Law Firm Client Trust Interest: IOLTA Reporting, Interest on Lawyer Trust Accounts, and Tax Implications

The Interest on Lawyer Trust Accounts (IOLTA) program exists because of a practical problem: a law firm holds small amounts of client funds for short periods, and the administrative cost of opening a separate interest-bearing account for each client would exceed the interest earned. Before IOLTA, these funds sat in non-interest-bearing trust accounts, and nobody earned interest. The IOLTA solution is that the firm deposits these funds into a pooled interest-bearing trust account, and the interest goes to the state bar foundation (which uses it to fund legal aid). The lawyer does not earn the interest. The client does not earn the interest. The bar foundation earns the interest. This arrangement was upheld by the Supreme Court in Brown v. Legal Foundation of Washington (2003) and is now mandatory in every state. But IOLTA only applies to funds that are nominal in amount or held for a short period. Larger or longer-duration client funds must be placed in a separate interest-bearing account where the interest is earned by the client, and that creates tax reporting obligations for the firm.

How does IOLTA work?

Every state requires lawyers who hold client funds to maintain a trust account at a financial institution approved by the state bar. The IOLTA program designates the pooled trust account as the default for client funds that are too small or too short-term to earn net interest for the client individually.

The IOLTA determination. When a lawyer receives client funds, the lawyer must decide: should these funds go into the IOLTA account (pooled, interest to the bar foundation) or a separate interest-bearing account (individual, interest to the client)? The standard is whether the funds could earn interest for the client in excess of the costs of administering the separate account. The factors are: the amount of the funds, the expected duration of the deposit, the cost of establishing a separate account (bank fees, accounting time), and the prevailing interest rate.

Most jurisdictions provide a rule of thumb: funds under $5,000 or held for fewer than 60 days go into IOLTA. Funds over $5,000 held for 60+ days go into a separate account. Some jurisdictions have higher thresholds. The lawyer exercises judgment, and the determination should be documented.

The IOLTA account structure. The IOLTA account is a pooled demand deposit account (typically a NOW account or IOLTA-designated account) at an eligible financial institution. The account is titled in the firm’s name as trustee (e.g., “Smith & Jones, LLP, IOLTA Account”). The bank sends the interest directly to the state bar foundation (or to the state IOLTA program, which forwards it). The bank reports the interest on Form 1099-INT to the state bar foundation’s tax identification number, not to the law firm or any client. The lawyer receives no 1099-INT for IOLTA interest.

Compliance rate reporting. Many states require IOLTA-eligible institutions to pay interest at a rate comparable to the rate paid on similar non-IOLTA accounts. This is the “comparability rule,” and it ensures that IOLTA accounts earn market-rate interest rather than minimal rates. Some states mandate that IOLTA accounts earn at least 60-75% of the federal funds rate.

When must funds go into a separate interest-bearing account?

The lawyer has an ethical obligation to place client funds that could earn meaningful interest for the client into a separate interest-bearing account. “Meaningful interest” means the interest earned would exceed the costs of maintaining the account (bank fees, the lawyer’s time to open and administer the account, and the cost of tax reporting).

Common scenarios requiring a separate account:

Settlement proceeds. A personal injury settlement of $500,000 arrives and will be held for 30-60 days while liens are resolved and the distribution is prepared. At current interest rates, the funds could earn $500-$2,000 in interest during that period. The funds should go into a separate account, and the interest belongs to the client.

Estate administration. Estate funds held for months or years during probate should be in a separate interest-bearing account. The interest is income of the estate (reported on the estate’s Form 1041) or the beneficiary (if the estate distributes the income).

Real estate closings. Earnest money deposits held in escrow for 30-90 days. If the deposit is substantial ($50,000+), a separate account is appropriate. If the deposit is $5,000 and held for 30 days, IOLTA is appropriate.

Retainers. A $25,000 retainer held in trust for a client whose matter will last several months. The funds should be in a separate account if the interest would be meaningful to the client. As the firm earns the retainer (by performing work and issuing invoices), the earned portion is transferred to the operating account, and the trust balance decreases.

