IOLTA Trust Accounting for Law Firms: The Three-Way Reconciliation and Common Violations

If your firm holds anyone else’s money, it goes into a trust account that is separate from the operating account, every dollar in it is traceable to a client or matter, and three balances get reconciled against each other on a fixed schedule. That’s the whole system. The rules come from your state’s version of Model Rule 1.15 rather than from the IRS, but the work behind them is ordinary bookkeeping. Florida’s rule, for example, requires the reconciliation monthly and the records kept for six years. Firms get into trouble on execution: earned fees left in trust, reconciliations skipped, a check written against money that belonged to a different client.

What funds go into a law firm trust account?

Anything you hold for someone else in connection with a representation. Florida Rule 5-1.1(a), a typical state version of Model Rule 1.15, puts it this way: a lawyer “must hold in trust, separate from the lawyer’s own property, funds and property of clients or third persons,” and “all funds, including advances for fees, costs, and expenses” go into a separately labeled trust account. Retainers, settlement proceeds, escrow deposits and money received from an opposing party all land there.

• The retainer a client pays up front is unearned on the day it arrives and belongs to the client until you do the work and bill it. Once billed, the earned portion moves to operating.
• Leaving earned fees in trust is the violation that surprises lawyers. Florida’s rule allows the lawyer’s own funds in the trust account only “in an amount no more than is reasonably sufficient to pay bank charges,” so earned fees sitting there past that allowance are commingling in the other direction.
• Flat fees are the gray area. States split on when a flat fee is earned, so check your own rule before moving one straight to operating. Absent clear guidance, trust first and transfer as earned is the position that survives a complaint.
• Florida also lets a lawyer deposit personal funds to replenish a shortage, but only up to the shortage and only with an immediate report to the bar’s regulation department. That’s a disclosure, and it starts an inquiry.

What’s an IOLTA account versus a separate client trust account?

An IOLTA account (IOTA in Florida) is the pooled trust account for client money that’s too small or held too briefly to earn anything for the client after bank costs. Florida defines “nominal or short term” as funds “that the lawyer has determined cannot earn income for the client or third person in excess of the costs to secure the income.” The interest on the pooled account goes to the state’s bar foundation to fund legal aid. Money that could earn a net return for the client goes into a separate interest-bearing account instead, with the interest accruing to the client.

Account	What goes in	Who gets the interest	TIN on the account	1099-INT
IOLTA / IOTA pooled trust account	Nominal or short-term client funds	The state bar foundation	The foundation’s	None to the firm or client
Separate client trust account	Funds large enough or held long enough to earn a net return for the client	The client	The client’s (or the firm as nominee)	Issued to the client
Operating account	Earned fees, firm money	The firm	The firm’s EIN	Ordinary firm income

The judgment call between the first two rows is the lawyer’s. Amount, expected holding period, the bank’s rate and the cost of opening a separate account all feed into it. Large settlement proceeds held pending distribution and real estate escrow funds are the usual candidates for a separate account. The client trust interest guide covers the reporting side of the separate account.

Is IOLTA interest taxable to the firm or the client?

No. In Private Letter Ruling 9909032 the IRS ruled that interest earned on a client’s funds in a law firm’s IOLTA account and paid to the foundation “is not includible in the income of Client or Law Firm,” relying on Rev. Rul. 81-209, which reached the same result for clients under an earlier state program. The client never controls the interest and the firm never receives it, so neither has income. The bank pays the foundation, which is exempt under section 501(a), and the firm has nothing to report.

• The same ruling says the law firm “is not required to report the interest paid to the Foundation because it is not the payor,” and the bank generally doesn’t file a 1099-INT either because the foundation is an exempt recipient.
• If your bank set the account up with the firm’s EIN or a partner’s SSN, you’ll get a Form 1099-INT for interest you never received. The fix is at the bank: have the account re-papered with the foundation’s TIN. Reporting the phantom interest and deducting it back out creates a mismatch with nothing behind it.
• Interest on a separate client account belongs to the client and is reported to the client. If that account sits under the firm’s EIN, the firm passes the interest through as nominee.

What does the three-way reconciliation require?

Three balances, taken on the same date, that agree with each other. Illinois Rule 1.15A(c) spells out the steps: compare the checkbook register balance with the adjusted bank statement balance, add up the ending balances of every client ledger, and run the receipts journal against the disbursements journal for the period. All three figures have to match. When they don’t, something is misposted or missing, and it has to be found before the next cycle.

