Among the many items you must consider when opening up your own practice, your accounting and finances might be the most important and the most daunting. Most law schools don’t teach you the ins and outs of getting your accounting right, so it is up to you to do the research and implement the proper measures to ensure your business is compliant.
While basic accounting principles are universal, there are special methods and financial measures that you should consider specifically for your law firm, like a trust account. While not a common general business practice, a trust account is required by the bar association for lawyers to use when handling their clients money.
What is a Trust ACcount?
A traditional trust account is an arrangement where funds or assets are held in a bank account by someone else (a “trustee”) on behalf of one or more beneficiaries. More specifically for lawyers, “a trust account is a special bank account that a lawyer must maintain when the lawyer receives and holds money on behalf of the lawyer’s clients or third parties.” (Lawyer’s Mutual)
Accounting for Lawyers: Why You May Want to Leverage a Trust Account
As a lawyer, when you manage a client’s payment, you are acting as a fiduciary. This means you have a lot of responsibility and must be held accountable for that payment received. This is where a trust account comes in. Separate from your other bank accounts, a trust account is a measure taken to prevent you from using the payment incorrectly.
How Do Trust Accounts Work
Unless you’re a personal injury lawyer or working on a tort case, you’ll either charge a flat fee or a retainer fee. If you charge a flat fee, you can make a withdrawal immediately and may not have to put any payment into a trust account unless otherwise agreed upon with your client. This agreement could be that a withdrawal may be made if and when a milestone in the case is reached.
If you charge a retainer fee, clients will pay a fee up front for your services, but that payment is put into a trust account and will only be withdrawn as you log billable hours. For instance, say you charged your client a retainer fee of $8,000 for your services. You charged this amount knowing that your hourly fee is $200 an hour and with the expectation that you would do about 40 hours of work for her case. Once you complete an hour of work, you have the right to go to that trust account and take only $200 out. The $7,800 remaining will stay in the trust account, untouched and earning interest until you perform more hours of billable work.
Interest on Lawyer Trust Accounts (IOLTA)
Most likely, interest from trust accounts will go to your state IOLTA program, which funds legal services for the poor and helps improve the justice system. The IOLTA program adds no additional costs to lawyers or their clients; It just takes the interest from trust accounts and puts it toward philanthropic efforts in the judicial system.
According to the IOLTA website, if the funds are large enough or the account starts gaining enough net interest, the interest may be allocated to your client and not the IOLTA program.
Trust Account Rules
As you can imagine, there are a lot of rules around trust accounts due to its nature. Here are a couple of rules and common mistakes lawyers should consider when addressing their trust accounts.
Your Trust Account Is Not a Rainy Day Fund
As we alluded to before, you may not borrow money from your trust account. Just like every business owner, there may come a time (or multiple!) when you’re experiencing cash flow issues and you need more money to cover your expenses. Unfortunately, your trust account funds cannot be used to make payroll or pay rent.
Despite your well-meaning intention to replenish the borrowed money as soon as possible, borrowing from trust accounts can have grave consequences that should deter you from borrowing even once. Make sure you trust your bookkeeper or accounting solution, and that they understand how trust accounts work because your career could be on the line for this mistake.
You need to understand what belongs in a trust account and what doesn’t. Even if you charge a flat fee and most of that money goes directly to you, there may be underlying fees that are required to go into a trust account. While the rules depend on your state bar association, many states limit the amount of personal funds or prohibit any amount of personal funds to be allocated to your trust account.
This is Not a Savings Account
Your trust account is not to be used for savings or operations. If you want to save the money you earned, you must remove your earnings from the trust account and allocate it to a separate savings account. Otherwise, your earned money will sit there gaining interest for the IOLTA until you withdraw it.
When it comes to categorizing your client’s transactions within your trust accounts, it’s important to be diligent about it. The bar association requires that you keep records of your balances for every client in your trust account(s). Keeping a detailed record of each of your clients’ transactions and your deposits/withdrawals will save you a lot of headaches and confusion.
While keeping a physical record of each of your clients’ transactions works, a digital file of your records will prevent mistakes, ensure it’s all in a safe place, and will help you document what you need in half the time.
Number of Trust Account(s)
Generally, you may set up one trust account for all your clients, as long as they are recorded and categorized accurately. If you are managing an escrow account (i.e. funds for property taxes/home insurance) or administering an estate, you may want to consider opening up multiple trust accounts.
Managing Your Trust Account(s)
Trust accounts can get complicated. Don’t let the fear of violating ethics keep you from talking to a professional at the state level. With every state bar association having varying rules, it’s important to pay attention and understand what’s required. They can help you identify how to better manage your trust account(s) to stay compliant.
Losing your practice over failed trust account management is not the way to go. Using a strong accounting solution, like ScaleFactor, to help keep your records organized and your trust account(s) separate will ensure accuracy and compliance with federal and state rules.
Running or starting your own law firm? Check out our Lawyer’s Guide to Accounting.