Who Pays Tax on IOLTA Interest? | Kathryn Meyer Law PC

Usually no one: in California, interest on a pooled IOLTA account is paid to the State Bar, which says the remittance has no tax consequences for the lawyer or the client. Interest on a separate trust account held for one client is paid to that client, and the IRS's audit guide for attorneys says it is taxable to the client. The lawyer's job is to choose the right account and keep records that show whose money is whose.

Trust accounts are also where an IRS examiner starts when a law firm is audited. Getting them right is part of Kathryn Meyer's work on tax planning for law firms.

How trust account interest is handled, step by step

Client money goes into a trust account. Rule 1.15(a) of the California Rules of Professional Conduct requires funds held for a client, including advances for fees, costs and expenses, to be deposited in an account labeled "Trust Account" or similar, maintained in California unless the client consents in writing to another jurisdiction with a substantial relationship to the client or the client's business.
The lawyer decides which kind of trust account. Under B&P 6211(a), client funds that are "nominal in amount or are on deposit or invested for a short period of time" go into an IOLTA account, and they may be pooled in a single account. The State Bar says funds that can earn income for the client above the costs of holding them must be deposited for the client's benefit instead (B&P 6211(b)).
The IOLTA is opened at an eligible institution. B&P 6212(a) requires an eligible institution, and the State Bar posts the list. Since January 1, 2026, lawyers must give the bank the State Bar's Notice to Financial Institutions naming the designated licensee and State Bar number for every new trust account; for existing accounts the deadline was July 1, 2026.
The bank sends the interest to the State Bar. B&P 6212(e) directs the institution to remit the interest, less reasonable fees, to the State Bar at least quarterly, and to send the lawyer a report of what was paid, the rate, the fees and the average balance.
The account carries the State Bar's taxpayer number for the interest only. The State Bar says its federal taxpayer identification number covers only the interest paid to it, not the principal of settlements or other funds in the account.
Interest on a separate client trust account goes to the client. B&P 6211(b) allows interest-bearing trust accounts with the interest "payable to clients" for funds not placed in an IOLTA.
The lawyer keeps the records. Rule 1.15 and the State Bar's record standards call for a ledger for each client, a journal for each account, bank statements and cancelled checks, and a monthly reconciliation, kept for at least five years after final distribution.

Who is taxed on what, account by account

Account	Who receives the interest	Tax result	Authority
Pooled IOLTA account	State Bar of California, through its Legal Services Trust Fund Program	No tax consequences to the lawyer or the client; no Form 1099 needed because the State Bar is tax exempt	B&P 6211(a), 6212; State Bar trust account banking guidelines; IRS Publication 5602
Separate interest-bearing trust account for one client	The client	Taxable to the client for whom the account was established	B&P 6211(b); IRS Publication 5602, citing Rev. Rul. 87-2
Noninterest-bearing trust account converted with State Bar approval	No one; the account earns nothing	None; the lawyer pays all account fees	State Bar trust account banking guidelines
Firm operating account	The firm	Interest is gross income of the firm	IRC 61(a)(4), as quoted in IRS Private Letter Ruling 199909032

The State Bar's Legal Services Trust Fund Program, which receives IOLTA revenue, describes itself as the State Bar's grant-making arm and says the money helps fund civil legal services programs serving low-income Californians.

What the IRS has said about IOLTA interest

The IRS's Attorneys Audit Technique Guide (Publication 5602, revised January 2022) says interest earned on pooled trust account funds and paid over to the IOLTA program "is not taxable to the clients, the attorney, or the organization itself," while interest on segregated trust funds "is taxable to the clients for whose benefit they were established," citing Rev. Rul. 87-2. The guide also says that segregated accounts may carry the identification number of the bar, the IOLTA program or the client, and tells examiners to contact the state bar about how accounts are handled. The guide states on its cover that it is not an official pronouncement of the law or the IRS's position and cannot be cited or relied on as such, so it shows how examiners are trained rather than binding the IRS.

The IRS also issued a private letter ruling in 1999 on another state's IOLTA program, ruling that the interest paid to that state's bar foundation was not includible in the income of the client or the law firm, that the firm was not the payor required to report it, and that the bank generally did not have to report it either, unless backup withholding was imposed and not refunded. That ruling says it is directed only to the taxpayers who requested it and, under IRC 6110(k)(3), may not be used or cited as precedent. For California, the State Bar's own guidance is the clearer statement: no tax consequences to lawyer or client, and no Form 1099 needed for IOLTA interest remitted under the State Bar's number.

Why the trust account matters in an audit

The same IRS guide explains that because many attorneys compute gross income from withdrawals out of the client trust account, analyzing that account "is obviously the first step in the audit process," and examiners should also look at deposits into every other account. The firm's tax planning page makes the same point from the other side: if you are audited, the IRS will want to see your trust account, so protecting clients' information is part of getting through the audit properly. The limits of privilege for client names and fees are discussed in Don't Neuberger Your IOLTA Account. The IRS's power to go to banks directly is covered in whether the IRS can contact your bank, clients or employer during an audit.

