Many law firms possess trust accounts in order to separately track client funds. In fact, the creation and maintenance of trust accounts is often required by state bar associations. Due to this commonness among firms and requirement by regulation, it is critical to understand how trust account bookkeeping works. Trust account bookkeeping is significantly different from bookkeeping for a firm’s operating account, and failure to understand the differences in bookkeeping treatments can lead to severe accounting and tax issues.
The most important aspect of a trust account is that funds held in the account do not belong to the attorney – they belong to the client. The implications of this fact, and the ensuing bookkeeping treatment, are perhaps best understood through an example.
1) Assume that a personal injury law firm wins a $50,000 settlement for a client. These funds are then paid to the firm on behalf of the client. Since the amount belongs to the client, it is deposited into the trust account.
Then, since the firm is holding the funds on behalf of the client, this receipt of $50,000 is not considered revenue – instead, it is a liability to the firm. As a result, it increases the firm’s “Trust Liability”, “Settlement Payable”, or similarly named account by $50,000.
2) Then, assume that the firm took the case on a contingent-fee basis of 30% of the settlement. Now that the settlement has been paid, the firm’s fees have been earned, and they are $15,000. As a result, a $15,000 portion of the settlement is no longer a liability – it is now revenue. As a result, $15,000 of revenue is recognized, and the Trust Liability account is decreased by $15,000.
Moreover, this $15,000 can now be transferred from the firm’s trust account to its operating account - as the firm has now earned the $15,000, this portion of funds no longer belong to the client, but rather to the firm.
3) Next, assume that the client has $22,000 in medical bills that need to be paid from the settlement. The firm directly pays the appropriate doctor(s) and hospital(s) out of the trust account. However, these payments are not expenses to the firm, since they’re being paid from the client’s funds held by the firm. Instead, when the $22,000 is paid from the trust account, the Trust Liability account is decreased by the same amount. Since $22,000 of the client’s funds have been used to pay the client’s bills, this $22,000 is no longer being held by the firm on behalf of the client, and thus is no longer a liability.
4) Finally, now that the firm’s fees and the client’s medical fees have been paid from the settlement, the remaining $13,000 held on behalf of the client can simply be directly paid to the client. Again, this client payment is not an expense to the law firm – it is simply a movement of the client’s own funds from the firm’s trust account to the client himself or herself. As a result, when the $13,000 is paid out of the trust account, the Trust Liability account is decreased by the same amount.
This example is fairly simple, and may not fully describe every type of trust account transaction that may occur in a given law firm. If you have any specific trust account accounting questions, you should contact an Atlanta accountant.
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