Category: Self-employed and business income

ACTLA Presentation – Loss of Income for Self-Employed Plaintiffs

Posted on By economica

Derek Aldridge, Economica

derek@economica.ca

(I consent to redistribution of this unmodified document)

ACTLA Presentation – Lunch and Learn

March 25, 2021

Loss of income for self-employed plaintiffs

I will briefly discuss the approach that I use to estimate the loss of income for self-employed plaintiffs. Simply determining the true income of a self-employed worker can be challenging, and I will address some of these challenges. I will also discuss some approaches that can be used to estimate their loss of income.

Note that my tables and charts are based on actual cases I have worked on, but I have made various adjustments to simplify the presentation to preserve confidentiality.

Estimating the income of a self-employed worker

Determining the income of a self-employed worker can be much more complicated than for a regular employee.

For a plaintiff who is an employee and not self-employed, their income is simply the amount they are paid by their employer. Employment insurance income is also relevant for our calculations. Both of these sources of income are usually easy to determine by looking at the plaintiff’s income tax records. An employee might have income tax records that look something like this:

Usually, the income tax records will give us an accurate description of the income of an employee-plaintiff – at least for the pre- accident period. After the accident there can be income replacement benefits that do not appear in the income tax records.

For a self-employed worker, their personal income tax records usually only tell us part of the story of their income. The personal income tax records for a self-employed plaintiff might look something like this:

For the self-employed worker, the income reported on their personal tax returns will often not reflect their true income in each year. I will discuss this below.

For my purposes, there are two categories of self-employed workers: those who operate their business as a sole proprietorship, and those who operate a corporation.

Sole proprietorship

  • These are usually fairly straightforward.
  • All business income appears on the personal income tax returns – usually as gross and net business income.
  • There is a statement of earnings with the personal tax return that shows a detailed description of revenue and expenses.
  • All business income is paid to the business owner each year. There is no separate corporation where profit can be held separately from the owner. Because there is not a separate corporation, most of the information we need to estimate the plaintiff’s income is usually contained in their personal tax records.

Corporation

  • These are more complicated, and I will focus my discussion on cases when the plaintiff’s business is a corporation.
  • The plaintiff operates his business through a numbered or named corporation (for example, 1234567 Alberta Ltd, or Derek Aldridge Consulting Ltd). The corporation is a separate entity from the plaintiff, so income earned through the corporation will not necessarily appear on the plaintiff’s personal income tax records. That is why we need the corporate financial statements.
  • The business income statements show the revenue and expenses for each year. When I combine the income statements for several years, I create a table that looks something like this:

The income statements can get quite complicated, but in general, we see the revenue at the top, which is the income the business earned each year. Then we have various categories of expenses. The business owner usually pays himself a salary, and it is included here as an expense, because his salary is an expense to the business. The salary for other workers at the business is also likely included in that same expense category. The revenue less the expenses gives us the income from operations (profit), before accounting for corporate taxes. In principle, the business owner could pay himself a high enough salary so zero profit would remain. But usually what happens is some of the profit is left in the business as retained earnings, which is effectively savings (the corporation does not need to pay out all profit to the owner every year). The business financial records will show us how these retained earnings have accumulated over time, and will also show us when the owner draws down these savings by taking dividends.

When examining the corporate income statements, I am most interested in how much the business paid the owner in salary (part of the business expenses), and how much before-tax profit the business had after expenses, since that profit effectively belongs to the owner and could have been paid to him as part of his salary. The business owner’s income is the total of the salary (employment income) that the business paid him, plus the profit that the business earned. The salary is reported on his personal tax return, but the business profit is not. The owner might also report dividend income from the corporation, but I do not normally count this as part of his income. Because I am attributing all of the business profit to the owner in each year, this captures all of the dividend income that could be paid in future years.

Note that dividend income can cause some confusion because it does not necessarily reflect earnings from the year under consideration. If the business has accumulated significant retained earnings from previous years’ profits, the owner could still pay himself a large dividend in a year when business was poor.

