Trust Accounting: Everything Lawyers Need to Know
Trusts are essential in estate planning, banking, and various other aspects of modern life. One problem with trusts is that they are financially and legally complex. That’s where professionals like you come in. Lawyers are often put in charge of trusts, which means that various trust accounting rules must be followed.
This guide will provide an overview of trust accounting, talk about the challenges of remaining in compliance with trust account rules, and discuss various software tools that make trust accounting safer and easier.
What is Trust Accounting?
A trust is a particular kind of legal arrangement in which the assets of an individual or a group of people, called the ‘beneficiary’, are held by a third party, called the ‘trustee’.
There are many types of trust accounts, and people choose to create them for many reasons. For example, escrow accounts might be used for real estate expenses, and trusts can be established to handle inheritance or estate planning.
Regardless of the underlying motivation, one of the core functions of a trust is to ensure that there is no commingling between the beneficiaries’ funds and the lawyer’s funds. Interacting with a trust account will usually look like this:
A client gives you money that does not belong to you. This money could be unearned fees like a retainer or could be for other expenses.
You place that money in the trust. If it’s an individual trust account, you’ll be the only one making these deposits. If it’s a pooled trust account shared with other lawyers, they may also be making deposits.
To withdraw funds from the trust for expenses, including paying yourself for your legal services, you have to move those funds into a separate account rather than drawing directly from the trust.
After all claims have been handled and the case is completed, whatever remains in the trust account is given back to the client.
In the case of a dispute, if client funds are still in the trust account, you will keep the money in the trust account until the dispute is resolved. This varies on a state-by-state basis, check to see how the procedure is carried out in yours.
Think of the trust as being almost like a checking account. Any assets which are transferred into the trust belong to the beneficiaries and must be managed on their behalf. Just as it would be inappropriate for an attorney to use a client’s checking account to pay for office supplies, it would be inappropriate for them to use beneficiaries’ funds on themselves.
When handled properly, this clean separation of funds ensures that you maintain ethical behaviors and reduces the possibility of legal troubles.
This is where trust accounting comes in.
Is Trust Accounting Difficult?
Trust accounting refers to carefully tracking the movement of funds into and out of a trust account, to make sure trust accounting rules have not been violated. When done well, trust accounting allows for the safe provisioning of client resources while simultaneously avoiding legal pitfalls.
Trust accounting compliance can be complex for several reasons.
Trust accounting has many rules. Trusts have no legal power until the beneficiaries transfer control of some assets to the trust, the trustee must be an adult with enough mental competence to enter a legal contract, the trustee has the legal responsibility to put the beneficiaries’ interests first when making any decision, and the trustee has considerable authority and flexibility in how the trust is managed, to name but a few.
The rules are famous for being so numerous, nebulous, and inconsistent from one state to the next that it could be a real struggle to keep it all straight.
The ramifications of violating trust accounting rules can be severe, up to and including disbarment.
These three factors–the number of rules, their vagueness and inconsistency, and their serious consequences–have contributed to horror stories of lawyers losing the ability to practice law because they accidentally violated some minor rule while handling accounting for trusts.
If you’re an attorney managing trust, it is therefore very important that you understand trust accounting and how you can avoid common mistakes that go with this kind of accounting.
Doing so allows you to fulfill your fiduciary responsibilities to the beneficiaries while minimizing your chances of making an error that negatively impacts your career.
Common Trust Account Mistakes Lawyers Make
With that in mind, let’s look at some common mistakes attorneys make when handling accounting for trusts.
Reporting Deposits as Income
Attorneys sometimes report deposits made into a trust they manage as their own income. This is committing the mistake warned about with the analogy between a trust and a checking account.
If you were charged with managing a client’s checking account it would be wrong to report deposits into that account as your own income, because it’s not.
The same applies to trusts.
Your responsibility as an attorney is to manage the trust, but you don’t own the assets placed there. You must maintain a strict separation between trust assets and your own assets, including when reporting income.
Blending Client and Business Accounts
A similar problem occurs when attorneys violate trust accounting rules by blending the client’s trust account with their own business accounts.
A subtle example involves the use of ‘earned funds’, which are funds that an attorney has earned for services rendered. If they’re placed in the trust account, you cannot draw from that account directly. The funds must first be moved to your business account before being used to cover operating expenses.
This may seem like a pointless headache. If you know there’s a specific quantity of earned funds available for your use, why go through the extra hassle of moving them into another account first?
But this is exactly the kind of slippery slope that encourages bad trust accounting. If you don’t enforce a strict distinction between client and business accounts, you’re asking for trouble down the road.
Withdrawing Funds too Early
When money goes into a trust, it does not belong to you. This is true even when it’s intended to eventually pay you for legal services–it’s not yours until you’ve actually earned it.
Sometimes an attorney will run into cash flow problems, and there can be a temptation to ‘borrow’ money from the trust account to make up for the discrepancy. This might seem harmless enough. After all, in a few weeks or months, the money will be yours, anyway. Why not take a little prematurely so you can get back to acting on your client’s behalf?
But this is a direct violation of an attorney’s trust. You may not withdraw funds from the trust until they’ve been earned. It’s not worth the risk.
How to Optimize Your Trust Accounting Process
Trust accounting has a fearsome (and well-earned) reputation as a malpractice minefield that could blow up otherwise carefully-run legal practices.
The good news is there’s plenty of room to optimize an attorney’s trust account process.
Step 1: Reckon with the Problem
First, you simply need to be aware of the challenge. You need to appreciate the subtlety of the trust account rules and the consequences for violating them. You also need to be aware of any state-specific laws which apply to you. This is a good overview of trust accounting from the American Bar Association, but we strongly recommend you do research on how your state handles trust accounting internally.
Step 2: Use the Right Tool for the Job
It also helps to use specialized software to handle the intricacies of trust accounting. All trust transactions must be carefully tracked, and at the end of the month, you have to undergo a process called 3-point reconciliation to make sure your books are in order.
The three points which must be reconciled are:
- The trust account balance
- The balance of your trust account liability
- Balances broken down on a per-client basis
Generic accounting software makes it difficult to keep all of this straight. But a trust accounting solution built with lawyers in mind can make all of this a breeze. LawPay gives you a unified place to accept payments and manage payments, and helps you avoid the ever-present danger of commingling funds. This will go a long way to maintaining compliance with trust accounting rules.
Step 3: Keep Your Books in Order
Finally, be sure to keep timely, detailed and accurate records. This includes tracking each and every deposit and withdrawal in separate client ledgers, recording the transactions as soon as they occur, and similar measures. This not only helps ensure your compliance, it’ll also help you handle an investigation of your accounting methods, should an error occur.
Effortless Trust Accounting With LawPay
If you’re in the market for software that can help manage the complexities of trust accounting, make sure you look for one with all the features you need.
To see what LawPay can do for your attorney’s trust, schedule a demo with a Payments Specialist today!