How does trust accounting work for a law firm?

Trust accounting is the way a law firm in the United States keeps money that belongs to clients and third parties in a bank account separate from its own, records it in a ledger for each client, and takes its fees out only once they are earned. The firm holds that money as a fiduciary: it sits in the firm's name at the bank, but it is not the firm's money, and the books must be able to show at any moment how much of the balance belongs to whom.

This article covers the framework that applies in the United States, built on Rule 1.15 of the American Bar Association's Model Rules of Professional Conduct. The Model Rule is a template: each state adopts its own version, with its own wording, deadlines and record lists, so the rule of the state where you practice is the one that binds you. This is general information, not legal advice.

The sections below take each piece in turn, then run a month of entries for three clients through the ledger, including a correct transfer of earned fees and the one mistake that pushes a client's balance below zero.

What counts as client funds?

Client funds are any money a lawyer holds in connection with a representation that belongs, in whole or in part, to a client or to a third person rather than to the firm. The test is ownership, not the purpose of the payment or the name written on the check.

Model Rule 1.15(a) frames the duty broadly: a lawyer must hold property of clients or third persons that is in the lawyer's possession in connection with a representation separate from the lawyer's own property. The preface to the American Bar Association's Model Rules for Client Trust Account Records describes the standard as the care required of a professional fiduciary. In day-to-day practice, the money that falls under the rule comes in five forms:

• Advance fees. Money a client pays before the work is done, to be applied against future invoices.
• Advance costs. Money a client pays ahead for filing fees, expert reports, court reporters and similar expenses.
• Settlement and judgment proceeds. Funds paid by an opposing party or an insurer that the firm receives on the client's behalf.
• Money held for a transaction. A deposit on a purchase, sale proceeds awaiting distribution, funds held under an agreement between two parties.
• Third-party money. Amounts in the firm's hands that a lienholder, a medical provider or another person has a claim on.

Fees already earned and billed, reimbursements of costs the firm has already paid, and the firm's own revenue are not client money and belong in the operating account.

What is the difference between the trust account and the operating account?

The trust account holds money that belongs to clients and third parties, and the operating account holds money that belongs to the firm. Every dollar a law firm touches goes to one or the other according to who owns it at the moment it arrives.

The Model Rule requires that client funds be kept in a separate account maintained in the state where the lawyer's office is situated, or elsewhere with the consent of the client or third person. The two accounts are compared below on the points that matter when a payment comes in.

One consequence follows from the table: firm expenses are never paid straight from trust. If the firm has earned $2,400, the $2,400 moves to the operating account first, and rent is paid from there. A rent check written on the trust account, even for an amount the firm has earned, removes the audit trail that shows the earning.

The trust account itself is usually one of two kinds. Sums that are small or held for a short time are pooled in an interest-bearing account under a state program known as IOLTA, for Interest on Lawyers' Trust Accounts, where the interest goes to a body that funds legal aid rather than to the firm or the client. A sum large enough or held long enough to earn meaningful net interest for one client is generally placed in a separate account for that client's benefit. The choice between the two, and the way the program works, is set state by state.

What does the rule against commingling forbid, and what is the exception?

Commingling is mixing the firm's own money with client money in the same account, in either direction, and the Model Rule forbids it with one narrow exception for bank service charges. The rule exists because, once funds are mixed, nobody can prove whose money was spent.

The prohibition runs both ways. Depositing a client's advance into the operating account exposes it to the firm's creditors and to the firm's cash-flow needs. Leaving earned fees in trust as a cushion, or parking the firm's own savings there, makes the trust balance larger than what clients are owed and hides shortages that would otherwise show up at once.

The exception is in Model Rule 1.15(b): a lawyer may deposit the lawyer's own funds in a client trust account for the sole purpose of paying bank service charges on that account, but only in an amount necessary for that purpose. That small sum is tracked on its own ledger, labeled as firm funds, so the books still show a named owner for every dollar. Without it, a monthly fee debited by the bank would be paid with a client's money. Many state versions of the rule cap the amount or describe it in their own terms, so the figure a firm may keep is a matter for the state rule.

Why does every client need their own ledger?

Every client needs a separate ledger because the bank sees one pooled balance while the firm owes a distinct sum to each client, and only the ledger shows where one client's money ends and the next client's begins. A pooled trust account without client ledgers is a single number with no owners.

The bookkeeping has two layers. The account journal records every deposit and every withdrawal on the account in date order and carries the running balance of the whole account. Under that journal sits one ledger per client, and often one per matter, recording that client's deposits, that client's payments and that client's running balance. Each entry is made twice: once in the journal, once in the ledger of the client it belongs to.

