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All partners in a law firm are responsible collectively for any client money kept in an Interest on Lawyer Trust Account (“IOLTA”) or individual client trust account. What steps can your firm take to reduce the risk of loss or fraud as it relates to IOLTAs? Also, what must be done to meet your state's client trust account record-keeping requirements? This article covers the basics and will help you think about what changes your firm should consider to protect against IOLTA loss or fraud.
1) Centralize the Client Trust Accounting
One of the easiest ways that your firm can open itself up to problems with inadequate record keeping, or even possible client trust fund fraud, is by allowing individual attorneys to have exclusive control of their own clients' trust accounts. There have been numerous high-profile cases about previously reputable attorneys stealing money from client trust accounts. After such episodes, the other partners in the firms have been held financially and professionally liable for the losses. In many of these cases, neither central firm management nor the other partners were even aware that the attorney was looking after client money.
It is in every firm's best interest to centralize all client trust accounting to reduce the risk of fraud by individuals or inadequate record keeping. The firm's finance department should be responsible for opening all new client trust accounts, and all checks written on the account over a certain threshold dollar amount should require two signatures. One of the signatories would be the responsible attorney and the other should be another partner designated by the firm's management committee. Along these lines, it is also important to ensure that the firm has appropriate controls over the receipt and disbursement of cash (more about this will be covered later).
The firm's finance department should be responsible for ensuring that the accounting steps necessary for compliance with the IOLTA record-keeping rules are consistently enforced. If your firm operates in various states, you may be required to maintain IOLTA and client trust accounts in each state to accommodate the differences in state record-keeping and compliance rules. You will also need to review each state's rules and ensure that your firm is in compliance with all of them.
2) Know Which Client Funds Must Be Deposited in the IOLTA or Separate Interest-Bearing Client Trust Account
The firm should ensure that all attorneys, as well as all accounting staff, are aware of the types of funds that must be deposited in a separate interest-bearing client trust account and not in an IOLTA. The main categories are as follows:
Amounts that are nominal, or will be held for a short period of time, should be deposited in the IOLTA. Monies that will be held for longer and large amounts should be deposited in an individually established, interest-bearing client trust account. Interest on IOLTA accounts is remitted to each state's IOLTA Committee, whereas interest on an individual client trust account must be remitted to the client to whom it pertains.
3) Ensure Your Firm Has Appropriate Controls over Cash
Strong internal controls over the cash receipts and disbursements process should form the foundation for the firm's procedures for handling clients' money. Best practices include appropriate segregation of duties over the performance of the bank reconciliation, which should always be prepared by someone who is not involved in the recording of transactions. Having the firm administrator or a designated partner review the bank reconciliations and the bank statements online is a critically important oversight function. The appropriate person should set aside time each month to perform this task.
Checks written on client trust accounts and IOLTAs should always be pre-numbered and live signatures should always be used. Never use signature stamps and never pre-sign trust account checks. Scanning of check deposits and locking away unused checks help to prevent possible check fraud.
4) Perform Regular Three-Way Reconciliations
Best practices include performing a three-way reconciliation at least monthly for the IOLTA and client trust accounts. Ensure that the following three balances are identical:
Similar three-way reconciliations must be performed for each separate client trust account.
A bank charges ledger is necessary because the firm must deposit a nominal sum (say $100) in a client trust account to cover potential future bank charges. This amount is not reflected in the client ledgers.
These reconciliations should be performed by someone in the finance department, unconnected from the function of recording transactions. For example, this responsibility is often undertaken by the controller or accounting manager, and the reconciliations are reviewed by the firm administrator.
5) Adhere to Client Notification Requirements When Funds Are Received and Before Funds Are Withdrawn for Fees
Clients must be notified promptly upon receipt of funds into an IOLTA or their client trust account. The best way to do this is to have the accounting system generate statements for each client ledger balance. Disbursements to pay for costs may occur frequently. It is therefore critical that the record keeping for each client trust account be kept up-to-date to ensure that a client balance never goes negative.
Whenever the firm receives funds on behalf of a client, a statement should be sent to the client showing the transactions and the current balance in the account. It is best practice for a statement to be sent monthly to any clients with client trust fund balances (regardless of whether these are in the IOLTA or individual client trust accounts). The current-month statement would show the balance at the start of the month, any receipts of new funds, any disbursements made for fees and costs, and the balance at the end of the month.
A separate notification must be sent before the law firm withdraws funds from a client trust account to pay the firm's fees. Once fees are earned by the law firm, the firm's bill for services should be rendered and the bill should inform the client that the bill will be paid from funds kept in the client trust account.
