Law Firm Finances: Everything You Need to Get Started

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This is a detailed how-to manual for setting up accounts, managing cash flow and credit, paying taxes and managing income, and forecasting income. These are critical skills that are not taught in law school, and many lawyers struggle to stay on top of their firm finances.

This is a must-read for anyone who manages a law firm’s finances or is even thinking about starting one.

This is a long post. Why not get it for your Kindle?

Index

Getting Started

When you go solo, you are responsible for everything from client intake to marketing to dealing with opposing counsel. And you are running a business, which is a whole other can of worms.

The financial aspects of running a law practice can be complicated, stressful, and time-consuming. Here is how to get started.

Open At Least Two Accounts

You probably need at least two accounts: a business checking and an IOLTA trust account. You will obviously need to put money into the checking account, at least. (If you don’t currently have money, please stop reading and reconsider your plans to start a law firm.)

You will need a checking account for day-to-day expenses. You could actually pay for nearly everything with a credit card and rack up benefits, but be careful. You definitely don’t want to get hit with huge interest fees every month. Even if you use a credit card for most expenses, you still need a firm checking account.

If you handle client funds, you also need an IOLTA account. Your IOLTA account contains your clients’ funds, not yours. Almost any bank is capable of setting up a trust account, but you need to check the rules to see if your state has additional requirements.

Opening Deposits

The amount of money you need depends on what type of cases you want to handle. Assuming that you are paying rent, malpractice insurance, and buying office supplies, I would suggest starting with $3–5,000.

It is a good idea to plan not to make much money for at least the first three months, even though you will need to cover expenses. Make sure you have that money in the beginning so you have one less thing to worry about in month two when you are still waiting on your first payment.

For the trust account, check the requirements in your jurisdiction. Although your IOLTA account cannot be your operating account, some jurisdictions allow you to deposit a nominal amount of money into your IOLTA account to cover service fees. Otherwise, those fees would come out of client funds, which is not good. Check your local rules to see what you can keep in the IOLTA account, if anything.

Choose the Right Bank

There are plenty of factors to consider when choosing a bank. One: if you already have accounts at a bank, you may want to open your business accounts there as well. It might streamline the application process. More importantly, it is usually easier to transfer money between your business and personal accounts. When you need to pay yourself, having all your accounts in the same place is usually a breeze.

Two: location, location, location. Especially when you first start your practice, there will likely be some hiccups during the startup phase. For example, you might deposit money but the bank deposits it to the wrong account. Or the bank erroneously charges a service fee to your trust account. Going into the bank to deal with these issues in person is more time-consuming, but it is usually more effective than trying to fix problems over the phone.

Depending on your practice area, you may need to make frequent deposits. Some banks now allow you to make deposits from a smartphone. Others are quick at handling transactions through the mail. I’m not a fan of either option. When I get a check, I drive to the bank and make a deposit. That may not be the most economic use of my time, but my bank is less than half a mile from my office, and I usually just stop in on the way to or from work.

Three, and not to be underestimated: customer service. As mentioned above, you will inevitably have some hiccups at the beginning of your relationship with your bank. If the bank’s customer service comes up short, take your business elsewhere. Even if you end up paying slightly more in service charges, you need a bank that can handle your needs. When you are running a firm, you have ten million concerns. The right bank will give you more time to focus on the non-banking ones.

Cash Flow and Lines of Credit

Once you have made the initial financial arrangements for your firm, you are ready for step two: dealing with cash flow and lines of credit.

Cash Flow is Different than Generating Receivables

Cash flow is money coming in your door and available for you to deposit and spend. That is very different than generating receivables and billing time. The quicker you can wrap your head around the difference, the better, because cash flow is critical.

For example, on contingent-fee cases, I don’t get paid unless I am successful and until I actually receive a check from the defendants. Some cases don’t resolve for months or over a year, while others resolve relatively quickly. Either way, it doesn’t mean much until the check arrives. This can create a major cash flow crunch at certain times.

I also defend consumers in debt collection lawsuits. For those cases, I require up-front payment — I get paid prior to completing the work. Most of these cases involve a limited-scope representation — unbundled services — like drafting an answer, discovery responses, or negotiating a settlement. They don’t generate as much revenue, but they do generate cash flow.

Figure Out Your Monthly Budget — Including What You Need to Pay Yourself

If you are running a small firm or work as a solo attorney, you are likely handling your own bookkeeping. You should also know what your firm’s expenses are every month. They will vary from month to month, of course, but you should have a good idea of the average.