Below I compare the income reported on this business owner’s personal income tax records with his true income:

We see that there can be quite a large difference between the business owner’s true income and the income that is reported on his personal income tax records. Another potential complication is that the corporation reports its income in a fiscal year, which may be different from a normal calendar year. So if fiscal 2019 for the corporation is the 12-month period from August 2018 through July 2019, it will make it more difficult to match up income reported on the personal tax returns with the corporate financial statements.

Documents and information required

Below I list some of the documents and information that I like to have when dealing with a self-employed plaintiff.

  • The business income statements show the revenue and expenses for each year.
  • The balance sheet is usually included with the income statement as part of the annual financial statements that are usually prepared by an accountant. However, there is usually not much useful for me in the balance sheet.
  • I need the plaintiff’s personal income tax records because they will show the salary (employment income) that he drew from the business.
  • Sometimes the business pays a salary to another family member. Perhaps the owner’s wife does bookkeeping and the business pays her a salary of $20,000 per year. That’s fine, but if she is being overpaid for this work (income-splitting) then I should account for this. For example, if she is being paid $20,000 but an arms-length bookkeeper would only be paid $12,000, then that extra $8,000 actually reflects the plaintiff’s income.

Approaches to determine a loss of income

Once we have a good estimate of the plaintiff’s true income in every year, the next step is to try to estimate his loss of income in each past year, and in the future. While I am focusing on cases when the plaintiff owns and operates a corporation, many of the same principles apply for sole-proprietorship cases.

One of the first things to consider is what is being claimed was the impact of the accident on the business income? This might look obvious from the financial records (for example, a sharp decline in revenue in the years following the accident), but there could be many other effects.

If business revenue declined following the accident, why was that? Is it because the plaintiff missed a few months of work? Is it because she reduced her work hours? Is it because she was less productive during the hours that she worked? Did she target jobs that were less physically demanding and less lucrative? Did she miss out on certain high-value contracts? In my view, answering these questions can be an important part of the narrative. There can be many reasons for a decline in revenue that are unrelated to an injury, so we want to know what is the reason for the revenue decline that we have observed.

Note that it could be the case that business revenue did not decline, but if the accident had not occurred, revenue would have been higher. That is, revenue might have been stable or increasing after the accident, but still less than it would have been absent the accident.

Sometimes business expenses increase because of the accident. This could happen if a worker or a subcontractor was hired to take on some of the duties that the plaintiff normally would have performed. This should also be accounted for in my calculations.

In some cases we can simply compare the plaintiff’s total business income in the years before the accident with her income after, and estimate a loss on that basis. However, because of the many factors that can influence business income, it is often preferrable to try to account for the specific impacts that the plaintiff’s injures had on her business revenue and expenses.

In one case, I had a self-employed worker who had a fairly straightforward business and she billed her services to several clients at an hourly rate. The claim was that because of her injuries, she was reduced in her ability to work and bill hours. Billing more hours would not have led to significant increased expenses. Fortunately, she had detailed records showing her billing and the pattern confirmed her claim:

As shown above, it appears that this plaintiff’s billed hours declined greatly following the accident. They have improved somewhat, but she continues to bill less than she did before the accident.

In this case I was able to estimate a loss of income by assuming that if the accident had not occurred, the plaintiff would have continued to bill her average monthly hours from before the accident, whereas with-accident, she will continue with her reduced billable hours. For the future calculations I can also include scenarios in which I assume that her billable hours will decline further (her condition declines), or that her billable hours will increase (her condition improves).

By examining the billable hours (instead of billings), this helps us account for revenue increases that are due to increases in the plaintiff’s hourly rate, versus increases due to billing more hours. For example, if the plaintiff has increased her hourly rate by 20 percent in the years following the accident, this could easily mask the revenue-effect of her average monthly hours having declined by 20 percent.

In another case that I worked on, the plaintiff was self-employed in a personal-services business and she charged an hourly rate for her services. It appeared that her total billable hours had decreased due to her injuries, and my client wanted me to simply provide a range of scenarios regarding the loss of income that would result from various reductions in billable hours. In the table below I show the potential annual loss that resulted from assumptions that her billable hours have been reduced by 5, 10, or 15 per week.

