawyer shall promptly distribute all portions of the property as to which the interests are not in dispute.
You should always review their state’s rules, which may include additional requirements for managing funds and setting up trust accounts.
If lawyers don’t adhere to the rules in their jurisdiction for trust accounts, they’re likely to be subject to disciplinary action. Depending on the severity of their transgression, they may face anything from a reprimand up to suspension and even disbarment.
So, let’s take a closer look at how law firms can meet their ethical responsibilities for trust accounts.
When you receive funds from a client or on behalf of a client, and this money is an advance payment for services, costs, or fees or is a settlement payment, you must take great care to handle this money in accordance with your ethical and fiduciary duties. What follows is a brief summary of some of these duties:
To satisfy this duty, a lawyer must deposit client funds into a trust account that is clearly identified and labeled with the client’s name or as an IOLTA account.
Be especially careful when setting up an IOLTA account. It’s very likely that you'll need to choose a financial institution that your state bar has approved before you can set up an IOLTA account. The bar may have specific registration requirements that you must follow. You may need to register the account with your state’s nonprofit that administers civil legal services. You’ll also need to obtain the nonprofit’s taxpayer identification number.
Here are some suggestions that may help you avoid depositing funds into the wrong account.
You must avoid commingling your firm’s operating funds with client funds. Depending on the number of funds that you are holding for your clients, you will need to proceed in one of two ways with the allocation of funds:
When you include client funds in an IOLTA account, you have an ethical responsibility to manage each client’s funds separately. To do so, you will need to set up a ledger for each client. You can set up a ledger in a legal practice management platform, or you can use Excel or accounting software like QuickBooks.
For each client, you must maintain a separate ledger of all funds received and deposited and all funds paid or distributed out of the account. You must also show the balance of funds in the trust account.
Note that there is one exception to the rule against commingling client and firm funds: you are permitted to keep a reserve of firm funds in your trust account to cover bank and credit card fees, so long as you maintain proper records.
Every time you receive or disburse funds from a client’s trust account, you must notify your client. That means you must contact your client whenever you deposit money or withdraw money to cover incurred expenses or pay for fees that you’ve earned. You must give the client a statement of the services you rendered or the expenses you paid on their behalf. This statement must also show the amount you are withdrawing from the account to cover these costs.
In some states, you may be required to notify your clients of the amount they owe before you take the money out of the trust account. This advance notice is required to allow the client to dispute the fee or expense. If you don’t comply with this rule, you might face a claim that you engaged in the misappropriation of client funds.
Here are some tips that will help you avoid fee disputes:
Clients have the right to ask for details about their funds. When this occurs, you must provide a report that shows how you have used their money in a timely manner. This is why it’s so important to maintain accurate records of client funds at all times, so you have an accurate audit trail showing all client-related fund activity.
This report, called a client trust ledger, shows all deposits and withdrawals from each client’s trust account in chronological order. Note that no account should ever have a negative balance, which would indicate that you’re disbursing money that you have not received.
Additionally, every month, you should reconcile your transaction records against your client trust accounts. Most jurisdictions require lawyers to reconcile their accounts on a set schedule, whether monthly, bimonthly, or at the time of audit.
Law firms have a unique way of reconciling their accounts: three-way reconciliation. This process checks your law firm’s books against the trust account balance and all individual client ledger balances. The sum of all of the individual client ledgers must match the balance in your books and the account balance.
To perform a three-way reconciliation, take these steps:
Three-way reconciliation offers yet another safeguard to protect client funds. It ensures that all money entrusted to your firm is correctly kept and isn’t being paid to cover another client’s charges, firm expenses, or bank fees. It’s important to conduct this activity frequently because if the bank has made an error, then you only have a short period to request a correction. It also ensures that if you have made an error, you correct it quickly to minimize the risk of harm to your client.
Here are some tips to reduce the risks in the account reconciliation process:
Handling trust accounts is challenging, especially when you have so many other responsibilities. But, lawyers are ultimately held accountable for all of their client funds in trust accounts. That’s why it’s so important to regularly review your accounts for compliance and take steps to avoid the most common trust account mistakes:
Lawyers should not mix their operating funds and client funds in any account. But while this principle sounds simple, it’s hard to implement.
Say, for example, that your client sends a check to cover both legal fees and costs. You’re being paid a flat fee for services, and the costs will cover the court fees when you file the client’s personal injury lawsuit. It may be tempting to deposit all of the fees in your operating account, because the bulk of the check is covering your fees, and write a check from one account to the other. However, that would be impermissibly commingling fees.
Because the check covers costs that have not yet been incurred, you should deposit the check into the trust account to hold those fees for your client. Then you should write a check payable to your operating account for the fees. It’s important to take all earned fees out of the trust account to pay for client invoices to avoid commingling.
It always takes some time for checks to clear. That’s why it’s important to get notice that a deposit has cleared before you write a check against funds in your trust account; otherwise, you’ll have a negative balance, which will show up when you reconcile your accounts and be a red flag that you aren’t following appropriate accounting procedures.
Don’t be pressured into sending clients settlement proceeds immediately. Wait for a notice from the bank that the deposit has cleared. To avoid upset clients, explain your bank’s policy on holding funds and your procedures for disbursements in advance.
If your firm isn’t tracking funds properly, or if you are short on cash one month, it can be tempting to dip into a trust account to pay for business-related expenses. After all, you’ll earn the money soon enough, so it doesn’t matter whether you wait until you’re actually ready to invoice the client, right? Or you might plan to put the money back into the trust account as soon as more money comes in.