Your monthly budget is your break-even point. In other words, you have to bring in at least enough to cover your expenses. That may sound obvious, but lots of new attorneys somehow forget about expenses (and taxes — keep reading).

Once you know your budget, now you need to figure out what you need to pay yourself every month. Yes, most people like to get paid, but many solo attorneys are fortunate enough to have another income-earner in the household. For them, income from their practice may not be critical to supporting their household. They may be able to pay themselves significantly less — or even not get paid at all. That flexibility can certainly make things easier.

Assuming you need to pay yourself, figure out how much you need. Not how much you want to make, or how much you think you can make, but how much you need to make in order to make your practice work. If you don’t have a household budget, now is the time to figure it out and determine your magic number.

Once you have that number, add it to your expenses. That total monthly budget is now much bigger than you probably expected, and you may be experiencing the following side effects: nausea, heart palpitations, nervousness, and second-guessing your plan to start a law practice. If you are experiencing of those side effects, congratulations! You are perfectly normal, healthy, and ready to start a law practice.

That number is probably scary, but it’s also probably workable. Knowing that number will guide you, motivate you, and help you run a successful small firm.

Using Credit to Alleviate Cash Flow Problems

Credit cards and lines of credit can be a great way to create temporary solutions to cash flow issues. Note the use of the words can be and temporary. Paying yourself (or your expenses) with a credit card or a line of credit is simply delaying the due date on those expenses. It is not a magic wand.

Think of it this way: you need to pay yourself $3,000, but you don’t have $3,000 right now. In two weeks, however, you will receive $5,000 from a settlement. In that scenario, using a line of credit or credit card to pay your salary might not be a bad move. If you cannot count on getting paid in two weeks, advancing yourself money isn’t quite as smart.

Lines of Credit

Lines of credit are nice because you can usually transfer funds instantaneously from your line of credit to another account. If you need some instant cash in your operating account, it is just a few clicks away. However, there are two major downsides.

One: interest starts accruing immediately and daily. Credit cards usually give you a 21–28 day grace period — if you pay the bill in full during that time, you pay no interest. It doesn’t work that way with lines of credit. You start paying interest immediately, even if you pay back the loan in two days. Under certain scenarios, it might make sense to pay the interest, but spending money just to get money is generally a losing proposition.

Two: most lines of credit require a personal guarantee. If your business has a $12,000 line of credit and you exhaust it and then default, the bank will come after you personally. In addition, you probably agreed to pay their collection costs, interest, and you may have waived your right to a jury trial. In other words, you are in big trouble if your firm defaults.

If you want a security blanket, lines of credit are nice, but only if you can exercise restraint and use your line of credit only when it is absolutely necessary. If you simply want access to a big chunk of money and don’t understand cash flow, do not get a line of credit.

Credit Cards

Credit cards are nice because you can get your firm name on a piece of plastic. I guarantee it will make you feel more legitimate. Credit cards also usually have lower balance limits, offer fraud protection, and offer a grace period to pay off your balance without charging interest.

The lack of interest is a huge issue. That means you can pay expenses now on credit, and pay it back within weeks without having to pay interest. If you use it correctly, you can use a credit card to bridge gaps in cash flow and make your life much easier.

Fraud protection, travel insurance, and extended warranties are other bonuses for using credit cards. If you have ever had your identity stolen, then you know how important that can be. Unfortunately, like a line of credit, a credit card will usually require a personal guarantee. In my humble opinion, a credit card is superior to a line of a credit.

Paying Taxes and Managing Income

The next step is what I consider a good problem: what to do when you make money. Make sure you withhold for taxes and stuff some cash under a mattress for the inevitable bad month.

Yes, You Have to Pay Taxes

In case you didn’t already know this, I’ve got some bad news: small business owners have to withhold and pay their own taxes. You need to pay estimated taxes throughout the year or take a penalty and write a bigger check at the end of the year (disclaimer: I am not an accountant or a tax attorney; I just pay taxes).

I know lots of solos, and exactly none of them use a payroll service to pay themselves. That means they are responsible for withholding and paying their own taxes. Some of them are better at it than others. For many attorneys, settling a big case means it’s time to go buy a new car, a new computer, or a new suit. In other words, spend everything and assume you can withhold enough for taxes later. Last time I checked, some of those attorneys were making installment payments to the IRS. I’d suggest avoiding that.