A case in which a plaintiff bills her services hourly, has no employees, and expenses that are mostly fixed (not increasing with additional billable hours), is almost an ideal scenario for estimating the loss. Her loss of income is directly linked to her ability to bill hours. Other cases can be much more complicated.

Another case that I worked on involved a plaintiff who was in the early stages of establishing his business when he was injured. Following the accident he was able to continue to grow his business, and his income increased accordingly. His business income was fairly complicated, with employees who also generated revenue, as well as numerous expenses. After estimating the income that he earned from his business, the potential loss of income was not at all obvious because his income had increased so much after the injury, as shown below.

Because the plaintiff was injured while he was in the early stages of establishing his business, I didn’t have a useful pre-accident history as a comparison. However, his business income was heavily linked to his ability to spend time at work, and to be productive during that time. Because of his injuries, it was claimed that he needed more many breaks at work and he was not able to perform some of the more lucrative jobs that would normally have been available to him. Effectively, the evidence was suggesting that if he was uninjured, his revenue and earnings would be much greater. The question of course, is how much greater? Ultimately I provided a range of scenarios, and one was that I assumed that his income has been reduced by 25 percent because of his residual deficits. (That is, he has only been earning 75 percent as much as he would have been earning if uninjured.) This is depicted in the chart below.

Clearly this is not as exact as we might hope, but providing a range of scenarios using this approach can at least provide an estimate of the loss if the Court accepts a certain set of assumptions. Dealing with a self-employed plaintiff can involve much more uncertainty than when we have (say) a teacher who is working three-quarters of full-time because of her injuries, rather than full-time.

Another approach that can potentially be useful is the replacement cost approach. In some cases it is possible for the plaintiff to hire a helper that will enable the business to continue as it would have in the absence of the accident, though with additional expenses (and reduced profit) due to the cost of the replacement worker. For example, an injured owner of a landscaping business might be able to hire a part-time labourer to assist him with some of the heavier tasks. If this helper is paid $40,000 per year, then business expenses will increase by $40,000 and profit will decrease by $40,000. That’s $40,000 that is not available to be paid to the owner, so his annual loss of income due to hiring the replacement worker would be $40,000 (not accounting for tax). In this case I am assuming that the self-employed landscaper can continue with the managerial aspects of his business, and he can perform some of the manual labour, but his residual deficits are preventing him from performing the heavier tasks.

The possibility of hiring a replacement worker is something that should especially be considered when the plaintiff is claiming that his income loss is particularly high. If the self-employed landscaper in my example above is claiming a huge annual loss, it is reasonable to ask why his loss is not capped at around the cost of a full-time labourer. But in other cases, the cost of hiring an assistant is not going to be a reasonable approach. For example, a surgeon with a back injury presumably cannot mitigate her losses by hiring a helper – her best option might be to take longer breaks in between procedures.

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For a PDF version of this presentation, click here.

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Under-reporting of Income by the Self-Employed

Posted on By economica

by Scott Beesley

This article was originally published in the Winter 2002/03 issue of the Expert Witness.

A common problem encountered when attempting to estimate the incomes of the self-employed is that those individuals are able to under-report their revenues and over-report their expenses. Many techniques have been suggested to correct for this bias in reporting, but most such techniques are ad hoc in nature. Also, as most techniques only attempt to adjust expenses (to remove personal expenses from reported business expenses), they are unable to capture the effect of unreported revenue.

Consider the example of a small-scale home renovation contractor. The vast majority of his customers have no use for a receipt, since the work is personal rather than a business expense. When the purchaser is having work done on a rental property, a receipt may be requested, but even then the under-the-table transaction may make both parties better off. (In some cases a rental property will show a loss from mortgage interest, utilities and property taxes alone, so the added “loss” resulting from claiming a renovation expense might be redundant to the landlord.) A second, more general example is the existence of one-off barter deals and bartering systems. If our self-employed renovator can make a deal with another provider to trade $5,000 worth of services, the result is that each under-reports revenue by $5,000. In addition, each probably claims GST input credits on any materials purchased, while not collecting any GST on the sale. Thus there is good reason to look for a “true income” estimator which builds in the possibility of non-reported revenue

Recently, Dr. Herb Schuetze, of the University of Victoria, has developed an objective method for estimating the average amount of under-reporting undertaken by the self-employed. (See Herb Schuetze, “Profiles of Tax Non-Compliance Among the Self-Employed in Canada” Canadian Public Policy, June 2002.)