From that structure comes the rule that defines trust accounting: one client's money never covers another client's payment. A client ledger can fall to zero and can never go below it. If Client A has $600 in trust and a $900 filing fee falls due on Client A's matter, the firm cannot write the $900 check on the trust account, even when the account holds $50,000. The other $49,400 belongs to other people. The firm either collects $300 more from the client first, or pays the fee from its operating account and bills it.

The same logic governs deposits that have not cleared. A check credited to the account on Monday may not be collected funds until later in the week. Paying out against it before the money is good means the payment is made, in fact, with other clients' money, and if the check is returned the shortage is real. Firms therefore disburse only against collected funds.

When are advance fees earned and moved to the operating account?

Advance fees stay in the trust account until the work is done, and the firm may withdraw them only as the fees are earned or the expenses incurred. That is the text of Model Rule 1.15(c), and it makes the date of the transfer follow the date of the work, never the date of the payment.

For hourly work, the fee is earned as the hours are worked, and the usual practice is to transfer after sending the client an invoice that shows the time, the rate and the amount being applied from trust. For a flat fee paid ahead, the engagement agreement should say when each part is earned, for instance by stage of the matter. States differ on flat fees and on payments labeled non-refundable, and on whether a fee paid simply to secure a lawyer's availability belongs in trust at all, so the label on the payment settles nothing until the state rule is read.

Once fees are earned and undisputed, they should leave. A firm that lets earned fees accumulate in trust for months is holding its own money in the client account, which is commingling by delay. How a retainer balance is drawn down invoice by invoice and replenished has its own mechanics; the trigger is what matters here: work first, invoice next, transfer last.

How are cost advances handled?

A cost advance is client money held in trust until the specific expense it was paid for is incurred, and it is spent only on that client's matter. Model Rule 1.15(c) treats expenses paid in advance exactly as it treats fees paid in advance.

When the expense falls due, the firm pays it from the trust account to the court, the expert or the vendor, and records the payment on the client's ledger with the payee and the purpose. When the firm has instead paid a cost from its operating account, it may reimburse itself from the client's trust balance once the cost has been incurred and billed, with a transfer recorded like a fee transfer.

Whether an advance paid "for costs" may also be applied to fees depends on what the engagement agreement says. If the agreement earmarks the money for costs, it stays earmarked. Whatever is left when the matter closes is the client's and goes back to the client.

What happens when ownership of the funds is disputed?

When two or more persons claim an interest in money a lawyer holds, the disputed part stays in the trust account until the dispute is resolved, and the undisputed part is paid out promptly. This is Model Rule 1.15(e), and one of the claimants it covers is the lawyer.

The most common case is a fee dispute. A firm bills $4,000 against a trust balance and the client objects to $1,000 of it. The firm may transfer the $3,000 that is not contested and must leave the $1,000 in trust. It may not take the contested sum on the strength of its own view of the invoice, and it may not hold back the uncontested remainder of the client's money as leverage.

The second case involves third parties: a medical provider with a lien on a settlement, a former lawyer with a fee claim, a creditor with a court order. Where the lawyer knows of a claim that the law requires the lawyer to respect, the claimed amount stays in trust while the client and the third party sort it out, by agreement or through a court. The lawyer holds the money for both sides and decides the dispute for neither.

How quickly must a firm notify and pay the client?

A lawyer who receives funds in which a client or third person has an interest must promptly notify that person and promptly deliver what that person is entitled to receive. Model Rule 1.15(d) adds that, on request, the lawyer must promptly render a full accounting of the property.

The Model Rule gives no number of days for "promptly"; some states do. In practice the word covers three duties. The client is told when money arrives, not weeks later. The money is paid out once the funds are collected and the amounts are settled, not held until a convenient moment. And the client can ask at any time for a statement of everything received, everything paid and what remains, and receive it without delay.

When a settlement is distributed among the client, the firm and lienholders, the distribution itself, with its written statement and the order of payments, is a subject of its own. For trust accounting, each payment is one line on the client's ledger, and the ledger must reach zero, or show exactly the amount still held and why.

What records must a law firm keep, and for how long?

Under the Model Rule, complete records of trust account funds must be kept by the lawyer and preserved for five years after the termination of the representation. Each state sets its own period when it adopts the rule, and some set a longer one, so the state version decides.

Rule 1.15 says "complete records" without listing them. The list comes from the American Bar Association's Model Rules for Client Trust Account Records, which give the rule its working definition, with the retention period and the frequencies left in brackets for each state to settle.

