June 13, 2016

Client Trust Accounts and Taxation of Funds

By David A. Oksenhorn, Senior Manager, Tax & Business Services

Client Trust Accounts and Taxation of Funds

A variety of accounts are used for the temporary holding of funds. The types of accounts that are familiar to attorneys are escrow and client trust accounts. An escrow account is generally defined as an account whereby funds are deposited with the attorney in relation to a real estate transaction or business acquisition. This attorney deposit account operates similarly to a bank for deposit accounts. The funds are deposited on behalf of the client and are released appropriately as the transaction dictates upon completion. A client trust account is a separate account used to hold client funds in trust by an attorney for the benefit of a client.

Debt collection is a common use for client trust accounts. The attorneys have contractual agreements whereby they collect debt payments on behalf of their clients. Of the total amounts collected, the law firm either retains a portion of the collection, representing its fee, or remits 100% of the collection in accordance with the agreement. In the instance where 100% of a collection is remitted to the client, the client pays a separate fee to the law firm. Insurance brokers also can maintain client trust accounts. The accounts may be inclusive of both insurance premiums and the broker’s commission. In this instance, the broker takes commission from the account and then remits the premium to the insurance company.

Client trust accounts can also be interest-bearing. There are two options available to law firms for accounts that bear interest. The interest can be earned and payable to the client, in which case the client would receive a 1099 for each year in which interest is earned, for tax return reporting. The other option is for the attorney to earn the interest. In this case, the interest is remitted in accordance with Interest on Lawyer Trust Accounts or IOLTA procedures.

An IOLTA is an account that has the purpose of providing assistance to low income individuals, generally with the goal of providing help with civil litigation costs. This is done by use of the interest earned on certain client trust accounts. The interest earned on these accounts is remitted to the state IOLTA programs and utilized for charitable purposes. In most instances, IOLTAs will consist of large funds to be held for short periods of time or smaller funds to be held for longer durations. Attorneys must use their judgement to determine if funds in a client trust account are of sufficient size or will be held for a significant enough period of time to justify being individually invested, as opposed to depositing in an IOLTA.

The purpose of IOLTA accounts is to provide protection for the client. These funds cannot be pierced for bankruptcy of the law firm. In addition, IOLTA accounts provide for segregation of funds between the law firm’s general operating account and client expenses and fees unearned by the law firm. A general rule for differentiating which funds should be commingled into operating funds vs. escrow accounts is as follows. The law firm invoices the client for related fees and recognizes this income after it is received and deposited into the law firm’s operating account. Client retainers received are also deposited into the law firm’s operating account. In contrast, transaction funds would be considered unearned and deposited into an escrow account. The law firm would not recognize this income until completion of the transaction, when fees are determined to be earned.

There are heavy sanctions for attorneys found to be illegally using client funds in escrow accounts. Depending on individual state laws, this could lead to an attorney being disbarred, as well as civil or criminal proceedings.

If there is an instance where funds remain in an escrow account for an extended period of time and the client is unable to be reached, and after all means of communication have been exhausted, remaining funds should be escheated to the state.

While most law practices utilize the cash basis methodology for tax reporting purposes, wherein even retainer fees are considered to be income and taxable when received, it is still important to understand the tax treatment of fees received, especially for those deposited into client trust accounts.