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.
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.
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 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!
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