This article first appeared in the summer 1997 issue of the Expert Witness.
For a number of reasons, the calculation of the loss of income for self-employed individuals — including farmers, professionals, and owners of small businesses — proves to be much more complex than is the comparable calculation for the “typical” employee. These additional complications arise from two sources.
First, although the relevant source of information for the calculation of the owner’s income is the business’s profit, as reported in its financial statements, there are (at least) two important differences between the firm’s profit and the owner’s income. On the one hand, the owner may have received more benefits from the firm than are indicated in the financial statements, because many of the items which have been listed as (legitimate) business expenses will have benefitted the owner directly.
On the other hand, the profit earned by the business may overestimate the loss to the owner if, following the owner’s accident, some of the assets of the firm could be sold and the proceeds invested.
Second, it is usually much more difficult to forecast the future growth of earnings of a business than it is to forecast growth in the earnings of an individual who has been working for wages or a salary.
The purpose of this article is to discuss these complications in some detail and to propose methods for dealing with the questions they raise.
The “Add-back” of Reported Business Expenses
There are many categories of business expenses in which part of the reported amount actually provided a personal benefit to the owner. An obvious example in the case of a farm operation is expenditures on gasoline, where it is clear that, if all purchases are listed as expenses on the farm tax return, that implies that taxable income will be “too low” by the value of gas that was consumed in personal use. Further expense items which could also require adjustment are heating fuel, telephone charges, repair and maintenance costs, vehicle capital costs, accounting and business service charges, travel costs, computer and software expenses, and mortgage payments, among others. The latter may not be obvious, but consider that if a farmhouse and its immediately adjacent property represent 1/4 of the value of an entire farm, and all mortgage interest is deducted as an expense, then 1/4 of that expense pays not for a cost of business but for the (interest) cost of the family home. Similar proportional adjustments must be made throughout: If half of telephone use is estimated to have been personal, and the total bill (and write-off) was $3,000, then it is exactly as if $1,500 of earned income had been available. These amounts must be added back to taxable income to reach an estimate of the equivalent salary income earned by the plaintiff.
This reporting of consumption spending as tax-deductible business expenses is, in my view, the reason why farmers and many other self-employed individuals (for example, truckers) with very low taxable incomes are not necessarily badly off, and may in fact be doing very well. Fair compensation for injury requires that this adjustment be done as well as is possible, by making reasonable estimates of the fraction of various expenses which actually went to family or individual consumption. As always, one should try to compare the estimates with similar prior cases, or simply use other information to assess the validity of a claim.
A related complication concerns “income splitting.” If the business has paid salaries to the owner’s spouse or children, then one needs to consider the possibility that those payments were artificially inflated for tax purposes. One method of dealing with this issue is to obtain detailed estimates of the types of services performed by the spouse (or children) and the amounts of time devoted to those activities and then estimate the cost of hiring a third party to perform those services. The resulting estimate can then be used to calculate the “true” value of the spouse’s services.
There is a further consideration that, to my knowledge, has not been raised previously. The amounts in question are after-tax. If the business owner spends $4,000 on a computer, and half of its usage is personal, then he/she has effectively enjoyed an after-tax income $2,000 higher than the tax return indicates. A salaried person, who has no access to the use of tax deductions on such an item, would have to earn not just $2,000, but somewhat more, to be put in the same position. Assuming a 33 percent tax rate, the salaried person would have had to earn $3,000, and pay $1,000 in tax, to have $2,000 free for the purchase of a computer. In that case, it could be argued that the plaintiff will only be fully compensated if he/she is paid $3,000.
Our experience is that the profits reported by many small businesses, and particularly by farms, may represent less than half of the true benefits provided by the business to the owner.