The transfer of funds for fees can be made using a check payable to the law firm, or by authorized electronic transfer to the firm's operating account. The timeliness of the transfer is critical because if it is done incorrectly or not at the proper time, the firm will be guilty of commingling the client's funds and its own funds (the earned fees).
6) Avoid a Dishonored Check Notification
In many states, in order to qualify as a financial institution authorized to handle client trust accounts, banks must agree to notify the Board of Bar Overseers if a check drawn on an IOLTA or client trust account is dishonored.
In the event of a notification of a dishonored check, the Board of Bar Overseers will write to the law firm and request an explanation for the dishonored check. This may result in an audit of the firm's client trust account records. If explanations are not satisfactory, possible sanctions against the attorneys and law firm involved could be made.
You can avoid the risk of a dishonored check by ensuring that the funds deposited in the trust account have properly cleared before any checks are written or transfers are made. Also, having good procedures in place for recording transactions on a timely basis and reconciling client trust accounts regularly will help ensure that this unfortunate situation does not arise. A regular review of bank account records is also necessary so that any accidental errors that a bank may make, such as applying funds to the wrong client trust account, are caught immediately.
7) Know Who Is Responsible for 1099 Reporting
The firm's accounting staff should understand its responsibility under the Internal Revenue Service Form 1099 reporting rules for transactions involving client trust accounts.
As an example, say your firm represents a client who is the plaintiff in a contingent fee case for discrimination, for which the client wins $1 million; your firm's fee is $300,000 plus costs. Another attorney is hired by your firm to act as an expert witness in this case, and her fee is $10,000. The $1 million paid in settlement is deposited into your firm's IOLTA account, and your firm disburses $10,000 to the expert attorney, $690,000 to the client and $300,000 to your firm's operating account in payment of fees.
In this example, IRS rules require multiple 1099s to be issued. Your client is required to issue a 1099 to your firm for $310,000 in legal fees. Your firm is required to issue a 1099 to the expert attorney for $10,000. The defendant company is required to issue a 1099 reporting $1 million paid to your client.
Consult the IRS Treasury Regulation 1.6045-5 for numerous examples of 1099 reporting involving attorneys.
8) Avoid Money-Laundering and Other Fraudulent 'Scams' By Having Sound Client Identification and Acceptance Procedures
What follows is one example of the many “scams” that law firms have fallen victim to in recent years. Remember that if you deposit a fraudulent check, the funds may not clear and any subsequent payments made on that deposit could result in the use of other clients' monies. If the scam involves your IOLTA or client trust account, then the State Board of Bar Overseers must be notified, which could trigger an audit and the risk of sanctions against your law firm.
An attorney receives an e-mail from a foreign business or person asking him to deposit some money in a client trust account and then wire transfer funds to a third party. The e-mail promises that the firm can keep 20% as a fee, and there is the suggestion of the possibility of representing the client in the future. The e-mail may include a link to the Web site of a company that appears to exist. The firm may even receive an authentic-looking check.
The golden rule is to know the company or person with whom you are doing business. If something seems too good to be true, it typically is! There is no substitute for appropriate client intake procedures, such as obtaining an engagement letter, running credit checks, getting a Dun & Bradstreet report on the company, asking for a tax identification number, and actually meeting a client in person! If you suspect that you have been the victim of a similar fraudulent transaction, then you should notify the local police and the FBI immediately.
9) Ensure That Your Firm Is Keeping Appropriate Computerized Client Trust Account Records
In August 2010, the American Bar Association issued new Model Rules for Client Trust Account Records, replacing the Model Rules on Financial Recordkeeping issued in 1993. These new Model Rules address changes in banking procedures and data storage as a result of the electronic age.
Client trust account records that must be kept include receipt and disbursement journals, check registers, records of all electronic transfers, trust account bank statements, records of deposits made, canceled checks or substitute check images, client ledger account records, bank charges ledgers, statements sent to clients showing activity, fee invoices, and retainer and other fee agreements with clients. The firm must also keep copies of the monthly three-way reconciliations performed, as well as any information contained in client files that pertain to client trust account transactions.
Typically, records must be kept for five years after the firm ceases to represent the client and all funds are disbursed. In some states that length of time increases to six years. The new ABA Model Rules for Client Trust Account Records allow for either physical or electronic equivalents of check registers, bank statements, deposit slips and canceled checks to be kept. Many checks are now cleared by a bank electronically, and paper copies of canceled checks are no longer returned to the payor. An electronic substitute check can be the legal equivalent of an original check as long as there is an image of both the front and back of the original and the complete MICR line is visible.