Here’s an easy way to avoid it: open a separate bank account that only contains money for taxes. When your firm receives money, set aside about a third for taxes. In all likelihood, that is an excessive amount. When you do your taxes (or when an accountant does them), you can pay yourself a nice bonus because you have an excess. The alternative is to guess low and end up having to cough up some extra cash to pay your taxes. I’d rather err on the side of caution, but depending on your financial situation, that may not be possible.

The reason to keep the money in a separate account is to ensure it doesn’t get spent, and to make it easier to track. If you simply put everything into your operating account, it will be harder to know how much money is set aside for taxes. If you are withholding a third of your revenue and transferring it into a special account for that purpose, you should get any fees waived, as well.

Open Another Account for Excess Revenue

Cash flow is like a roller coaster, but less predictable and less safe. Depending on your practice area, you might go months without generating much income. One month you might make $15,000, but the next two might result in $2,500, total. I’m not pulling those numbers out of thin air — that is based on real-life experience.

During a great month, I don’t buy a new car, a new computer, or a new suit. I pay myself the same salary that I make when my income for the month is just $50. The only reason I can do that is because I stick all the excess into my fourth account, my excess account. I call it the “rainy day” account. Or, practically speaking, the “I can pay myself out of this account when I have a month that sucks” account.

You will have bad months. If you still want to pay yourself during those months, create an excess account. Even if you just need to float some cash to pay part of your salary, an excess account is perfect for that. Psychologically speaking, having an account with a few extra months of paychecks in it is worth ten times the actual balance. Even if you cannot afford to put much in an excess account, make contributions when you can.

Until you get used to the ups and downs of cash flow, just knowing you have a safety net is useful, even if you never touch it. Unfortunately, chances are you will probably need to dig into your excess, but hopefully not to the point of draining it.

Forecasting Income and Balance Sheets

Some attorneys spend inordinate amounts of time doing their works and paralyzed by the constant fear of not making money. The fear never goes away, but it does get better.

After a few months, take a look at your balance sheet and consider forecasting income to help maintain your financial sanity.

Spend Quality Time with Your Income Statement

So you’re making money, you think you will continue to do so, and you are even paying yourself a modest amount. Why is that amount so modest? If you are doing your accounting correctly, your income statement sheet should provide answers.

If you have a bookkeeper, then ask them to generate you a detailed income statement every couple of months. Otherwise, use your accounting software to generate it yourself.

Your income statement will show you income, expenses, and what your firm has actually made. I previously talked about making a monthly budget and the importance of knowing what it takes to run your firm every month.

Looking at your income statement will help you catch changes in those numbers and help you decide if your expenses are worth it. I know lots of attorneys who are constantly surprised at how much they spend. That’s not a good thing.

Your income statement should also give you helpful feedback on how your firm is making money, if you separate your revenue sources. Knowing whether divorces or criminal defense are your bread and butter can help you tweak your advertising, your intake, and maybe even your rates.

Don’t Count Your Chickens before They Hatch — Most of the Time

It’s dangerous to rely on any revenue that is not actually in your possession and control. Whether you bill clients monthly or do contingency work, it can be easy to spend money you don’t have by looking at what “should be” coming in soon. If you take anything from this post, it should be to exercise financial responsibility — don’t spend money that you do not have.

However, you may find yourself working your butt off but freaking out about cash flow if you have gone a while without getting paid. That is a major downside of contingency work, especially. Until the case settles and the settlement check rolls in, you do not make a dime. When this happens, I pull out my legal pad, list all my cases, and make a conservative projection of what the cases will settle for, and when. I still might not see any money for months, but it provides reassurance that there will be a payoff down the road from busting my butt.

Again, there’s no guarantee of getting anything until I actually receive the check and it clears. Psychologically speaking, however, doing a projection can help put your mind at ease — at least for a couple of days. When it happens again, do another projection.

Good Times to Buy Equipment

If you withhold money for taxes, stash away cash for a rainy day, and still have money left over, it’s a good time to upgrade your equipment. If you need a new desk, new client chairs, or a new computer, make them when you have extra money.

Don’t wait until the chair breaks or your hard drive fizzles out. Just upgrade now. Otherwise, there is a decent chance your computer will just happen to go kaput during a really bad month. You cannot plan for the unexpected, but the right time to make business purchases is when you have the cash on hand.

