Tag: newsletter (volume 2 issue 2)

Structured Settlements: Case Suitability

Posted on By economica

by Heber G. Smith

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

It has been said that “only the very large cases” merit consideration for a structured settlement. Some suggest that the list should be expanded to include actions that involve minors and/or those otherwise incapable of managing their own resources.

In reality any injury action that has been reserved for $50,000 or more may merit consideration for a structure, but that doesn’t mean that every case in that category should be structured. Typically, files that, if structured, might generate insignificant income, may not merit consideration in the final analysis. For example, actions involving tax-creditable Cost of Future Care under which the claimant may be financially sophisticated, may also not be worth consideration; but only if the claimant is elderly. A young claimant in a high marginal tax bracket may find him/herself in the unfortunate situation whereby the tax credits reduce tax payable at the lowest rate while investment income increases tax payable at the highest rates. The spread between the two rates of tax and the long period over which the investment must compound to offset inflation may tilt the scale in favour of the structure. Such little nuances make it tricky for plaintiff’s counsel to determine exactly when to recommend that his/her client entertain a structure.

Typically, those cases most suitable for structuring include:

  • Infants;
  • Those claimants not mentally capable of managing their own resources;
  • Claimants whose future life expectancy may be in doubt;
  • Claimants who are in high income tax brackets;
  • Cases involving a Cost of Future Care claim;
  • The elderly who wish to control the distribution of their estates;
  • Claims that might entail a Tax Gross-Up or Management Fees; and
  • Excess of Policy Limits cases.

Effects of Taxation

For any Canadian taxpayer, regardless of his/her tax jurisdiction, taxation will have an onerous impact on resultant net income. With 40% taxation on incomes in excess of $30,000 it becomes incumbent on plaintiff’s counsel to introduce the structure option and the tax free nature of the resultant income to a claimant. With a structure analogous to a “matching grant” or “imputed contribution” from Revenue Canada it is no wonder that such a settlement vehicle has become instrumental as the main incentive to conclude many personal injury actions.

Design Development

Input by plaintiff’s counsel to the modeling of the payment scheme is critical to the ultimate success and conclusion of an action by means of a structure. Consideration must be given to medical, rehabilitation, custodial and health care costs, adjusted for anticipated inflation. Future education costs (for both the claimant and/or his/her family) and loss of future income estimates should also be discussed during the settlement negotiation process.

Ideally, the structured settlement specialist should attend that meeting and work with the plaintiff and his/her counsel on the same basis that a mediator caucuses during that process. When accurate estimates of the claimant’s future income and eligible tax credits are known, it is possible to accurately estimate Revenue Canada’s imputed contribution to the proposed settlement — a sum that may very well be sufficient to bridge the gap between the parties.

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Heber Smith is the principal of Smith Structured Settlements Inc. a structured settlement and annuity brokerage with offices in Calgary and Vancouver. He is also a partner in Structured Settlement Software, a firm that provides tax driven software to the American structured settlement industry.

The Children of Immigrants – How Do They Fare?

Posted on By economica

by Therese Brown

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

It has been argued that one of the factors relevant in predicting the income of minors is the immigrant status of their parents. In this vein, it has been suggested that those with foreign-born parents will not do as well as those with Canadian-born parents. This assumption is based on the belief that the former have a disadvantage deriving from a lack of familiarity with the culture, labour market institutions, and in many cases with the language. Our research does not support this theory. There is considerable evidence, rather, to suggest that second generation Canadians will surpass their more established counterparts.

The Socio-economic Indicators of Success

Numerous studies have lent support to the view that those with foreign parentage are not disadvantaged by that fact, either in terms of earnings, or educational and occupational attainment. A study by Charles M. Beach and Ross Finnie, “A Recursive Earnings-Generation Model For Canadian Males,” found the effect on earnings of having grown up with immigrant parents to be positive, and substantially so. Barry Chiswick and Paul Miller found in their study “Earnings in Canada: The Roles of Immigrant Generation, French Ethnicity, and Language,” that men who have at least one foreign-born parent earn 13 percent more than comparable men with native-born parents. Even if all else is held constant, Canadian-born sons of immigrants have earnings which are two percent higher than their male counterparts with native-born parents. What Chiswick and Miller found particularly striking was the consistency with the findings of other studies in Canada, the U.S. and Australia. This would suggest that American studies are relevant in this discussion as well.