Many banks are no longer issuing paper copies of bank statements, which are only available electronically for download. It is therefore critical that the firm have procedures in place to ensure that electronic bank statements and check images are downloaded regularly and stored on the firm's computer system with the firm's other client trust account records. If the firm's client trust accounts were to be audited by the State Board of Bar Overseers, the firm would have to print out bank statements and canceled check images for the auditor.
Firms should also ensure that computerized accounting systems are keeping appropriate client trust account information for the requisite number of years. Some systems archive or purge records after a set number of years, and firms change accounting systems periodically. It is best practice for the firm's accounting staff to download (for example to a PDF file) all of the client trust account records and store them outside of the accounting system on another server.
It is also important that the firm's data backup procedures are sufficient and are operating properly. Does your firm have off-site data backup storage and a disaster recovery plan in place in the event of a failure of the firm's data servers?
10) Perform a Self-Audit of Your Computerized Trust Account Records
Ensure that your firm's client trust accounting procedures and computerized trust account records are sufficient and meeting the requirements of your state rules by conducting a self-audit of the records. Perform spot checks of individual client account records. For example, select one client who has been with the firm for at least five years and download all of the trust account records related to that client. Review them to ensure that documentation is complete and includes all the necessary information for each transaction. Review the monthly three-way reconciliations and ensure that each of the three totals reconcile with the check register, bank reconciliation and client ledgers (as reviewed above). Check that timely notification was sent to the client of deposits and withdrawals from trust accounts. Audit a broad selection of the firm's client trust account records over the year. Keep the records of your audit and use the results to improve your firm's accounting procedures.
Conclusion
All firms should undertake a review of their procedures and controls over client trust accounts and the maintenance of computerized records to ensure they are in compliance with the rules of the states in which they operate. Modify the oversight and reconciliation controls now, before a fraud occurs.
Neil F. Scullion, CPA is a director in the Law Firm Services Group at Feeley & Driscoll, P.C. (http://www.fdcpa.com/). The Law Firm Services Group provides tax, accounting, business advisory and consulting services to law firms. Based in Boston, Scullion can be reached at [email protected] or by phone at 617-456-2475.
All partners in a law firm are responsible collectively for any client money kept in an Interest on Lawyer Trust Account (“IOLTA”) or individual client trust account. What steps can your firm take to reduce the risk of loss or fraud as it relates to IOLTAs? Also, what must be done to meet your state's client trust account record-keeping requirements? This article covers the basics and will help you think about what changes your firm should consider to protect against IOLTA loss or fraud.
1) Centralize the Client Trust Accounting
One of the easiest ways that your firm can open itself up to problems with inadequate record keeping, or even possible client trust fund fraud, is by allowing individual attorneys to have exclusive control of their own clients' trust accounts. There have been numerous high-profile cases about previously reputable attorneys stealing money from client trust accounts. After such episodes, the other partners in the firms have been held financially and professionally liable for the losses. In many of these cases, neither central firm management nor the other partners were even aware that the attorney was looking after client money.
It is in every firm's best interest to centralize all client trust accounting to reduce the risk of fraud by individuals or inadequate record keeping. The firm's finance department should be responsible for opening all new client trust accounts, and all checks written on the account over a certain threshold dollar amount should require two signatures. One of the signatories would be the responsible attorney and the other should be another partner designated by the firm's management committee. Along these lines, it is also important to ensure that the firm has appropriate controls over the receipt and disbursement of cash (more about this will be covered later).
The firm's finance department should be responsible for ensuring that the accounting steps necessary for compliance with the IOLTA record-keeping rules are consistently enforced. If your firm operates in various states, you may be required to maintain IOLTA and client trust accounts in each state to accommodate the differences in state record-keeping and compliance rules. You will also need to review each state's rules and ensure that your firm is in compliance with all of them.
2) Know Which Client Funds Must Be Deposited in the IOLTA or Separate Interest-Bearing Client Trust Account
The firm should ensure that all attorneys, as well as all accounting staff, are aware of the types of funds that must be deposited in a separate interest-bearing client trust account and not in an IOLTA. The main categories are as follows:
Amounts that are nominal, or will be held for a short period of time, should be deposited in the IOLTA. Monies that will be held for longer and large amounts should be deposited in an individually established, interest-bearing client trust account. Interest on IOLTA accounts is remitted to each state's IOLTA Committee, whereas interest on an individual client trust account must be remitted to the client to whom it pertains.
