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Industry tax guide

Law firms tax and accounting

Tax and accounting for practices that hold client money and advance case costs.

Law Firms business environment

Law firms hold client funds in trust, advance costs on cases that may take years, and distribute most of their profit to partners who live in different states.

That creates tax questions specific to the practice: when advanced costs are deductible, how partner income is taxed, and how state entity-level taxes can work around the SALT cap.

Compared with a general business

What makes taxes different for law firms

Client trust accounts

IOLTA funds belong to clients and stay out of income until earned and transferred.

Advanced case costs

Costs advanced on contingency cases are treated as loans until the case resolves.

Specified service business

Law firm income loses the QBI deduction above the income threshold.

Partners in many states

Partners resident in different states need composite returns, withholding or PTET elections.

The rules in detail

Tax rules for law firms

Advanced case costs

Filing fees, expert fees and other costs a firm advances on contingency cases are generally treated as loans to the client, not deductible expenses, until the case resolves and the firm knows whether it will be repaid.

Law is a specified service business

Partners above the income threshold lose the 20% qualified business income deduction on legal fees. Retirement plans, including cash balance plans, become the main way to reduce partner taxable income.

Pass-through entity tax elections

Many states let a partnership or S corporation pay state income tax at the entity level, where it is deductible for federal purposes, letting partners work around the $40,400 SALT cap in 2026.

Planning moves

Ways to save tax in law firms

  1. Cash balance plans for partners

    Large deductible contributions for senior partners.

  2. Make the PTET election

    Partners deduct state tax above the SALT cap.

  3. Use the cash method

    Most law firms report fees when collected.

  4. Deduct unrecovered case costs

    Costs are deducted when a case resolves without recovery.

  5. Structure partner compensation

    Guaranteed payments and allocations reviewed each year.

  6. Deduct office build-outs

    Interior improvements qualify for 100% bonus depreciation.

Working with OICPA

How we help

Service

Partner compensation and PTET

Allocations, guaranteed payments and state entity-level tax elections reviewed each year.

Business Tax Advisory
Service

Trust accounting and monthly close

IOLTA reconciliations, case cost tracking and a fixed close calendar.

Month-End Close
Service

Plan partner tax for the year

Projections and estimates for partners who receive income from several states.

Business Tax Planning

Bookkeeping and reporting

The accounting behind the tax work

Client trust funds are never the firm's money, and every other financial decision a firm makes sits on top of that discipline. We build the trust accounting, revenue recognition, and partner compensation practices that hold up to bar and IRS scrutiny alike.

Trust accounting risk

Client funds held in trust have to stay segregated and reconciled client by client. A firm whose books don't explicitly separate trust balances from firm revenue is one mistake away from an ethics and accounting problem at once.

Contingency fee timing

Fee income from a contingency matter isn't earned until the case resolves and the fee is collectible, not when it's filed, and not based on an optimistic estimate. Smoothed revenue estimates make monthly numbers easier to read but less accurate.

Partner compensation scrutiny

Legal income is unusually well-documented for benchmarking, which means a reasonable compensation figure set once at formation and never revisited is a real, avoidable weak point in an S-Corp election.

What you can expect

  • Trust account reconciliation separate from firm operating books
  • Contingency and referral fee revenue tracking tied to actual case resolution
  • Annual reasonable compensation memo with comparability support

Frequently asked questions

When can we deduct costs advanced on a contingency case?

Generally when the case is resolved and the costs are not recovered. Until then, they are treated as loans to the client.

Is client trust money our income?

No. Funds held in trust belong to clients and are not income until earned and transferred to the operating account.

Does a PTET election help our partners?

In most states with an entity-level tax, yes, for partners whose state taxes exceed the federal SALT cap. Some states require the election early in the year.

Related articles

References

  1. 26 U.S. Code § 199A: Qualified business incomeLegal Information Institute, Cornell Law School
  2. Publication 538 (01/2022), Accounting Periods and MethodsInternal Revenue Service

Rules reflect federal tax law as of November 2026.