The Deduction of the Return to Capital Employed
The income earned by a farm, or any business, can usefully be thought of as being divided into the return on capital employed and the return due to the contributions of the family member or members. As an example, consider a sole proprietorship having $800,000 in net assets (i.e. after deduction of liabilities) which earns $60,000 per year, after all expenses (including interest). Should the owner sell the business, bank the net proceeds and collect the interest, he or she would receive $40,000 per annum in interest on the $800,000 investment, assuming a 5 percent real interest rate. The difference between the firm’s reported profit of $60,000 and the $40,000 interest, $20,000, is the value of the proprietor’s labour, and is the amount on which an income or dependency claim should properly be based.
Note that the estimation of this deduction could potentially be very difficult. The asset value used should reflect actual market value, not the value listed for tax purposes. This raises the issue of depreciation. One can illustrate the problem using an example: an asset is bought that, for arguments’ sake, never depreciates, in the sense that its market price is constant. Yet its cost is deductible at some standard rate. The difference between actual and reported depreciation creates a difference between true market value of the operation and the figure listed in financial statements. This gap also affects the original income calculation, discussed above, since reported depreciation is taken out in calculating taxable income. Though the error could be large in any one year, over time the problem is self-correcting, since all items that will depreciate do so in a few years. This is another reason, along with the obvious fact that business results are quite variable at times, to try to base income calculations on as many years of data as possible.
Additional error can result from honest over or underestimation of the market value of property and equipment. Balance sheets prepared in support of loan applications are generally more optimistic than market reality. At other times the goal may be to minimise the apparent value of assets.
One interesting detail is that the use of this deduction will ensure that we reach the same estimate of labour income regardless of the debt situation of the business. If, in any one year, the business owner pays down debt by, say, $100,000, then explicit (listed) interest will fall, but implicit interest (interest on the liquidation value of the business) will increase by the same amount.
Forecasting Business Income
The basic approach employed is to obtain an adjusted income figure for each year of available data, then average that figure over the period. One can then see any trends in net available income prior to the accident, and make projections into the post-accident period. The problem with this approach is that markets for the products of small businesses are often unstable. As a result, the state of markets must also be considered: if prices have fallen since the accident, and are expected to remain low, we would of course take that into account in projecting pre-accident revenue and income.
More complex is the situation in which the total level of business in the market has fluctuated widely over the past (and is expected to do so in the future). Construction and oil exploration are two sectors which are well known to have experienced such fluctuations in Alberta. In these cases, adjustments to the firm’s past income must be made to reflect the stage in the business cycle in which that income was earned. For example, in one recent case we showed that the income earned by a firm operating in the construction sector was very unlikely to have continued into the future because earnings in the years immediately preceding the plaintiff’s injury were at an unprecedented high for that sector. And, in another case, we were able to show that what appeared to be a very low income for a farm operation was, in fact, well above average; as the years immediately preceding the farmer’s accident had coincided with a trough in the business cycle for that farm’s crop.
An Alternative Approach
From the preceding discussion, it can be seen that basing the estimate of the self-employed individual’s income on the financial returns to the firm will require a detailed, and costly, set of calculations. A much less complex approach, which can be justified in many cases, is to estimate the cost of hiring a worker to replace the plaintiff’s involvement in the business.
This approach is most likely to be appropriate (i) when the plaintiff had no special knowledge or goodwill; or (ii) when the plaintiff’s injuries are such that he/she is limited only in the ability to undertake the physical aspects of the business. A grain farm might be a good example. If a farmer was of only average ability, his widow might be able to hire a farm manager who would be as productive (or almost as productive) as the farmer himself would have been. Or, if the farmer has suffered a physical injury, he may be able to hire individuals to replace his physical involvement in the farm operation, while he maintained control over decisions such as when to plant, the type of fertilisers to be used, etc.
However, if neither of the above conditions holds, use of the “replacement cost” approach may become problematic. If the deceased or seriously injured plaintiff had special knowledge of the industry, or had developed goodwill with clients, the replacement worker may not be able to generate the same level of income as had the deceased/plaintiff. In some cases, it may be possible to deal with this issue by estimating the difference between the profit which the firm would have earned under the management of the deceased/plaintiff and that which the replacement manager can be expected to earn. In other situations, however, this estimation may be as complex as that required to estimate, from the financial statements, the individual’s income from the firm.