What changes the answer

The size and length of the deposit. B&P 6211(a) limits IOLTA to nominal or short-term funds; the State Bar points to the factors in Rule 2.110(A) of the Rules of the State Bar and says it will not discipline a lawyer for a good-faith decision on whether funds go into an IOLTA (Rule 2.110(B)).
Which taxpayer number is on the account. The State Bar's tax statement covers interest remitted from an IOLTA "that bears the State Bar's taxpayer identification number."
Bank fees. B&P 6212(c) allows only reasonable fees to be deducted from IOLTA interest; other charges fall on the lawyer, and the State Bar calls items like check printing and wire fees the lawyer's business expenses. Which expenses a firm can deduct is covered in which law firm expenses are deductible.
The lawyer's own money in the account. Rule 1.15(c) allows only funds reasonably sufficient to pay bank charges, plus mixed funds whose lawyer portion must be withdrawn at the earliest reasonable time once fixed.
What flows out of the account. Interest is one question; settlement and fee disbursements raise information reporting questions of their own, covered in when payments to your law firm are reported on Form 1099.
Cash coming in. Large cash receipts into any firm account can trigger federal reporting; see whether your law firm has to report cash payments over $10,000.

For example: retainers in the IOLTA, sale proceeds in a separate account

For example, a California firm holds small advance fee deposits for 40 clients in one IOLTA account. In a quarter the account earns $60 of interest, the bank deducts $20 of reasonable fees, and it remits $40 to the State Bar with a report to the firm. Under the State Bar's guidance, neither the firm nor any client has tax consequences from that $40, and no Form 1099 is needed. The same firm also holds $400,000 for one client from the sale of a home, which will sit for nine months while a dispute is resolved. Because those funds can clearly earn net income for the client, the firm opens a separate interest-bearing trust account for that client under B&P 6211(b). If that account earns $6,000, the interest belongs to the client, and under the IRS audit guide it is taxable to the client. The firm records both accounts in its ledgers and reconciles them monthly. This is a hypothetical, not a real case.

Common mistakes with trust account interest

Leaving large or long-term client funds in the IOLTA. B&P 6211 reserves IOLTA for nominal or short-term funds; money that can earn net income for the client belongs in an account for that client.
Using the State Bar's taxpayer number beyond the interest. The State Bar says its number is only for the interest paid to it, not the principal in the account.
Leaving earned fees in trust, or paying personal costs from it. Rule 1.15(c) requires the lawyer's share to come out at the earliest reasonable time; claiming substantial business expense deductions for personal expenditures is on the IRS's list of fraud indicators in IRM 25.1.2, as explained in the warning signs that a civil IRS audit could turn criminal.
Skipping the 2026 bank notice. The Notice to Financial Institutions was due by July 1, 2026 for existing accounts and is required for every new one.
Not reconciling monthly. The State Bar's record standards require a monthly reconciliation of client ledgers, account journals and bank statements.
Treating the trust ledger as private. The IRS audit guide treats it as the starting point, and the firm's IOLTA post explains why client identities and fee arrangements are rarely privileged.

What to do this week

List every trust account the firm has and mark each one as IOLTA or a separate client account.
Confirm a Notice to Financial Institutions was served for each account, and that "Report my IOLTA status" in My State Bar Profile is current.
Review any client balance that is large or has been held for months, and decide whether it should move to a separate interest-bearing account.
Check the last three monthly reconciliations against the client ledgers and bank statements.
Move any earned fees out of trust and confirm no firm or personal expenses are paid from it.
Add a yearly trust account review; it is the third-quarter topic of the Quarterly Tax Health Checkup.

Frequently asked questions

Does the firm report IOLTA interest on its tax return?

No. The State Bar says there are no tax consequences to the attorney or the client for interest remitted to the State Bar from an IOLTA bearing its taxpayer number, and the IRS audit guide says that interest is not taxable to the attorney.

Will the bank send the firm a Form 1099 for IOLTA interest?

The State Bar says it is not necessary for the bank to complete a Form 1099 for IOLTA interest, because the State Bar is tax exempt. The bank does send the firm a periodic report of what it remitted (B&P 6212(e)).

What happens if bank fees are larger than the interest?

The State Bar says a lawyer whose fees routinely exceed the interest may apply to convert the IOLTA to a noninterest-bearing trust checking account. The State Bar's number is then removed, and the lawyer pays all fees.

Does a client have to report interest from a separate trust account?

The IRS audit guide says interest on segregated trust funds is taxable to the clients for whose benefit the accounts were established. A client with funds in such an account should keep the bank's interest statements with their tax records.

How long must trust account records be kept?

Rule 1.15 requires records of client funds and property to be kept for at least five years after final distribution. Tax records may need to be kept for other periods, as explained in what records the IRS requires to support business deductions.

Do these rules apply outside California?

Each state runs its own program. The IRS audit guide notes that IOLTA programs are set by state statute or court rule, so a lawyer licensed elsewhere should check that state's rules.

Keeping trust accounts audit ready

Trust accounts are where client protection and tax compliance meet. Kathryn Meyer spent more than two decades in the IRS Office of Chief Counsel and knows how examiners approach a law firm's books; the Quarterly Tax Health Checkup includes an IOLTA review in its third quarter. To review your firm's accounts, contact the firm or call (571) 560-8674.

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