The last line is where the system proves itself. A three-way reconciliation compares the adjusted bank statement balance, the balance in the account journal and the total of all client ledgers; the three must be equal. Many states require it monthly rather than quarterly. The procedure, with outstanding checks and deposits in transit, deserves its own treatment, but its role is plain: it is the control that finds a negative ledger, a missed entry or a bank error before a client does.

How does overdraft notification work?

Overdraft notification is an arrangement under which the bank holding a lawyer's trust account agrees to report to the state's lawyer disciplinary agency whenever an instrument is presented against insufficient funds. Under the American Bar Association's Model Rule for Trust Account Overdraft Notification, the report is made whether or not the bank honors the instrument.

In outline, the model works in three parts. A trust account may be kept only at a financial institution that has agreed to make these reports and has filed that agreement with the state's highest court or its disciplinary agency. The bank does not judge whether the overdraft was serious or innocent; it gives notice and the agency decides whether anything more is needed. And where the overdraft came from an accounting error, the model's commentary provides for a written explanation from the bank that the lawyer can pass to the agency.

Not every state has adopted the model, and those that have use their own text. The practical point is the same everywhere it applies: an overdraft on a trust account is not a private matter between the firm and its bank. It is also a late signal: an account can be short for one client long before the bank balance reaches zero, as the worked example shows.

What does a month of trust entries look like for three clients?

A month of trust entries is a dated list of deposits and withdrawals, each posted to the account journal and to one client's ledger, with every ledger staying at or above zero. The worked example below is illustrative: a small firm with one pooled trust account, an hourly rate of $300, and three clients called Alder, Birch and Cedar.

The assumptions at the start of the month are these. Alder has $5,000 of advance fees in trust on an hourly matter. Birch is a new client with nothing in trust yet. Cedar is an injury client whose claim is about to settle on a 30% contingency fee. The firm keeps $100 of its own money in the account for bank charges. The account therefore opens at $5,100.

The Day 15 entry is the correct transfer. The firm worked 8 hours for Alder at $300, which is $2,400. Alder's ledger held $5,000, the invoice went out, and exactly $2,400 moved to the operating account. Alder's ledger now shows $2,600, still the client's until more work is done.

Cedar's settlement shows prompt delivery and a disputed sum in the same file. The $40,000 arrived on Day 10 and nothing left until the funds were collected. On Day 18 the firm took its fee of $12,000, which is 30% of $40,000, recovered $1,500 of case costs it had paid from its operating account, and paid Cedar $20,000. A medical provider claimed $6,500 under a lien and Cedar contested $2,000 of it, so the firm paid the $4,500 that nobody disputed and kept $2,000 on Cedar's ledger. The five amounts, $12,000, $1,500, $4,500, $20,000 and the $2,000 still held, add up to the $40,000 received.

What error creates a negative client balance?

A negative client balance appears when the firm withdraws more for one client than that client's ledger holds, and the difference is paid, in fact, with other clients' money. In the example it happens on Day 22, and the bank account never comes close to an overdraft.

By Day 22 the firm had worked 12 hours for Birch, worth $3,600 at $300 an hour, and Birch's engagement agreement allowed the whole deposit to be applied to fees and costs. The bookkeeper saw $7,800 in the bank and transferred the full $3,600. Birch's ledger, though, held only $3,100: the $3,500 deposit less the $400 filing fee.

Read the middle column. Alder, Cedar and the firm's own ledger are owed $4,700 between them, and the account holds $4,200. The missing $500 is the $3,600 taken less the $3,100 Birch had, and it came out of money belonging to Alder and Cedar. No check bounced and no notice went to anyone, yet the firm had used client funds for its own fees. Only a list of client ledger balances, with one of them below zero, reveals it.

The correct entry on Day 22 was a transfer of $3,100, the whole of Birch's balance, with the remaining $500 of the invoice billed to Birch for payment into the operating account. The correction on Day 23 is the firm paying $500 from its operating account back into trust, posted to Birch's ledger, which returns that ledger to zero and the account to $4,700. The entry is recorded as what it is, with a note of the cause, and never erased. Depending on the state, a shortage of this kind may carry a reporting duty of its own, and a lawyer who finds one should read the state rule or call the state bar's ethics line before deciding the matter is closed.

The month ends with the Day 28 bank charge of $25, taken from the firm's own $100 and leaving $75 on that ledger. The closing balances are Alder $2,600, Birch $0, Cedar $2,000 and firm funds $75, a total of $4,675, which is the balance of the account.