I would still be careful about going overboard, but spend the money when you have it, not when you are praying for it to come in the door. It’s also a nice tangible and physical reminder that you made money (and will likely continue to do so). Another nice side effect if are buying something for your business is that it should be deductible. Yes, you are still spending the money, but it should offset some of your income and in theory lower your taxes. That doesn’t mean the purchases are free, but you get the idea.

It Gets Easier

Running your own firm is not easy. Chances are good it will actually be much harder than you anticipated. Fortunately, the longer you do it, the easier it gets. Hang in there and reach out to other resources (tax attorneys, accountants, other attorneys) when you need help. And never forget that your IOLTA account is only for client funds!

Featured image: “Little Girl Playing with Colorful Abacus Beads” from Shutterstock.

Practice Management, Starting a Law Firm

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  • http://constructionlawva.com/ Chris Hill

    Randall,

    All good points. I don’t use a payroll service, but I did hire an accountant to help with the expense tracking, taxes, etc. and to handle my year end tax return for the firm. He also handles “payroll”. While this is a monthly expense (he charges a flat monthly fee), it is a fee that is less than the value of the time it would take me to do the “back office” work that he handles for me.

    I know this isn’t for everyone, but it’s been a good arrangement for me.

  • Paul Spitz

    Excellent overview. I would strongly advise keeping overhead as low as possible, and watch expenses carefully (but not foolishly, because some money is well-spent). When your overhead is low, you don’t feel like you are bleeding from gaping wounds during slow periods.

  • aff

    Kinda dumb question: in your writing you say “When your firm receives money, set aside about a third for taxes.” Isn’t it more accurate to say when your firm distributes money, set aside a third for taxes? You don’t pay taxes on revenue (when your firm gets $$), only when it makes a distribution (when your members have income). In my case, I have a single member LLC with pass through taxation for now. When I want to pay myself $1000, I set aside an extra $300 in my taxes account, and $1300 total comes out of my operating account. When I want to buy a new laptop, I just spend $1000 from my operating account and don’t set aside any $$ for taxes, because it’s not income.

    • Aaron Street

      Without getting too deep into taxation laws (of which I’m not an expert), neither of these is correct.

      A single-member pass-through LLC is taxed not on “distributions” but on “net income.” So the proper amount to set aside for taxes would be based on your revenue minus your expenses, not just the amount you actually distribute to yourself.

      30% is a safe estimate to give yourself a cushion, but after your first year, you could develop a more precise calculation of what your actual effective rate is. For most people, your effective rate is probably closer to 20% after exemptions and deductions, but it can vary wildly based on your personal financial status.

      • http://samglover.net/ Sam Glover

        I think part of Randall’s point was that it’s better to overestimate your taxes and give yourself a bonus at the end of the year than to underestimate them and have to come up with a chunk of cash to pay in.

        • Aaron Street

          That’s how I read Randall’s post, too.

          I think for your first year (or two) over-estimating/over-saving is a great idea. After a couple of years, though, you should be able to calculate it more precisely.

          “Bonus” money feels fun in the moment, but windfalls tend not to be the best strategic use of funds.

          • Randall Ryder

            I would agree with all of that. I have altered my withholding/set-aside amounts now that I am in year 4 of my firm. But I have refrained from paying myself a huge bonus based on a good settlement outcome.

    • Anne-Marie Rábago

      Aff, this is not a dumb question at all! I am a business and tax attorney (for attorneys) and pass through taxation is a difficult concept to wrap your brain around. I spent a full year studying Subchapter K, and I still have to go back and review many of its intricacies.

      Aaron is correct as a single member LLC, you will pay income taxes on all of the profit (gross revenue minus allowable expenses) you generate in your law business. PLUS, you will pay a 15.3% self-employment tax on all of the profit you generate in your law business.

      An LLC gives you some liabilities protections (obviously not professional liability), but and LLC offers zero tax benefits. As a single member LLC, you are taxed JUST like a sole proprietor unless your state allows and
      you make an affirmative election to be taxed as either a C or an S
      Corporation. This is where you would be very very wise to hire a tax professional who can help you understand the nuances of how your business would be taxed while operating in these different forms.

      In terms of the amount to set aside for taxes, this varies greatly from state to state. Given the 15.3% self-employment tax I mentioned earlier, I would say that at 20% effective tax rate seems quite low. Here in California (where our highest marginal tax rate is now 12.5%), I generally recommend that my clients save set aside 30-40% depending on the rest of their financial picture. For the ones who are interested, I sit down with them and determine more accurate estimates based their individual facts and circumstances. This is another service a good tax professional can and should offer to clients!