He uses data regarding family expenditures on food to impute the true income level of self-employed persons. His fundamental assumption is that the fraction of true family income devoted to expenditures on food is the same for the self-employed as for wage earners. A second presumption is that, since the amounts involved are small, persons reporting family expenditures will not worry that their tax evasion will be revealed because their food consumption is inordinately high. Thus, they are assumed to report their food expenditures correctly. By assuming that families of the same size who report the same expenditures on food will have the same incomes, Dr. Schuetze is able to calculate the “true” incomes of self-employed individuals by comparing their food expenditures to the expenditures of wage earners.

For example, assume that most four-person families with after-tax income of $50,000 spend $10,000 on food. If we observe that a family headed by a self-employed individual spends $10,000 on food, it might reasonably be assumed that that family’s income was $50,000 (after-tax). Hence, if that individual had reported only $42,000 of income, Dr. Schuetze would conclude that that individual had under reported his or her income by $8,000.

Employing this general approach, Dr. Schuetze controls for (takes into account) various household characteristics, such as the level of education of the head of the household, the age of any children, the region in which the family lives, and the value of their house if it is owned. The study looks at data from 1969 to 1992, at six points in time.

The results indicate that non-compliance among the self-employed was significant enough to be worthy of further study, and future added attention from the Canada Customs and Revenue Agency (CCRA). The estimates cover families in which at least 30 percent of reported income was generated through self-employment. For those families in which either the husband or wife, but not both, were self-employed, it was estimated that 12 to 21 percent of income was not reported. The figure was significantly lower when both spouses were self-employed (you cannot income-split both ways!).

Another interesting conclusion is that there was no pattern across time and across educational groupings, but there was a significant variation across different occupations. The construction and service industries had the highest degree of non-reporting, whereas product fabricating apparently afforded the least opportunity for evasion. (This is in complete agreement with Economica’s experience in performing loss assessments over the last few years.) The reported income of those in construction had to be multiplied by a factor of 1.46 to estimate true income, implying that a full 31.5 percent of total income (= 0.46/1.46) went unreported. When we consider that that figure is itself based on a sample including households which received as little as 30 percent of their reported income from self-employment, we conclude that for those who are predominantly self-employed, the applicable multiple must be much higher. Indeed, in those cases in which the self-employed person’s reported income is roughly zero, (and we have encountered a surprising number of these) the multiple is infinite!

Finally, we note that Dr. Schuetze grants that his measurement of the income from self-employment is in fact in error (biased downwards) because of exactly the issue being studied! That is, if a family reports $30,000 in earned salary and $10,000 from self-employment, the apparent share from self-employment is 25 percent. At that level they would not have been included in the self-employed pool, for the purpose of his study. (He required at least 30 percent of income to be from self-employment before considering an individual to be self-employed.) If, however, that couple had another $20,000 in hidden income, the true fraction from self-employment is 50 percent. I suspect that the result is that the overall “fraction of income hidden” estimates are, if anything, conservative.

Dr. Schuetze’s paper points out that because of the steady increase in the fraction of the population in self-employment, tax non-compliance is becoming more important over time. He suggests that the results of his analysis may be helpful in identifying occupations and demographic characteristics associated with non-compliance. The article certainly establishes that a marked level of tax non-compliance is not at all unusual among the self-employed in Canada.

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Scott Beesley is a consultant with Economica and has a Master of Arts degree (in economics) from the University of British Columbia.

Mitigation vs. Rights in Self-Employed Cases

Posted on By economica

by Scott Beesley

This article was originally published in the winter 1998 issue of the Expert Witness.

Should an injured person hire a replacement? Sell the business? Lease assets? Or, finally, operate as best they can without a replacement?