Who reports the interest and how?

IOLTA interest. Nobody reports IOLTA interest on a tax return. The bank reports the interest to the state bar foundation on Form 1099-INT using the foundation’s TIN. The law firm does not report it. The client does not report it. The state bar foundation reports the interest as income on its Form 990 (it is a tax-exempt organization).

Separate client trust account interest. The interest belongs to the client and must be reported to the client on Form 1099-INT. The reporting obligation depends on the account structure:

If the account is in the client’s name and TIN: The bank issues the 1099-INT directly to the client. The law firm has no reporting obligation for the interest. This is the cleanest structure but is less common because it requires opening a bank account in the client’s name.

If the account is in the firm’s name as trustee (with the client’s TIN as the beneficial owner): The bank may issue the 1099-INT to the firm’s TIN. The firm must then issue a nominee 1099-INT to the client, reporting the interest as the client’s income. The firm reports the interest on its own return as “nominee interest” (included in gross income on Schedule K, then subtracted as nominee interest, netting to zero).

If the account is in the firm’s name and TIN without a nominee designation: The bank issues the 1099-INT to the firm. The firm receives the interest income and must report it, then issue a 1099-INT to the client for the client’s share. This is the most common scenario and the one that creates the most confusion. The firm must: (1) include the interest in its gross income, (2) deduct the interest paid to the client (as it is the client’s money), and (3) issue a 1099-INT to the client by January 31 of the following year.

What are the common compliance mistakes?

Commingling. Depositing firm funds into the trust account (other than funds to cover bank fees, which some jurisdictions permit) or depositing client funds into the operating account. Commingling is the most serious trust account violation and can result in suspension or disbarment.

Failure to segregate large/long-term deposits. Placing all client funds into IOLTA regardless of amount or duration. This deprives the client of interest that the client is entitled to earn. While the ethical rules frame this as a judgment call, a pattern of depositing large sums into IOLTA (rather than separate accounts) when the client would have earned meaningful interest is a violation of the lawyer’s fiduciary duty.

Failure to issue 1099-INT. When interest on a separate client trust account is earned by the client, the firm must issue a 1099-INT to the client. Many firms fail to do this, particularly when the interest is paid directly to the client (as part of a settlement distribution, for example) without a formal 1099-INT filing. The penalty for failure to file a correct 1099-INT is $310 per form (for 2025, adjusted annually) if corrected within 30 days, up to $660 per form if not corrected by August 1.

Incorrect tax treatment of trust interest. Some firms incorrectly report trust account interest as the firm’s income (without the nominee adjustment), which overstates the firm’s income and understates the client’s. Others fail to report the interest at all (neither as the firm’s income nor as the client’s), which leaves the interest unreported.

Earning interest on IOLTA-eligible funds in a non-IOLTA account. If a firm deposits IOLTA-eligible funds (nominal amount, short duration) into a regular interest-bearing account and keeps the interest, the firm is keeping interest that belongs to the client. The client did not consent to the firm earning interest on the client’s money, and the ethical rules prohibit it.

What should I do next?

Review your trust account structure: is there one IOLTA account and a process for segregating larger or longer-duration deposits into separate accounts? If all client funds go into a single IOLTA account regardless of size, the firm may be depriving clients of interest they are entitled to earn. If the firm holds client funds in separate interest-bearing accounts, confirm that 1099-INT forms are issued to the clients and that the interest is correctly reported on the firm’s return.

• IOLTA trust accounting, the full trust account compliance guide including the three-way reconciliation and common violations
• Law firm bookkeeping, the chart of accounts that separates trust transactions from operating transactions
• Law firm billing and collections, the retainer management process that determines which funds sit in trust
• Law firm partner compensation, how trust account management affects the partners’ K-1 reporting
• Nonprofit donor acknowledgment, a parallel fiduciary reporting obligation (different context, same rigor)

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