What is trust accounting in law firm bookkeeping?

Imagine losing track of $50,000 in client funds because it was mistakenly deposited into the wrong account! It might sound like fiction—because who could possibly make such an error? But this actually happened. One attorney’s mistake led to costly consequences and serious legal headaches.

Source: Attorney at Law Magazine^[1]

This seemingly simple error, known as commingling funds, is one of the common pitfalls in law firm bookkeeping and accounting that can result in hefty fines, a tarnished reputation, or even disciplinary action for lawyers.

Managing trust accounts may seem like an administrative task, but it’s one that can make or break your law firm’s compliance.

Every dollar in those accounts belongs to your clients—not your firm.

Failing to track these funds accurately can escalate into a major legal issue, and many law firms admit that managing trust accounts is one of the most challenging aspects of running their practice.

But here’s the thing: while trust accounting is undeniably complex, with the right approach, you can stay compliant and safeguard your firm from costly mistakes.

So, what exactly is trust accounting? More importantly, how can you streamline it to ensure your law firm remains compliant?

Read on to find out.

What is a client trust account?

A client trust account is more than just a bank account; it’s a legal safeguard for funds that belong to clients—not your law firm. Whether it’s an unearned retainer, settlement funds, or court fees, any money held in trust remains the client’s property until it is earned through billable work or used for specific client-related expenses.

Here’s a breakdown of the types of funds you might manage in a client trust account:

• Unearned retainer or flat fees: Fees provided upfront by clients that are held until the services are completed.
• Disputed fees: Any fees that are contested by the client but must remain secure until resolved.
• Settlement funds: Any money awarded to the client from a case that must be held in trust before disbursement.
• Court fees: Fees that need to be paid on behalf of the client but are held in the trust account until required.
• Advanced costs: Any funds provided by the client to cover expenses like expert witnesses or filing fees.

It’s crucial to remember that money in a client trust account can only be accessed when it’s earned or for specific client-related costs. Under no circumstances can these funds commingle with your firm’s operating account. Strict compliance is not just a matter of good practice—it’s a legal and ethical requirement that helps protect your firm from disciplinary action.

Common account types in bookkeeping for law firms

When managing your law firm’s finances, it’s essential to understand the different types of accounts you’ll use and how they function—especially when handling client funds.

• Operating accounts: These accounts are used to cover your law firm’s day-to-day expenses, such as salaries, rent, and utility bills. Unlike trust accounts, operating accounts are for your firm’s internal operations, meaning no client funds should ever be deposited here.
• Escrow accounts: These accounts hold funds during a transaction and are typically managed by a neutral third party. For example, real estate transactions often involve escrow accounts. While escrow accounts share similarities with trust accounts, they are not exclusively for client trust funds. Be sure to clarify with your financial institution that you’re opening the correct type of account.

Keeping your client trust funds separate from both operating and escrow accounts is critical to avoid accidental commingling or misuse of client funds.

When setting up a client trust account, you have two primary options:

• Pooled trust account: This is the most common method for managing client trust funds. All client funds are pooled into a single account, but your law firm is responsible for maintaining detailed records of how much money belongs to each client, along with any deposits or withdrawals. You’ll need to manage this carefully using accounting ledgers to track individual client balances.
• Separate trust account: In cases where large sums of money are held for extended periods—or at the client’s specific request—firms may opt to create separate trust accounts for individual clients. This provides more clarity and avoids confusion when managing significant or long-term trust funds.

What is an IOLTA account?

When setting up a trust account for your law firm, it’s often recommended—and in many states, required—to open an Interest on Lawyer Trust Account (IOLTA). IOLTA accounts earn interest on the funds held for clients, but here’s the key difference: instead of that interest going to the client or your firm, it’s automatically transferred to your state’s Bar Association. These funds are then used to support civil legal services and other public service programs.