We presume that an injured business owner does as well as they can, under the circumstances. Shortly after an injury, it will often be difficult to assess how complete the recovery will be. I would suggest that a plaintiff who has spent 15 years building a business cannot be expected to quickly conclude that a sale is their best option. They may believe that they have a right to continue to operate the business, even if it can be demonstrated that to continue does not minimise the loss. If the court accepts that such a right exists, the loss would be calculated under the presumption that the business will continue to be run by that person indefinitely. Conversely, if the court states that “maximum mitigation” must be pursued, whatever that implies, then each alternative must be assessed to discover which minimises the loss.

In most cases the outcome mixes these alternatives. The pre-trial loss generally allows for good-faith errors, as I believe it should. If the plaintiff did what seemed best, possibly hoping for a recovery that did not occur, then the pre-trial loss calculation uses actual post-accident income, not what should have been generated, as seen with benefit of hindsight. The future loss estimation then presumes that the best possible mitigation will be pursued.

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Scott Beesley is a consultant with Economica and has a Master of Arts degree (in economics) from the University of British Columbia.

D’Amato v. Badger – Complications Arising when the Plaintiff is a Business Partner

Posted on By economica

by Christopher Bruce and Scott Beesley

This article first appeared in the winter 1997 issue of the Expert Witness.

Some of the issues arising when an injured party had been a partner in a small business were recently discussed by the Supreme Court of Canada in D’Amato v. Badger, [1996] 8 W.W.R. 390 (S.C.C.). In that case, D’Amato had been one of two partners in an autobody repair shop. As a result of injuries suffered in an automobile accident, D’Amato’s ability to contribute to the operation of the business was severely and permanently restricted. D’Amato continued to provide some managerial services, but his primary services, as a skilled autobody repairman, had to be replaced with hired workers.

Nevertheless, between the time of D’Amato’s injury, in August 1987, and the trial, in March 1993, D’Amato’s partner, Namura, continued to pay D’Amato his pre-accident salary of $55,000 per year. Although the company recouped some of this payment from the services of replacement workers, the court found that the company’s profits were significantly lower during the pre-trial period than they would have been had D’Amato been healthy.

In this article, we wish to add to the analysis of the D’Amato decision by providing an economist’s perspective on the issues which were raised there. We do not, however, represent ourselves as experts on the legal doctrines which were discussed, in some detail, by the court.

Can a Company Claim When a Partner Is Injured?

Although the trial judge in D’Amato, Mr. Justice Vickers, awarded damages to D’Amato’s company, Arbor Auto Body, the Court of Appeal and the Supreme Court, ruled that the claim had to be made on behalf only of the injured partner. There was some suggestion from both of these courts that, as a public policy goal, claims from shareholders resulting from employee injuries should be discouraged (in order to encourage companies to insure themselves against such losses, and prevent frivolous claims). From an economist’s perspective, the critical factor in deciding whether or not a corporation (or partnership) suffers a loss when an employee is injured is simply whether or not that person’s labour can be replaced at constant cost. If the company can easily hire a replacement, or combination of replacements, who can produce identical business results at identical cost, then the company has suffered no loss at all. As this is almost always the case, few shareholder loss claims, for lost market share or profit, would succeed.

In practice, however, the business may incur additional costs associated with hiring and training and either lower quality or reduced productivity of replacement help. The loss claimed by Arbor (in particular the half of it claimed by Mr. D’Amato’s partner) was simply an attempt to recover an overpayment of salary relative to work provided, not an attempt to claim that the business was seriously impaired by Mr. D’Amato’s limitations.

In general, for medium-sized and larger companies, the employer’s loss in this type of case would be small, and the cost of putting forth a claim could be considerable, thereby limiting the number of claims. For a smaller business, however, any potential claim related to a loss of business volume would be greater, in a relative sense. It is quite plausible that the loss of a skilled technician like Mr. D’Amato could result in a loss of business, or that the added costs imposed on the company to find, train, and supervise replacement workers could be significant. As long as courts demand that the company in question provide firm evidence of any loss of business, or additional costs, then there would be no overcompensation. An additional factor which would create a tendency to modest awards is the short-term nature of this loss: Reputations can be re-established, training takes only so long, and hiring costs are a one-time item in most cases.

Should a Business Partner be Altruistic?

