Client-Billable vs Firm Expenses

To keep client-billable expenses and firm operational costs separate, it's essential to establish clear distinction between the two. This means maintaining separate bank accounts for client funds and firm expenses, which can be a straightforward process if done correctly. By understanding the differences between client-billable and non-client-billable activities, such as understanding IRS per diem and mileage rates, it's also crucial to differentiate between billable and non-billable activities. This distinction is vital for accurate client billing, financial management, and tax compliance. For the bigger picture, see our guide to expense management for law firms.

Understanding IRS Per Diem and Mileage Rates

• High-cost localities: $329 per day (up from $319 for 2025-2026)
• Other localities within the continental U.S.: $230 per day (up from $225 for 2025-2026)

• January 1 to June 30, 2026: 72.5 cents per mile
• July 1 to December 31, 2026: 76 cents per mile

IRS per diem and mileage rates are updated annually by the IRS, typically taking effect on October 1 for per diem rates and January 1 for mileage rates.

Differentiating Billable and Non-Billable Activities

To maintain accurate client billing and financial management, it's essential to differentiate between billable and non-billable activities. Here's how to do it:

• Maintain separate bank accounts for client deposits and firm expenses. This ensures that client payments are clearly labeled and that firm expenses are not commingled with client funds.
• Clearly categorize and invoice client services, such as phone calls, meetings, and document preparation. Make sure to distinguish between services that are billable and those that are not, such as research or advice rendered.
• Use a billing system that allows you to track and separate billable and non-billable time. This can include using a spreadsheet, accounting software, or a specialized billing tool.
• When invoicing clients, include a clear statement of the services provided and the rate charged. Make sure to include a note indicating that the services are billable and will be deducted from the client's account.
• Be mindful of the time spent on non-billable activities, such as answering phones, responding to emails, and preparing documents. These activities should be time-stamped and documented to justify their value to the client.
• Consider using a "billable hour" system, where each activity is assigned a specific billable hour. This can help you track the time spent on each activity and ensure that you're accurately billing clients.
• Review your billing system regularly to ensure that you're accurately categorizing and invoicing client services. This may require adjusting your billing system or consulting with an accountant to ensure that you're meeting the necessary requirements.

Client-Billable vs Firm Expenses: Keeping Them Separate

Client-billable expenses and firm operational costs are two distinct categories that require separate tracking and management. For law firms, accurately distinguishing between these two is crucial for client billing, financial management, and tax compliance.

Commingling these funds is a violation of State Bar rules and can lead to disciplinary action. In California, effective January 1, 2026, new rules require a "designated licensee" to be identified for each client trust account, starting July 1, 2026.

To differentiate between billable and non-billable activities, it's essential to understand the distinction between these two categories. Billable hours are time spent directly working on a client's project, while non-billable hours include administrative tasks, marketing, business development, and internal firm matters. Financial institutions holding California client trust accounts must collect and maintain attorneys' State Bar license numbers, and they must also electronically report account details to the State Bar annually starting March 1, 2026.

By maintaining separate bank accounts and tracking client-billable expenses and firm operational costs, law firms can ensure compliance with State Bar rules and regulations, as well as avoid any potential disciplinary action.

Maintaining Separate Bank Accounts

Here's how to maintain separate bank accounts:

• Open a dedicated business bank account in the firm's name for client-billable expenses, such as travel, meals, and entertainment. This account should be used exclusively for these purposes.
• Keep the firm's business bank account open for firm operational costs, such as rent, utilities, and office expenses. This account should be used for all firm business expenses, regardless of whether they are client-billable or not.
• Consider setting up sub-accounts within both the client-billable and firm operational accounts to track specific expenses. For example, create a sub-account for client meals and a separate sub-account for firm travel expenses.
• Make sure all account statements are reconciled regularly to ensure accuracy and detect any discrepancies.

This separation of accounts will help you:

• Accurately categorize and bill clients for expenses
• Keep accurate records of firm business expenses
• Ensure compliance with tax laws and regulations
• Maintain a clear audit trail for financial transactions

Tax Implications of Retainers and Independent Contractors

As a small law firm, accurately managing client-billable expenses and firm operational costs is crucial for tax compliance and financial reporting. Retainer income is considered self-employment income and is subject to a 15.3% self-employment tax in 2026.

This means that if you have an independent contractor who worked with you in 2026, you will need to file a 1099-NEC form with the IRS and report their income on Schedule C (Form 1040).

This means that if you have a significant amount of expenses related to equipment, software, or other business assets, you may be able to deduct a substantial portion of these expenses on your tax return.

It's essential to keep track of client-billable expenses and firm operational costs to ensure accurate financial reporting and compliance with tax regulations. This may involve maintaining separate bank accounts for client and firm expenses, as well as tracking income and expenses on a regular basis.

Tax rules, limits and rates change. Confirm current figures with the IRS or your accountant before you file.