3) Ensure Your Firm Has Appropriate Controls over Cash
Strong internal controls over the cash receipts and disbursements process should form the foundation for the firm's procedures for handling clients' money. Best practices include appropriate segregation of duties over the performance of the bank reconciliation, which should always be prepared by someone who is not involved in the recording of transactions. Having the firm administrator or a designated partner review the bank reconciliations and the bank statements online is a critically important oversight function. The appropriate person should set aside time each month to perform this task.
Checks written on client trust accounts and IOLTAs should always be pre-numbered and live signatures should always be used. Never use signature stamps and never pre-sign trust account checks. Scanning of check deposits and locking away unused checks help to prevent possible check fraud.
4) Perform Regular Three-Way Reconciliations
Best practices include performing a three-way reconciliation at least monthly for the IOLTA and client trust accounts. Ensure that the following three balances are identical:
Similar three-way reconciliations must be performed for each separate client trust account.
A bank charges ledger is necessary because the firm must deposit a nominal sum (say $100) in a client trust account to cover potential future bank charges. This amount is not reflected in the client ledgers.
These reconciliations should be performed by someone in the finance department, unconnected from the function of recording transactions. For example, this responsibility is often undertaken by the controller or accounting manager, and the reconciliations are reviewed by the firm administrator.
5) Adhere to Client Notification Requirements When Funds Are Received and Before Funds Are Withdrawn for Fees
Clients must be notified promptly upon receipt of funds into an IOLTA or their client trust account. The best way to do this is to have the accounting system generate statements for each client ledger balance. Disbursements to pay for costs may occur frequently. It is therefore critical that the record keeping for each client trust account be kept up-to-date to ensure that a client balance never goes negative.
Whenever the firm receives funds on behalf of a client, a statement should be sent to the client showing the transactions and the current balance in the account. It is best practice for a statement to be sent monthly to any clients with client trust fund balances (regardless of whether these are in the IOLTA or individual client trust accounts). The current-month statement would show the balance at the start of the month, any receipts of new funds, any disbursements made for fees and costs, and the balance at the end of the month.
A separate notification must be sent before the law firm withdraws funds from a client trust account to pay the firm's fees. Once fees are earned by the law firm, the firm's bill for services should be rendered and the bill should inform the client that the bill will be paid from funds kept in the client trust account.
The transfer of funds for fees can be made using a check payable to the law firm, or by authorized electronic transfer to the firm's operating account. The timeliness of the transfer is critical because if it is done incorrectly or not at the proper time, the firm will be guilty of commingling the client's funds and its own funds (the earned fees).
6) Avoid a Dishonored Check Notification
In many states, in order to qualify as a financial institution authorized to handle client trust accounts, banks must agree to notify the Board of Bar Overseers if a check drawn on an IOLTA or client trust account is dishonored.
In the event of a notification of a dishonored check, the Board of Bar Overseers will write to the law firm and request an explanation for the dishonored check. This may result in an audit of the firm's client trust account records. If explanations are not satisfactory, possible sanctions against the attorneys and law firm involved could be made.
You can avoid the risk of a dishonored check by ensuring that the funds deposited in the trust account have properly cleared before any checks are written or transfers are made. Also, having good procedures in place for recording transactions on a timely basis and reconciling client trust accounts regularly will help ensure that this unfortunate situation does not arise. A regular review of bank account records is also necessary so that any accidental errors that a bank may make, such as applying funds to the wrong client trust account, are caught immediately.
7) Know Who Is Responsible for 1099 Reporting
The firm's accounting staff should understand its responsibility under the Internal Revenue Service Form 1099 reporting rules for transactions involving client trust accounts.
As an example, say your firm represents a client who is the plaintiff in a contingent fee case for discrimination, for which the client wins $1 million; your firm's fee is $300,000 plus costs. Another attorney is hired by your firm to act as an expert witness in this case, and her fee is $10,000. The $1 million paid in settlement is deposited into your firm's IOLTA account, and your firm disburses $10,000 to the expert attorney, $690,000 to the client and $300,000 to your firm's operating account in payment of fees.
In this example, IRS rules require multiple 1099s to be issued. Your client is required to issue a 1099 to your firm for $310,000 in legal fees. Your firm is required to issue a 1099 to the expert attorney for $10,000. The defendant company is required to issue a 1099 reporting $1 million paid to your client.
Consult the IRS Treasury Regulation 1.6045-5 for numerous examples of 1099 reporting involving attorneys.