A complicating factor in D’Amato, which does not appear to have been considered explicitly by the Supreme Court, was that D’Amato’s partner continued to pay D’Amato his pre-injury salary after the injury, even though D’Amato’s productivity had been reduced significantly. According to Mr. Justice Vickers’ decision, D’Amato’s post-injury value to the company was only 25 percent of the salary which was paid to him. Had D’Amato been paid the actual value of his work, his pre-trial claim would have been roughly 75 percent of $55,000, or $41,250, per year. The business’ only losses, if any existed, would be from loss of volume, since customers would know Mr. D’Amato was not doing the work, or from the additional costs of hiring and training discussed above.

But Namura/Arbor did continue to pay D’Amato his pre-injury income. Hence, although the total loss which was incurred was the same as if Namura/Arbor had paid D’Amato only according to his post-accident productivity, the nexus of the loss was shifted – from D’Amato to Namura and Arbor. In spite of the fact that the total value of the loss was unaffected by this shift, the Court, by refusing to compensate Arbor for its overpayments to D’Amato, allowed the defendants to benefit from an altruistic act on the part of Namura.

From an economist’s perspective, if an injured employee’s compensation exceeds the value of his work in the open market, then restitutio requires that the excess amount paid will be claimable from the person who caused the injury. The difficulty is not in the principle, but in the details: it may not be instantly clear what the amount of the “overpayment” is. Replacement cost is one simple way to address the issue since, if the injured party is receiving his/her full prior salary, the cost of replacements represents the value of the services which the injured can no longer perform. Evaluation of replacement cost generally provides a reliable estimate of the employee’s decline in market value. When this overpayment has occurred, the correct redress is quite clear: the employer receives the amount by which the employee was overpaid, and the employee receives the amount they lost relative to his/her pre-accident level (so he/she receives nothing if the company continued to pay his/her full income).

An alternative view of the situation is that the overpayment provided by a partner (or any well-meaning employer) could be considered to be a gift or charitable donation and, hence, a form of collateral benefit, as receipt of the “gift” would not reduce the injured party’s claim. In that case, the replacement cost method should still be used to estimate the injured person’s true loss of income. Note that if a court judged annual pre-trial losses to be small, because the injured person received such benevolent overpayments, and based a future loss estimate on those artificially low figures, then the plaintiff’s loss could be seriously under-estimated, as the partner or employer is very unlikely to continue to overcompensate the plaintiff indefinitely. (This did not occur in Mr. D’Amato’s case, however, as the Court in that case implicitly assumed that Namura would cease to make overpayments after the trial.).

Furthermore, a finding by the Court that the plaintiff could be denied recovery if he had been “compensated” by his partner would send a strong signal to partners that they should refrain from assisting their colleagues when the latter had been injured. It does not seem likely to us that this is the signal which the Supreme Court intended to send, yet this is undeniably the signal which savvy partners will receive.

Two Examples

Two examples, based on D’Amato, will hopefully clarify these points. In both, we assume that, pre-accident, a partner in a business received compensation of $55,000 from the company for his physical and managerial labour, as full and fair compensation for those services. (The individual was also entitled to 1/2 of any business profit, as his return on capital. However, we ignore this as we assume that it is not affected by the injury.) After the accident, the injured party is able to contribute only the managerial component of the previous position, the market value of which contribution would approximate 25% of the pre-accident salary, or $13,750. In both cases, the total loss, $41,250, is identical. In both cases, as well, it is assumed that the business’ additional costs are limited to the cost of hiring replacement labour. Thus, the potential for a loss to the company, based on additional costs for hiring or training replacement labour, or decreased business volume due to loss of reputation, is not considered. The main point of difference between these cases concerns the post-accident compensation to the injured party, which results in different distributions of the total loss. If we assume that there are no other costs associated with hiring and training, and no loss of business due to loss of reputation, etc., then the financial position of the company is unchanged.

Case 1: Assume that the company pays the injured party only fair market value for his work, and that the balance of pre-accident salary of $41,250 (equivalent to $55,000 – $13,750) is paid to a replacement worker. Since other additional costs are not being considered here, it can be assumed that the financial position of the company remains unchanged. The injured person claims an annual loss of $41,250, from the dependant continuing into the future if the annual loss of income is not expected to change. Both the partner’s income and the injured person’s partnership income are also the same as prior to the injury.