There are a few important things to know about managing an IOLTA account:

• Banking fees: Banks that manage IOLTA accounts are typically prohibited from charging maintenance fees, bad check charges, or other costs directly to the client’s trust funds. If these fees are improperly deducted from the trust account, your firm could face sanctions.
• Choosing the right bank: It’s crucial to work with a bank that participates in the IOLTA program and understands the rules. An experienced banker will ensure that the account is managed properly and that all interest is forwarded to the appropriate legal fund.

IOLTA accounts are essential for law firms to comply with state requirements and manage client trust funds responsibly. Be sure to check the specific IOLTA rules in your state^[2] to confirm whether you’re required to use one and ensure your firm remains compliant.

What is trust accounting?

Trust accounting in law firms is the practice of managing, tracking, and properly utilizing client funds to cover fees and expenses related to their legal cases. It’s not just an administrative task—it’s a legal and ethical requirement governed by the rules of each state’s Bar Association. Mismanagement of these funds can result in serious consequences for law firms, from hefty fines to disciplinary action, and in extreme cases, the loss of an attorney’s license to practice.

Here’s a step-by-step look at how trust accounting typically works:

1. Client deposits funds: A client provides your firm with money, either as an advance for billable work, unearned retainer fees, or for specific costs related to their case (like filing fees or court costs).
2. Funds are placed in a trust account: Depending on the amount and duration of the funds being held, they are deposited into either a pooled or separate trust account. In most cases, smaller amounts are pooled together, while larger sums or longer-term holdings might require separate accounts.
3. Withdrawal after billable work or expenses: Once the firm completes the billable work or incurs the client-related expenses, you can withdraw the appropriate funds. However, it’s crucial to ensure that the withdrawals correspond directly to work completed or fees paid. Misusing these funds or withdrawing prematurely can lead to commingling issues, which is a major violation in trust accounting.
4. Accurate record-keeping: Maintaining detailed records of all transactions is essential. Law firms must keep separate ledgers for each client’s trust funds and regularly update them to reflect deposits, withdrawals, and remaining balances.
5. Three-way reconciliation: Law firms should perform three-way reconciliation—comparing the trust ledger, individual client ledgers, and bank statements—at least quarterly, although monthly reconciliation is ideal for ensuring accuracy and avoiding any discrepancies.
6. Final disbursement of funds: At the end of the case, once all work is completed and fees have been paid, any remaining funds should be returned to the client. In situations where there are disputes over fees, the disputed amount must remain in the trust account until the issue is resolved.

For example, let’s say your firm is representing a client in a real estate transaction. The client deposits $20,000 into your firm’s trust account to cover legal fees and costs. As the work progresses, you bill for $5,000 worth of services. You can now withdraw $5,000 from the trust account to your firm’s operating account, but only after the services are rendered. The remaining $15,000 must stay in the trust account until additional work is completed or the case is closed.

How to make trust accounting entries

The best way to stay on top of trust accounts is to have complete visibility into the financial records. Every transaction should be properly logged and reconciled, and each client’s funds must be tracked separately within the overall trust account. A common method for recording trust fund transactions is to break them into straightforward entries:

• Debit: Trust bank account (to reflect incoming client funds)
• Credit: Trust liability account (to record that these funds are owed to the client)

For example, when a client deposits $10,000 into your trust account, you would debit the trust bank account and credit the trust liability account. Then, when billable work is completed and $3,000 is earned, you would debit the trust liability account and credit your firm’s operating account.

The bottom line

Trust accounting isn’t something you can afford to get wrong. Mismanaging client funds, even unintentionally, can lead to severe consequences—from hefty fines to the loss of your license.

However, ensuring best practices for trust accounting can be overwhelming, and managing it on your own without an expert is a challenge.

This is where CoCountant can simplify things for you, ensuring your law firm stays on the right side of the law. We specialize in law firm bookkeeping, simplifying expense allocation, creating tailored solutions that clearly distinguish between chargeable and non-chargeable expenses, ensuring every dollar is accounted for.

Our team of expert bookkeepers and accountants manages statutory compliance and reporting so you can focus on serving your clients without the added stress.