What Every Lawyer Should Know About Operating and Trust Accounts
No matter how large or small, almost every law firm needs an operating account and a client trust account. But despite how common it is to need both types of accounts, not every lawyer understands the important differences between them—a mistake with major implications.
Below, we’ll break down how to keep it all straight, avoid common pitfalls, and even run your law firm without having to stress too much over your accounting.
Trust accounts and operating accounts
A law firm’s operating and trust accounts function independently of each other and even require separate recordkeeping processes.
Law firms routinely use trust accounts to hold client funds. A trust account typically holds money paid by a client ahead of time for legal work a lawyer is going to perform. However, depending on the practice area, it may sometimes hold funds from a settlement that will be distributed to a client or funds held as part of a real estate transaction.
Regardless, the money in the trust account belongs to the client, even though the law firm oversees the account. As such, funds in trust accounts are not money a lawyer can legally access whenever they want.
An operating account, on the other hand, does belong to the law firm. This is because the lawyer has already earned money in an operating account, and it can be used to cover expenses, such as paying bills and staff salaries.
Fees and retainers
In addition to settlements and real estate transactions, lawyers should use trust accounts for security retainers and court filing fees that aren’t included in a flat fee.
Depending on the law firm’s practice area, one commonly-used pay structure is a security retainer: a client deposits money with a lawyer, who places the money in a trust account. Then, as the lawyer performs the agreed-upon legal work, they bill the client and withdraw funds accordingly, which get placed in the firm’s operating account.
Law firms must track retainer balances—typically with the assistance of their practice management software—allowing them to prompt the client to replenish the balance before the lawyer performs more work. In this way, the law firm knows they will get paid, and the client knows they have “reserved” services.
Another pay structure frequently used by law firms is a flat fee charge. This approach can give clients peace of mind knowing that payments will be capped at a certain amount. It’s typically used with routine legal work, such as drafting a will.
However, the written agreements around a flat fee need to be clear about what will be done and what the fee includes. For instance, if the flat fee for a first-time DUI offense includes court filing fees, then the entire amount may be deposited in the operating account. However, if the flat fee doesn’t include the court filing fees, then those funds must be held in the trust account.
Commingling client and attorney funds—depositing what should go into the trust account in the operating account or the reverse—is one of the most common errors law firms make with client trust accounts.
For example, if a client pays $1,000 for a bankruptcy filing fee, plus an additional $200 for a court filing fee, that court filing fee must go into the trust account because it isn’t the law firm’s money. Instead, it’s the client’s money being held in trust to pay for the filing fee.
Therefore, if the client writes a check or makes a single credit card payment of $1200, the money must go into the trust account. A detour through the firm’s operating account, however briefly, isn’t ethical. This holds true even if the lawyer is entitled to the flat fee right away.
Accessing trust account funds too early
It’s crucial to treat operating and trust accounts as entirely independent.
Accessing funds from the trust account before actually earning them through work performed for the client is considered a significant ethics violation. It doesn’t matter if the legal work will be done next week or the next day—if the funds haven’t been earned yet, they must stay in the trust account.
Withdrawing funds too early in an attempt to fix a cash flow problem may seem to patch things up in the short term but can lead to long-term problems that end in disbarment. This type of ethics violation is typically considered the most egregious and therefore comes with the harshest penalties.
Not keeping detailed records
Another common error occurs when law firms fail to understand that operating and trust accounts have different recordkeeping requirements. While lawyers need to keep records for both, the requirements for trust accounts are more stringent.
Again, the reasons for this have to do with ethics standards and making sure that legal clients don’t get taken advantage of.
Every time a check is written from the law firm’s trust account to the operating account, the client or matter should be included in the memo. This helps prevent mix-ups in client funds and means that the law firm can always know where a matter balance sits.
In addition to the detailed tracking of the trust account’s deposits and disbursements, law firms need to run monthly reconciliation and three-way reconciliation. These essential trust accounting processes catch mistakes when they’re fresh and help ensure a firm’s books are in order in the event of a random audit.
How to keep it all straight
Ultimately, the differences between operating and trust accounts matter at every point of the accounting cycle—from where the new funds should be deposited to when they can be moved and how transactions must be detailed and reconciled.
Not understanding the differences at any point can result in an ethics violation.
It’s also worth acknowledging that staying on top of the rules and regulations for two distinct accounts can result in many billable hours lost to accounting tasks. Three-way reconciliation isn’t exactly a walk in the park.
Law firms often benefit from using practice management programs with legal-specific accounting tools. Having a fully integrated billing and accounting system that’s programmed to understand the nuanced differences between operating and trust accounts at every stage of the accounting cycle can prove critically helpful.
Not only does using a practice management system save law firms time by, say, running three-way reconciliation in just a few clicks, but it also provides important safeguards against making a mistake—freeing up lawyers to put aside their accounting hats and practice law instead.