Trust accounting, billing, reconciliations, fees, and compliance
1. The Core Principle Everything Else Flows From
Client money is not firm money.
If a law firm violates this principle, even by accident, it becomes a compliance issue, not just an accounting mistake.
2. Mandatory Bank Account Structure
Every law firm must maintain at least two separate bank accounts.
Operating Account
Used for:
- Earned legal fees
- Reimbursements already billed
- Firm expenses – salary, rent, software, tax payments
Trust Account (IOLTA)
Used for:
- Client retainers
- Advance fees
- Settlement funds held temporarily
Key rule: No firm expense is ever paid from trust. Even a temporary transfer without billing is a violation.
3. Trust Accounting: How It Actually Works
Step 1: Client Pays Retainer
- Money goes into the trust bank account
- Booked as a trust liability, not income
- A client-specific ledger is created or updated
Wrong treatment: Crediting income or accounts receivable.
Step 2: Work Is Performed
- Time is recorded, or a milestone is completed
- No accounting entry is made yet
- Trust balance remains untouched
Time is not revenue.
Step 3: Invoice Is Raised
The invoice must clearly show:
- Services rendered
- Amount to be applied from trust
- Remaining trust balance (recommended)
Step 4: Trust Transfer
Only after invoice approval:
- Transfer the exact invoiced amount from trust to operating
- Reduce the client's trust liability
- Recognize revenue
No rounding. No estimates. No backdating.
4. Types of Retainers and Correct Treatment
| Retainer Type | Where Held | When It Becomes Income |
|---|---|---|
| Advance Fee Retainer | Trust | When billed |
| Evergreen Retainer | Trust | As billed |
| Flat Fee (most states) | Trust | On completion or milestones |
| Non-Refundable Retainer | Operating (state-specific) | Immediately, with disclosure |
Important: Calling a retainer "non-refundable" does not automatically make it income. State bar rules override contract wording.
5. Client Trust Ledgers Are Non-Negotiable
Each client must have a ledger showing:
- Opening trust balance
- Receipts
- Transfers to operating
- Closing balance
At any moment, the firm must be able to answer: "How much of this trust balance belongs to Client X?" If it can't, the firm is already non-compliant.
6. Three-Way Trust Reconciliation (Monthly)
This reconciliation is unique to law firms. All three figures must match exactly:
- Trust bank statement balance
- Trust liability balance in the accounting system
- Sum of all individual client trust ledgers
If even $1 is off: The trust is considered out of balance, and investigation is required immediately.
Common causes of mismatch:
- Bank fees posted incorrectly
- Interest not recorded
- Transfer made without an invoice
- Client ledger not updated
7. Bank Fees: Correct Treatment
Trust Account Bank Fees
There are only two acceptable treatments:
- Paid from the operating account, or
- Allocated to a firm-owned buffer balance (if allowed)
They can never reduce client trust balances.
Never: Deduct fees proportionately from clients.
Operating Account Bank Fees
Treated as a normal expense, with no special restriction.
8. Interest on Trust (IOLTA)
- Interest does not belong to the firm or the client
- It is automatically remitted to the state legal aid authority
- Recorded as a pass-through, not as income
The firm should never touch or reclassify this interest.
9. Settlement Accounting: A High-Risk Area
Typical flow:
- Settlement received into trust
- Ledger created showing the client portion, attorney fees, and third-party payments such as medical liens
- Disbursements made only after written approval
- Final zero balance for that client
Mistake that gets firms audited: Paying attorney fees before lien resolution.
10. Expense Reimbursements
A. Advanced by the Firm
- Booked as a reimbursable cost
- Billed to the client
- Recovered via trust transfer
B. Paid from Trust
Allowed only if:
- Client approval exists
- Proper documentation is maintained
- The ledger clearly reflects the purpose
Never mix the two.
11. Payroll and Partner Draws
- Never paid from trust
- Paid only from the operating account
- Partner draws tracked separately from expenses
Trust is not a cash buffer for slow months.
12. Software Setup: Why Most Firms Still Fail
QuickBooks alone is possible, but risky without strict controls. Best practice pairs legal practice software to handle trust with accounting software to handle the general ledger, connected by clear integration rules.
Key configuration requirements:
- Trust liability account
- Client sub-ledgers
- Locked transfer workflows
- No manual journal entries to trust
A clean P&L does not mean a compliant trust.
13. Year-End and Audit Readiness
At year end, the firm must have:
- Monthly trust reconciliations on file
- Client-wise trust balances
- A clear audit trail for every transfer
- Zero negative client trust balances
Note: A negative trust balance is a violation even if it's only temporary.
14. Responsibility and Liability
- Partners are personally responsible
- Bookkeeper error is not a defense
- "We didn't know" does not protect a license
This is why law firm accounting cannot be treated as routine bookkeeping.
15. Common Red Flags to Fix Immediately
- Trust bank balance does not match the books
- One client subsidizing another
- Transfers made without invoices
- Old, unreconciled trust balances
- Bank fees deducted from trust
- Flat fees treated as income by default