Accounting for law firms has several unique features. The primary reason for this is the use of retainers. Similar to a deposit, this is the fee paid to your firm before work commences. Retainers can vary, depending on the case in question, the lawyer’s fees, and other factors. Once a case has been completed, the remainder of the retainer, if any, is returned to the client.
However, this payment structure can greatly impact the accounting practices of your law firm, especially when it comes to trust accounts.
Understanding Retainer-Based Cases and IOLTA Accounts
A common trust account in legal firms – and perhaps one of the trickiest to manage – is an IOLTA (Interest on Lawyers Trust Account).
What is an IOLTA?
IOLTAs are closely linked to client retainers. Essentially, these advanced payments are kept in an IOLTA until your firm completes the necessary services. Thereafter, the funds are transferred to your business’ operating account, where they officially become earned income.
What makes these accounts special is that the interest they earn is not kept by your firm as profit. Instead, it is collected by your state bar association for charitable purposes and activities, including:
- Civil legal services.
- Funding law school scholarships.
- Providing legal assistance and legal aid to those who can’t afford it.
- Funding grants for non-profit organizations and public service programs.
How does an IOLTA differ from a traditional bank account?
Because the interest from these accounts is used by your state’s bar association, IOLTAs are tax-exempt. According to the IRS, interest derived from these accounts is not taxable to the client, firm, or an individual attorney, as it is not accounted for as gross income.
However, IOLTAs have strict record-keeping requirements, along with several ethical and legal obligations that affect accounting for law firms. Moreover, some of the regulations around managing these accounts vary between states.
All funds in an IOLTA must be carefully tracked, and any movements in the account need to be clearly and promptly communicated. It is also essential that they are kept entirely separate from your existing transactional accounts.
Setting Up and Managing IOLTA Accounts
IOLTAs must be interest-bearing trust accounts opened at an eligible state or federally insured-financial institution. They should be named after the attorney or firm handling the account, rather than the client. It’s worth noting that not all banks offer these accounts; however, your state’s foundation will be able to advise you where to open an IOLTA if you are in doubt. Do some research about where to open these accounts, as some banks offer more competitive interest rates, or waive admin and maintenance fees associated with IOLTAs.
Regardless of where you open the account, most jurisdictions have three primary considerations for managing client funds:
- Account identification: IOLTAs must be specifically labeled as a trust/client account.
- Account segregation: Your firm must avoid commingling of accounts; in other words, you need to keep client funds separate from your own funds.
- Accounting records: Appropriate records must be created and maintained of all funds belonging to clients.
Best practices for managing IOLTA accounts
The American Bar Association has several rules and regulations in place for IOLTAs, so you need to pay careful attention to these accounts. Beyond ensuring that all deposits are made in a timely manner and that all funds are accounted for, trust disbursements must also be accurate and timely.
Other factors to consider include:
- Keeping IOLTAs separate from your firm’s accounts. The funds in these accounts do not belong to your firm, so an IOLTA cannot be used as a regular transactional account. This means you cannot make payments from this account, even if the income in it has already been earned. When recognized as earned income, the funds need to be transferred to your operational accounts. In addition, separate ledgers must be kept for each client, to accurately track funds.
- Perform regular reconciliation. This ensures that all transactions are accounted for and there are no discrepancies. Depending on which state you operate in, there may be requirements to perform reconciliations on a set schedule – monthly, quarterly or annually. Usually, this takes the form of a three-way reconciliation, which checks your firm’s books against the IOLTA balance, as well as the client’s ledger balances.
- Accurate record-keeping is essential. Each transaction in a trust account must be accounted for. Your client is entitled to a client trust ledger, or a report explaining how you have used their money. In addition, state bar foundations can ask for detailed account breakdowns at any time, and failure to account for any transaction can have serious consequences.
Accounting Procedures for Retainer-Based Cases
Generally accepted accounting principles (GAAP) are general guidelines for accounting, and also apply to IOLTA. One such requirement is that IOLTA accounts must conform to the principles of double-entry accounting. In a nutshell, this means entering corresponding debits and credits into two ledgers – one for your firm, and one for the client.
This can become especially challenging in law firm accounting, due to retainer fees.
For example, say a new client wants to enlist your services, and pays a $5,000 retainer. This money is immediately deposited into an IOLTA, as it is considered unearned income until your client needs your services.
When you complete work (perhaps five hours at $100 per hour), you present the client with an invoice for $500.
However, you still cannot move this amount from the IOLTA into your operating accounts. First, the client must review and approve your invoice. Only once this is done, the $500 is considered earned income, and you can withdraw it from the trust account. The remaining $4500 stays in the IOLTA, until such time that it is used or needs to be returned to the client.
Handling Case Closure and Fund Disbursement
When your client’s case ends and all claims are settled, any money remaining in the IOLTA should be returned to your client. However, as per regulatory requirements surrounding law firm accounting, funds can only be disbursed from an IOLTA to your firm when they become earned income (after services are completed).
The funds can also be disbursed to any other entities entitled to them, such as lienholders, expert witnesses, or to cover court costs and settlements. As with all transactions, these need to go through your firm’s transactional account first.
When it comes to IOLTA disbursements, you must notify the client of any payments that need to be made, via a statement of services and expenses which indicates what the fees are being used for. Some states also require advanced notice to be given to the client before you can take money out of the account for these payments.
Common Challenges and Solutions in IOLTA Accounting
Mishandling your client’s IOLTA accounts can lead to challenges in accounting for law firms, and can also have legal repercussions. Financial mismanagement can lead to accusations of misappropriation of funds, disciplinary action, and even having your license revoked.
Despite this, it is possible to make mistakes handling an IOLTA, including:
- Commingling funds.
- Depositing fees into your account rather than the trust account. For example, if a client pays a retainer and service fees together, the payment must be separated so that the retainer – no matter how small – goes into an IOLTA, while the service fees can be paid into your account.
- Borrowing client funds from an account. Even if you have cash flow problems and are guaranteed to receive the money from an IOLTA on completion of services, you cannot use retainer money for purposes not linked to the client’s case.
- Paying service or transaction fees from an IOLTA. Your clients are only responsible for fees relating directly to their trust account. Such charges must be taken out of your firm’s operating account.
- Delayed reporting or transactions. All transactions in trust accounts must be recorded immediately, and any received funds should be deposited immediately.
- Not keeping records. The American Bar Association stipulates that law firms maintain trust account records for at least five years after the case has been closed.
The best way to avoid making these mistakes is to educate or train your staff on the moral and legal considerations of an IOLTA, invest in specialized tools and software, and consult with a CPA who specializes in law firm accounting.
The importance of specialized accounting software
As outlined above, there are several factors to consider when it comes to accounting for law firms. However, with software tailored to your needs, managing retainers, IOLTA accounts, and other bookkeeping matters can be greatly simplified.
Systems like NetSuite and QuickBooks are ideal platforms for accurate legal financial management, as they offer the following:
Your chosen accounting software should allow you to do the following:
- Link trust transactions to clients, including the date and purpose.
- Build comprehensive ledgers that track all transactions until a case is closed.
- Prevent entries of trust transactions until these are reviewed and approved.
- Filter transaction data.
- Move funds from trust accounts to operating accounts, and vice versa.
- Maintain an accurate audit trail.
- Allow for three-way reconciliation and detailed reporting.
For assistance with accounting for law firms, schedule a Discovery Call with one of our CPAs.
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.