8) Avoid Money-Laundering and Other Fraudulent 'Scams' By Having Sound Client Identification and Acceptance Procedures
What follows is one example of the many “scams” that law firms have fallen victim to in recent years. Remember that if you deposit a fraudulent check, the funds may not clear and any subsequent payments made on that deposit could result in the use of other clients' monies. If the scam involves your IOLTA or client trust account, then the State Board of Bar Overseers must be notified, which could trigger an audit and the risk of sanctions against your law firm.
An attorney receives an e-mail from a foreign business or person asking him to deposit some money in a client trust account and then wire transfer funds to a third party. The e-mail promises that the firm can keep 20% as a fee, and there is the suggestion of the possibility of representing the client in the future. The e-mail may include a link to the Web site of a company that appears to exist. The firm may even receive an authentic-looking check.
The golden rule is to know the company or person with whom you are doing business. If something seems too good to be true, it typically is! There is no substitute for appropriate client intake procedures, such as obtaining an engagement letter, running credit checks, getting a Dun & Bradstreet report on the company, asking for a tax identification number, and actually meeting a client in person! If you suspect that you have been the victim of a similar fraudulent transaction, then you should notify the local police and the FBI immediately.
9) Ensure That Your Firm Is Keeping Appropriate Computerized Client Trust Account Records
In August 2010, the American Bar Association issued new Model Rules for Client Trust Account Records, replacing the Model Rules on Financial Recordkeeping issued in 1993. These new Model Rules address changes in banking procedures and data storage as a result of the electronic age.
Client trust account records that must be kept include receipt and disbursement journals, check registers, records of all electronic transfers, trust account bank statements, records of deposits made, canceled checks or substitute check images, client ledger account records, bank charges ledgers, statements sent to clients showing activity, fee invoices, and retainer and other fee agreements with clients. The firm must also keep copies of the monthly three-way reconciliations performed, as well as any information contained in client files that pertain to client trust account transactions.
Typically, records must be kept for five years after the firm ceases to represent the client and all funds are disbursed. In some states that length of time increases to six years. The new ABA Model Rules for Client Trust Account Records allow for either physical or electronic equivalents of check registers, bank statements, deposit slips and canceled checks to be kept. Many checks are now cleared by a bank electronically, and paper copies of canceled checks are no longer returned to the payor. An electronic substitute check can be the legal equivalent of an original check as long as there is an image of both the front and back of the original and the complete MICR line is visible.
Many banks are no longer issuing paper copies of bank statements, which are only available electronically for download. It is therefore critical that the firm have procedures in place to ensure that electronic bank statements and check images are downloaded regularly and stored on the firm's computer system with the firm's other client trust account records. If the firm's client trust accounts were to be audited by the State Board of Bar Overseers, the firm would have to print out bank statements and canceled check images for the auditor.
Firms should also ensure that computerized accounting systems are keeping appropriate client trust account information for the requisite number of years. Some systems archive or purge records after a set number of years, and firms change accounting systems periodically. It is best practice for the firm's accounting staff to download (for example to a PDF file) all of the client trust account records and store them outside of the accounting system on another server.
It is also important that the firm's data backup procedures are sufficient and are operating properly. Does your firm have off-site data backup storage and a disaster recovery plan in place in the event of a failure of the firm's data servers?
10) Perform a Self-Audit of Your Computerized Trust Account Records
Ensure that your firm's client trust accounting procedures and computerized trust account records are sufficient and meeting the requirements of your state rules by conducting a self-audit of the records. Perform spot checks of individual client account records. For example, select one client who has been with the firm for at least five years and download all of the trust account records related to that client. Review them to ensure that documentation is complete and includes all the necessary information for each transaction. Review the monthly three-way reconciliations and ensure that each of the three totals reconcile with the check register, bank reconciliation and client ledgers (as reviewed above). Check that timely notification was sent to the client of deposits and withdrawals from trust accounts. Audit a broad selection of the firm's client trust account records over the year. Keep the records of your audit and use the results to improve your firm's accounting procedures.
Conclusion
All firms should undertake a review of their procedures and controls over client trust accounts and the maintenance of computerized records to ensure they are in compliance with the rules of the states in which they operate. Modify the oversight and reconciliation controls now, before a fraud occurs.
Neil F. Scullion, CPA is a director in the Law Firm Services Group at Feeley & Driscoll, P.C. (http://www.fdcpa.com/). The Law Firm Services Group provides tax, accounting, business advisory and consulting services to law firms. Based in Boston, Scullion can be reached at [email protected] or by phone at 617-456-2475.
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