      One last comment, I love most everything that Randall has said here. The only point I take pause with is the addition of a third and fourth bank account. I find that most attorneys have enough trouble keeping up with their finances, tracking, and reconciliation for two business bank account (operating and IOLTA). While I agree with the principal and purposes behind the two additional accounts, I say keep it simple. Until you have the resources (time being one of them) to handle the additional burden, just practice some discipline. Overall, great guide here, Randall!

      • Randall Ryder

        I agree that having extra accounts means extra burden. But it’s a fairly minor burden and those two accounts require about 10% of the time of the other two accounts. I regularly encounter attorneys who have serious financial issues at tax time because they did not withhold any money for taxes. That’s insane. Having that extra account makes it easy and formulaic.

        • Paul Spitz

          Many banks will waive account management fees if you hold multiple accounts at the bank. Adding a savings account for tax set-asides may eliminate those $12/month account fees.

          • http://samglover.net/ Sam Glover

            I should try that. I have plenty of accounts at my bank.

  • Craig Hensel

    Good review, generally. I did spot one error, though.

    “You will obviously need to put money into both accounts [operating and IOLTA].” This is wrong. In fact, this is dangerously wrong. Unless your IOLTA charges fees, not only SHOULD you not put money in there, but you CANNOT put money in there. The IOLTA is for client funds only. You could get in trouble with the bar if you’re throwing your own money into an IOLTA.

    • http://samglover.net/ Sam Glover

      If you read the very next section, I think it will make more sense to you. In at least some states, you actually need to keep a nominal amount in the trust account in case of bank fees or accidental charges.

      • Craig Hensel

        I saw that it was covered later (kind of, and without retraction). Was not aware that some states require a cushion for accidental charges—NC does not.

        In any case, the sentence “You will obviously need to put money into both accounts” is still there, and “obviously” implies that it’s categorically true. That’s dangerous advice. I can see how someone just starting up, with their mind scattered on a thousand different things, may come away from this with a less-than-clear picture about what they can and cannot do with the IOLTA.

        • http://samglover.net/ Sam Glover

          I’ve updated the post to address your concern.

      • Jonathan Kleiman

        I was simply able to get the bank to take all fees for my trust account out of my general account

        • http://samglover.net/ Sam Glover

          In theory. My bank said it would do that, too. Then every time I ordered checks they would get charged to my trust account anyway.

          • legalofficeguru

            Does your bank *require* you to order checks from them? I generally find they’re the most expensive option, and if you order elsewhere, you’ll have complete control over what account you use you pay for them.

  • Marzella Law Group

    I like the part where you talk about buying new equipment. If you can set money aside to do this, and get equipment before the old stuff breaks, then you can probably even go and sell your old equipment for a small amount, meaning the new equipment costs even less. Small amounts, but every little bit counts. We just did this and were very happy with the deals we got.

    http://www.marzellalawgroup.com/practice-areas/business/

  • Jonathan Kleiman

    So true about using credit

  • Jonathan Kleiman

    A tip for keeping overhead down with a virtual office: I do “free consultations” and meet clients when necessary from my Regus office. I pay about $300 per month including the use of reception and the hours I use. Once or twice a week I will book new consultations into 10 minute slots. I meet them, tell them what I can do, take a copy of their ID, and send them on their way. It has really kept overhead low and allows me to work from anywhere (library, starbucks, client’s office, etc)

  • Trapp Law Firm

    This is a great article and has provided me with some great information. The income statement info was very helpful. I have always just taken what money is made, and never looked into what I can do to be more profitable. After having someone create me an income statement I noticed that there are a few expenses that i can cut back on.

  • Brian Scott Lyda

    I really like the article and the related comments. Thank you for posting.

    But what is lacking in the discussion is “how” to create the income to start the process. When you have a “down” month, when you’ve tapped your credit line, when you’ve made an agreement to pay installments with the IRS, etc., the solution is in the “how”. I’ve read what seems like thousands of articles on the reasons for/against starting a law practice, how to set up the office, the equipment selection, staffing, etc. But it seems that no one shares the “how”. I get the networking piece, referrals, etc. but when the well dries up, where can you go for more income?

    • http://samglover.net/ Sam Glover

      That’s a question about marketing or business strategy, not finances. But the bottom line is that if the well dries up, you go find another well. Kick your marketing efforts back into high gear, for example, or try another practice area, or go get a job.