Case 2: Assume the facts are as in Case 1, with one exception: the company continues to pay the full $55,000 per year to the injured employee, and therefore they are paying $41,250 “too much,” in order to assist the injured. The replacement labour must still, of course, be hired. The injured person can claim no loss there, unless, as discussed above, the excess payment is viewed as a collateral benefit. Company profit will fall by $41,250, the additional labour expense which has been incurred. Each of the partners bears half of the total loss of profit of $41,250 per year, and the economic analysis suggests that the business should be able to claim that amount from the defendant. The “overpayment” of salary to the injured party, of $41,250, is mitigating income which, in our analysis, represents a loan which required compensation. Should the court find that this overpayment is not compensable, the company would incur a loss of $41,250 per annum – a loss which it could have avoided by refusing to compensate the injured party.

Some Additional Complications

The above examples only discuss one form of loss, the physical inability to work. The situation is more complex at times. For instance, the injured person’s skills may be unique and, hence, irreplaceable. All business profit earned on the activity in question is now lost, in addition to the person’s own income as an employee. If other revenue is contingent on the presence of the injured party (e.g. painting after autobody work), then losses could in principle occur on all of that revenue also. Yet this would be a rather unrealistic extreme, since few if any of us are virtually irreplaceable. It is more realistic to imagine that the loss of a senior and extremely skilled person, who has a reputation for superior work, would indeed cause some loss of business volume, in addition to a proportional loss in an associated field within the business. In Mr. D’Amato’s case, it is not hard to imagine that most senior technicians who could work at his level already would own their own shops, in partnerships or otherwise. They might not be enticed to work for Arbor by anything less than Mr. D’Amato’s base employee income and a profit share, if they would move at all.

Correct determination of loss in such a case would require accurately estimating the loss of volume and profit which has resulted from the absence of the injured person. This may be uncertain, given that other changes in the operating climate occur at the same time, but if industry statistics suggest the company did indeed lose revenue in relative terms, then the difference between predicted and actual revenue may in turn have caused a loss of profit. We still suggest that the entire loss should be recoverable, by both the injured party and all other shareholders. If the partner’s employee income falls, that should in principle be recoverable as well (though that loss would be much smaller, since it would be mitigated by the fact that the partner can still work at something, even if his/her most lucrative opportunity is foreclosed by the absence of the injured person).

A further difficulty with D’Amato, in all three judgments, is that there was no discussion of the components of the company’s estimated pre-trial loss of $73,299. This figure may be interpreted primarily as replacement costs, in which event the analysis in the two cases discussed above applies, and the loss is really just D’Amato’s loss mitigated by a loan from Namura. Or is a significant part of that figure the result of decreases in business volume? The suggestion, that the loss reflects replacement expenses, is never confirmed. The denial of 50 percent of the pre-trial award to Namura suggests that in either case, the BCCA believed the company could not recover its loss. We disagree, particularly in the first instance, since it seems quite unfair to artificially lower a loss estimate because the partner or employer provided assistance in the form of a loan after the injury. In the loss of profit situation, we would still argue that both loss of labour income (suffered by the partner), and net business profits (suffered by the injured and the partner) should be recoverable.

Finally, we note that the judgments in D’Amato remain puzzling numerically. The trial justice and the Supreme Court each concluded that Mr. D’Amato’s future loss was best valued at 3/4 of $55,000 per year, or $41,250. There was no suggestion of any significant worsening of his condition on or about the time of the initial trial. That suggests that his pre-trial loss was also approximately the same annual amount, yet the plaintiff’s accountant reached a total pre-trial loss of $73,299, or only about $13,000 per year (over roughly 5.5 years). Even assuming that all of the $73,299 is actually Mr. D’Amato’s loss of value of work, the gap between pre-trial and post-trial is very large. Assuming no major changes occurred in Mr. D’Amato’s condition, then either the pre-trial loss was seriously underestimated, the future loss overestimated, or some combination of the two. A more exact determination of the value of Mr. D’Amato’s post-accident labour would be required to reach the correct figures, and similarly an estimate of business volume lost, or other costs imposed, would be needed to deduce the loss suffered by the business, in addition to “losses” which are actually just loans to a partner.