Either way, this is wrong. It’s unethical to transfer unearned money from the trust account to your operating account to cover expenses for your firm or another client. You’d also be violating a number of other ethical duties, including failing to account for your client’s funds, commingling business and client funds, and failing to maintain accurate records.
If you don’t limit who has access to your trust accounts, you’re putting client funds at risk and breaching your ethical responsibility to safeguard them. And if you aren’t following good accounting practices and regularly reconciling your accounts, you may not notice if a check goes missing or if someone writes a check to themselves until it’s too late.
Law practice management software and online banking systems can alert you in case of problems like these. You can also ask the bank to send you an email whenever a check clears. Additionally, consider implementing physical safeguards, such as keeping trust account checkbooks locked in a cabinet.
Memories fade, so recordkeeping is important. It’s especially important when you have a fiduciary duty to track your clients’ funds and to be able to give clients account statements on demand.
To make sure you don’t lose track of checks, make sure you write the client’s name and matter number on each check that you issue. This will also help you reconstruct records in the event your records are lost, hacked, or destroyed. If you have to rebuild your client ledgers using bank statements and old checks, you’ll be able to more quickly get back up to speed.
When you receive funds for a client trust account, don’t record it as income in your accounting software. These funds are your client’s property, not your own. If you record them as firm income, not only are you breaching your fiduciary duty to your client, but you are also creating a potential mess with taxing authorities and regulators, including the IRS.
ABA Model Rule of Professional Conduct 1.15 recommends that lawyers should maintain trust account records for at least five years after the termination of the representation. Some states require longer periods and start the retention period with the last disbursement of funds.
Best practices suggest that you should keep online records as well as hard copies of every important document. Print and securely store all client ledgers, monthly reconciliation reports, and trial balances for receipts and disbursements. And, make sure to back up your electronic records frequently.
The best approach to managing retainers is one that complies with your jurisdiction’s requirements, meets your clients’ expectations, and is the easiest for you to manage.
In many cases, that will mean that you should keep client retainers in your trust account. A few jurisdictions will allow you to keep a retainer in your operating account. Check your state’s rules if you’re not sure of the requirements.
No matter which account you choose, the key is to keep good records of your client trust funds. You must make sure you know which client and matter to associate the retainer with. You must also keep each client’s retainer funds separate, and, if you’re keeping the retainer in your operating account, keep it separate from other firm funds. This is why client ledgers are so important: you must be able to segregate each transaction for each client and keep up to date with each client’s balance.
It’s also prudent to keep your clients apprised of the status of their retainer balance. That way, when the retainer fee is running low, you won’t ever have work in progress that exceeds your retainer balance. Legal practice management software can alert you when a client’s retainer dips below a certain level.
Settlement checks can pose another accounting quandary for lawyers—especially if settlement checks are jointly payable to the lawyer for fees and expenses with the balance going to the client.
Settlement checks are the client’s property and should be deposited in a client’s trust account or an IOLTA account—never in the firm’s operating account. Before depositing the check, make sure the client and the firm both sign the check if the check is made out to both parties. Record the client number, matter number, and matter description on the check. Copy or scan the check, saving the copy in the client’s file.
The lawyers should present information to the client that explains how they propose to disburse the funds. This statement should spell out what funds will be payable to the client, what portion will cover fees and expenses, and what if any, portion will be paid to a third party. You should be able to get a copy of the expenses paid from your practice management system.
Sending a report for the client to review also allows time for the settlement check to clear. Lawyers cannot advance funds from a trust account to pay the client while they wait for the bank to process the check.
After the check has cleared and the client has approved the disposition of funds, the lawyer should transfer the funds from the trust account to the client. Before doing so, prepare an invoice detailing your fees and expenses, then write a check from the trust account payable to your firm. The check should include the client’s name and matter number. Be sure to record the transaction in your client’s account ledger, then deposit the payment in your firm’s operating account. Write any other checks to your client and third parties as required by the settlement statement.
Finally, check for a zero balance. Run a client ledger report that shows all deposits and checks written. When you’re satisfied that you’ve reconciled all of the transactions, send the settlement statement, settlement check paid invoice, ledger report, and signed settlement agreement to the client, saving a copy of everything you send in the client’s file.
With so many moving parts in trust accounts, it’s easy to see how a lawyer might make a mistake. That’s especially true if you’re using manual bookkeeping methods or Excel spreadsheets to keep track of your accounts. It’s always prudent to run your accounting methods by a professional accountant who has experience with trust accounts and IOLTA accounts.
If you're worried that you've made a mistake, a smart first step is to check with a practice management advisor in your state. Many of these advisors work confidentially, so they can advise you without reporting any ethics violations to the bar. Visit your state bar website to learn whether you have access to a free advisor.
In most cases, the safest bet is to self-report a mistake and take good faith steps to correct it immediately. The failure to report can be as bad as, if not worse than, the initial accounting mistake.
As you can see from this guide, trust accounting can be challenging. But it doesn’t have to be another headache on top of the stresses of your law practice.
The first step is to put down the pencil and paper—or even the Excel spreadsheet. And if you want to really get serious about your accounting and recordkeeping, you need to ditch small business accounting platforms that weren’t designed specifically to meet lawyers’ needs.
You need a legal practice management platform that includes full billing and accounting capabilities, making sure that you’re able to track every last penny and satisfy your ethical obligations to your clients.
To find a tool that’s able to resolve your biggest trust accounting challenges and meet your firm’s needs, look for a platform equipped with the following capabilities:
Features like these can make the difference between an inefficient trust account management process that’s prone to errors and bookkeeping and accounting systems that run like clockwork, enabling you to meet your ethical obligations and client trust account reporting requirements.
