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What\u2019s in Your Firm\u2019s Trust Account?<\/h2>\n
One of the audit steps in the IRS\u2019s Attorneys Audit Technique Guide<\/a> is to analyze the source of funds remaining in the law firm\u2019s trust account at year-end, particularly when the ending balance is large. That is a useful way to think about your law firm\u2019s year-end close.<\/p>\n Your CPA needs clean revenue and expense records, support for deductions, owner distributions and the other pieces that ultimately make their way onto the tax return. But a law firm also has to account for money that belongs to clients or passed through the firm on someone else\u2019s behalf.<\/p>\n Think of client funds in trust. Advanced case costs. Outstanding trust checks. Liability balances. Payments to attorneys and other service providers.<\/p>\n Those accounts deserve their own year-end review.<\/p>\n Start with the December trust reconciliation.<\/p>\n Your adjusted bank balance, your trust account records and the total of the individual client ledgers should agree. The word adjusted<\/em> matters. A December 31 bank statement may still include checks that have not cleared or exclude deposits that were in transit at month\u2019s end.<\/p>\n If you\u2019ve reconciled the trust account every month, December should confirm work that was already done throughout the year. If you haven\u2019t, year-end can turn into a reconstruction project.<\/p>\n This is where you may find issues such as: <\/p>\n Don\u2019t stop because the bank reconciles. A bank account can reconcile while the client-level trust records are still wrong.<\/p>\n By December 31, you should be able to show exactly whose money makes up the trust balance.<\/p>\n Read Amy\u2019s article \u201cTrust Account Reconciliation: Can You Find the Errors Hiding in a Positive Bank Balance?\u201d<\/a> for more on handling trust accounts.<\/em><\/p>\n Pull the firm\u2019s \u201coutstanding check\u201d list and age it. A trust check that has not cleared still affects the reconciliation, and an old one needs more than an accounting adjustment.<\/p>\n Maybe the client moved and never received a refund. Maybe a medical provider never deposited a settlement check. Perhaps the check was lost and needs to be reissued.<\/p>\n Whatever happened, don\u2019t treat an old trust check the way you would an old operating check. The underlying funds are not <\/em>automatically available to the firm because the check went stale. Steps you want to take:<\/p>\n This is also why I would not judge a trust reconciliation only by whether it has a zero variance. A reconciliation can mathematically tie while an old outstanding check has been sitting there for two years.<\/p>\n For contingency firms, advanced case costs deserve a separate year-end review.<\/p>\n Filing fees, medical records, expert witnesses, deposition costs and similar expenses can materially distort the firm\u2019s financial statements when they are recorded incorrectly.<\/p>\n The IRS Attorneys Audit Technique Guide says cash-method attorneys generally may not take a current deduction for client expense advances when they expect the client to reimburse them. In those circumstances, the advance is treated more like a receivable or loan than an ordinary operating expense.<\/p>\n That means putting $80,000 of reimbursable case costs on the P&L can make the firm appear $80,000 less profitable even though those costs are expected to come back when the cases resolve.<\/p>\n The IRS guide itself discusses an exception recognized by the Ninth Circuit in James F. Boccardo v. United States for certain gross-fee contingency contracts where the client had no obligation to repay the costs.<\/p>\n The year-end job is to identify what is sitting in the books, confirm that advanced costs have been recorded consistently with the firm\u2019s fee agreements and tax treatment, and give the CPA a clean schedule to review.<\/p>\n If amounts being carried as reimbursable costs are no longer collectible, flag those separately instead of leaving them buried in the asset account indefinitely.<\/p>\n A liability balance should be there because the firm still has an obligation, not because nobody knows how to clear it.<\/p>\n Review every balance representing money the firm is holding or owes to someone else. That may include client trust liabilities, unearned fees, settlement-related balances and other amounts that have accumulated during the year.<\/p>\n For each balance, ask three basic questions: <\/p>\n Old balances deserve particular attention.<\/p>\n If an amount has been sitting in a liability account for nine months and no one can explain what created it, December 31 is a poor time to roll it into another year without finding out.<\/p>\n Do the information-reporting review before January. Law firms have several payment types that deserve extra attention, and attorney payments have their own rules.<\/p>\n The usual corporate exemption does not apply to payments for legal services. Under the IRS\u2019s 2026 instructions, attorney fees of $2,000 or more paid in the course of business are generally reportable on Form 1099-NEC, even when the recipient is a corporation.<\/p>\n Gross proceeds paid to an attorney in connection with legal services, such as certain settlement payments, are generally reported on Form 1099-MISC, Box 10, when they reach $600.<\/p>\n Those are not interchangeable rules<\/strong>, and not every payment leaving a trust account creates a reporting obligation for the law firm that disbursed it. Settlement payments in particular can depend on who the payer is and what the payment represents.<\/p>\n Experts, medical providers and other service providers may also create information-reporting obligations depending on the amount, type of payment, recipient and how the payment was made.<\/p>\n By year-end, identify the payees that need review and collect any missing W-9s. January is much easier when you\u2019re filing forms instead of chasing tax IDs.<\/p>\n A good law firm year-end close should leave you with records you can support without having to reconstruct them later on.<\/p>\n And if someone asks what makes up the money sitting in the trust account on December 31, you can answer from the records.<\/p>\n The IRS considers that question worth asking. Your firm should be able to answer it before they do.<\/p>\n Images created in Adobe Firefly<\/p>\n What Flat Fees Actually Cost Family and Immigration Attorneys<\/a><\/p>\n Law Firm Billing Leakage: You Are Giving Money Away Before the Invoice Goes Out<\/a><\/p>\n Write-Offs: What Your Leakage Is Trying to Tell You<\/a><\/p>\nComplete the Three-Way Trust Account Reconciliation<\/strong><\/h2>\n
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Review and Age Every Outstanding Trust Check<\/h2>\n
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Review How Advanced Client Costs Were Recorded<\/strong><\/h2>\n
The tax treatment is not identical in every arrangement. <\/h3>\n
Reconcile Your Law Firm Liability Accounts and Unearned Fees<\/h2>\n
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Collect Missing W-9s and Review 1099 <\/strong>Reporting<\/h2>\n
What Your Accountant Wants to See on December 31<\/h2>\n
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More Law Firm Accounting Tips from Amy Coats<\/h2>\n