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Christopher Bruce is the President of Economica and a Professor of Economics at the University of Calgary. He is also the author of Assessment of Personal Injury Damages (Butterworths, 2004).

Scott Beesley is a consultant with Economica and has a Master of Arts degree (in economics) from the University of British Columbia.

Issues in Loss of Income Calculations for Self-Employed Individuals

Posted on By economica

by Scott Beesley

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.

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Scott Beesley is a consultant with Economica and has a Master of Arts degree (in economics) from the University of British Columbia.

Forecasting the Earning Capacity of Self-Employed Individuals

Posted on By economica

by Denise Froese

This article first appeared in the summer 1996 issue of the Expert Witness.

Financial experts encounter two major problems when attempting to forecast the earnings of self-employed individuals. First, although tax returns and financial statements are often available, these documents may not provide an accurate picture of the plaintiff’s potential in any given year. This may be the case for one or more of the following reasons. The structure of the taxation system may allow self-employed individuals to claim some of their personal expenses as business expenses, thus reducing their taxable incomes. The owner-operator of a company may not receive payment for his product or service in the year he earned the income. The plaintiff may receive cash or payment-in-kind for his product or service and, therefore, not report that income. The plaintiff may be able to enter into an income-splitting arrangement with a spouse who is a co-owner of the company.

Resolution of these issues often requires the assistance of the plaintiff’s accounting firm. (Further information about the problems which must be taken into account can be found on pages 10-11 of Christopher Bruce, Assessment of Personal Injury Damages, 2nd Edition, Butterworths, 1992.)

Second, even if the expert is able to determine that the net income reported by the owner-operator of the company represents his actual income in any particular year, it may still be difficult to project the self- employed plaintiff’s future earning potential, had the accident not occurred. This is because the available documents often will not yield useful information about the cyclical and/or seasonal nature of the industry the company belongs to. In particular, the firm’s financial data may not identify whether the industry was at a “peak” or a “trough” in business activity, nor whether the growth of the firm’s business was consistent with overall trends in the industry or whether the firm was growing more (or less) rapidly than the industry as a whole.

Many of these problems can be dealt with through the use of Statistics Canada’s Small Business Profiles. These publications contain data compiled on a biannual basis from tax returns submitted to Revenue Canada by businesses reporting gross revenues between $25,000 and $5,000,000. The Small Business Profiles present detailed operating ratios, financial ratios, balance sheet information and employment data for most industries by province and territory for the 1987, 1989, 1991 and 1993 taxation years. (Data for the 1995 taxation year will not be available until June of 1997.) More importantly, these profiles report the distribution of net profits, for both profitable and non-profitable businesses, in each industry.

As an example of a situation in which the Small Business Profiles can prove valuable, Economica was recently retained by the defendant to provide evidence concerning a plaintiff who had operated a small, specialized company in the construction industry. Although his business had been operating for less than two years at the time of his accident in late 1989, he had earned a substantial profit in the six months preceding the accident. Indeed, Small Business Profiles indicated that he was earning the average profit level of the firms in the top 25 percent of the industry. Based on this limited evidence, the plaintiff’s expert projected that the plaintiff would have maintained the level of net income he had earned in that six month period for the remainder of his working life (almost 30 years).

What Economica was able to show, using the Small Business Profile for that industry, was that the annual profits of the top 25 percent of profitable companies in the same business as the plaintiff decreased by 76 percent between 1989 and 1993. Moreover, data from Statistics Canada showed that construction activity peaked in the plaintiff’s province in 1988/89, and that at the time of the plaintiff’s accident, the construction industry was on the verge of entering a slump from which it has yet to recover. (Activity decreased by 78.2 percent between 1989 and 1993, which corresponds directly with the decline in the net profits earned by companies providing the same service as the plaintiff.) Therefore, this information suggested that the plaintiff’s net profit would have declined significantly from the profit level he was achieving at the time of his accident, and that he would not have been able to maintain his 1989 level of income throughout the remainder of his working career.

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Until January 1997, Denise Froese was a consultant at Economica.