• Adjusted bank balance. The statement balance plus deposits not yet credited, minus checks and debits not yet cleared. This is the same bank reconciliation every business does, on the trust account.
• Trust ledger (book) balance. The firm’s own running record of every deposit and disbursement, in QuickBooks, Clio, CosmoLex or a manual journal.
• Client sub-ledger total. Every client or matter with money in trust has its own ledger. The sum of all of them equals the money the firm should be holding.
• Florida frames the second and third legs as a monthly “comparison between the total of the reconciled balances of all trust accounts and the total of the trust ledger cards or pages, together with specific descriptions of any differences between the 2 totals and reasons for these differences.”

How often must you reconcile, and how long do you keep the records?

It depends on the state, and the two examples below bracket the range. Florida requires the reconciliation and the ledger comparison monthly and keeps them for at least six years. Illinois requires a three-way reconciliation at least quarterly and keeps trust records for seven years after the representation ends. Monthly is the safe schedule everywhere, because a quarterly rule is a floor and a three-month-old error is harder to trace than a three-week-old one.

Requirement	Florida (Rule 5-1.2)	Illinois (Rule 1.15A)
Reconciliation frequency	Monthly bank reconciliation plus monthly comparison to the client ledger total	Three-way reconciliation “on at least a quarterly basis”
Annual listing	Annual detailed list of unexpended trust money by client or matter	Not stated in 1.15A
Record retention	Trust records kept “for 6 years after the final conclusion of each representation”; reconciliations, comparisons and listings “for at least 6 years"	"seven years after termination of the representation”
Overdraft reporting	Lawyer must authorize the bank to notify the Florida Bar of any overdraft or dishonored trust check	Handled under the state’s separate overdraft rules
Annual compliance filing	Trust accounting certificate filed between June 1 and August 15; failure makes the lawyer delinquent	None in 1.15A

Records in both states can be kept electronically as long as they can be printed and produced. Keep the reconciliation reports, bank statements, deposit records, canceled check images, the trust journal, every client ledger and copies of fee agreements and client bills together, because a bar records request asks for all of them at once.

What are the most common trust account violations, and how does the bar find out?

Commingling, borrowing from trust, and not reconciling. Commingling runs both ways: firm money in trust beyond the bank-charge allowance, and earned fees left in trust after billing. Borrowing from trust to cover payroll is a disciplinary matter even when it’s repaid. Skipped reconciliations let a small posting error grow for months until it surfaces as a bounced check. And the bank is the one that tells the bar: Florida requires the lawyer to authorize the bank to notify the Bar “in the event the account is overdrawn or any trust check is dishonored.”

• Overdraft protection is off the table. Florida Rule 5-1.1(k): “A lawyer must not authorize overdraft protection for any account that contains trust funds.” The overdraft has to bounce so the bar hears about it.
• What the inquiry asks for. Monthly reconciliations, the trust ledger, client sub-ledgers and bank statements for a stated period. A firm with current reconciliations answers in a day and shows the overdraft was a timing issue. A firm without them faces a reconstruction and the presumption that the account isn’t being managed.
• Stale balances. A closed matter with $200 left in its sub-ledger has to be refunded or handled under the state’s unclaimed property rules. Left alone, those balances pile up into a pool nobody can explain.
• Missing client ledgers. A trust ledger with no per-client detail makes the three-way reconciliation impossible, and a firm in that position can’t show any client that it’s holding the right amount for them.
• The annual certificate. In Florida, missing the trust accounting certificate deadline makes the lawyer a delinquent member, ineligible to practice, with no complaint needed.

What should I do next?

If your trust accounting consists of glancing at the bank balance, run the three-way reconciliation for last month and see whether the three figures agree. If they don’t, or if the client ledgers don’t exist, the reconstruction back to the last known clean balance is the priority before anything else. If you’re current but doing it by hand, configuring the practice-management system to produce the report is a one-quarter payback.

• Law firm bookkeeping and chart of accounts, the operating-side books that sit next to the trust account
• Client trust interest and IOLTA reporting, separate-account interest, nominee reporting and the 1099-INT
• Law firm billing and collections, retainer replenishment and the revenue cycle that feeds the trust-to-operating transfers
• Law firm partner compensation, how the earned fees are taxed once they reach the partners
• Trust fund recovery penalty, the other “trust” obligation that attaches to you personally, on the payroll side
• Accuracy-related penalties and reasonable cause, if the firm’s return picks up an error from the trust-to-revenue flow

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.