In an American study entitled, “Sons of Immigrants: Are They at an Earnings Disadvantage?” Barry Chiswick states that sons with one or more foreign-born parents have higher earnings on average than those with native-born parents, if other things are held constant. The earnings advantage is approximately eight percent, four percent, and six percent respectively for those who have a foreign-born father, a foreign-born mother, or two foreign-born parents. Another American study undertaken by Geoffrey Carliner, “Wages, Earnings and Hours of First, Second, And Third Generation American Males,” showed that second generation males had higher wages and earnings, in addition to working more hours, than did their third generation counterparts.

Advantages accruing to the second generation have not been limited to higher potential earnings. Frank E. Jones, in his article “Nativity: Further Considerations,” reports that the purely native-born (both parents are native-born) are consistently the least successful in terms of both educational and occupational attainment. A study of Ontario high school students by Marion Porter, John Porter, and Bernard Blishen found that students whose parents were immigrants had higher educational and occupational aspirations than did students with Canadian-born parents (Porter, Porter and Blishen: unpublished).

Peter C. Pineo and John Porter in their study entitled “Ethnic Origin and Occupational Attainment,” refer to the non-British and non-French immigrant populations in Canada, when they state that they find no support for the view that the children of immigrants suffer a disadvantage,

. . . the second and third generation of non-charter immigrant groups have moved out of their low-status origins, acquired as much education as Anglo-Celts (and more than the French), ceased to speak their ethnic language, and diffused into the occupational structure of developing urban Canada . . . neither cultural effects nor discrimination are evident;

Finally, Rao et al. reporting on the educational attainment of the children of immigrants found that those who had at least one foreign-born parent attained higher levels of education, than those with native-born parents, in both Canada and Australia, with this tendency being much stronger in Canada. They found this advantage to be especially apparent for Canadian males with one foreign-born parent.

The Importance of Educational Attainment

Not surprisingly, the economic success of the children of immigrants is strongly correlated with their educational attainment. Monica Boyd et al. conclude that the correlation between father’s and son’s occupational status has declined at the same time that education has become increasingly important in the determination of occupation. Further, they assert that education is the dominating effect on occupational attainment, at labour force entry, so that status attainment and occupational mobility are largely functions of acquired skills, ability and motivation, rather than status which has been ascribed to the individual due to the circumstances of birth.

Others have concurred that education is crucial in terms of occupational attainment, and point to the Canadian immigrant selection policies of the 1960s, as well as excellent educational opportunities, which have led to increasingly well-educated immigrants. Rao et al. conclude that although there is some variance by country of origin, both immigrants and their children are more highly qualified than third-plus generations.

Factors Enhancing or Impeding Mobility

Researchers who have studied the occupational status of immigrants, prior to and after arrival in the host country, indicate that most of the improvement in the status of immigrants, over generations, derives from an increase in labour force skills and the acquisition of language. Chiswick and Miller associate the success of the children of immigrants with the relatively high levels of ability and motivation which they have acquired or inherited from their parents, who exhibit those characteristics. They also acknowledge that the earnings advantage of the sons of immigrants is attributable in large part to education, as these individuals have, on average, almost one additional year of education relative to those of native-parentage. They suggest, however, that part of the advantage may also derive from other factors: first, that a smaller proportion of that population remain unmarried; and second, that they have approximately two years additional labour market experience. Beach and Finnie associate the positive earnings effects of immigrant parentage with factors such as intense work effort, efficient use of human capital, and heightened striving for economic success and pecuniary benefits.

The effects of foreign parentage are not uniformly positive. Chiswick and Miller note that the children of immigrants may be subject to discriminatory labour practices in terms of access to jobs and wages, and they may be disadvantaged by a lack of familiarity with the language and with labour market institutions.

Carliner, while acknowledging that immigrants exhibit a deficit in human capital, proposes that they demonstrate more motivation than non-migrants, made apparent by the lower value which they place on family ties, leisure and easy work. He states that his results, showing higher earnings for the second generation, support the hypothesis that though the motivation of subsequent generations may become somewhat diluted, the human capital which they have acquired more than compensates for that diminution. By the third generation, however, the enhancement of human capital does not fully offset the ongoing attenuation of motivation. The second generation, thus, does better than either the first or third generation.

Conclusion

While various studies support the view that there are both positive and negative effects associated with foreign parentage, there seems to be fairly broad consensus that the net effect of these differences, when other factors are held constant, are negligible. Jones cautions that, while differences in educational and occupational attainment on the basis of foreign versus native parentage are small, Canadian-born sons with one foreign-born parent have higher attainment in both categories, and that the purely native-born exhibit the lowest levels of attainment. In response to the competing arguments that either group, the relative newcomers or those whose families have been resident for multiple generations, have the upper hand, he concludes that
“. . . neither birthplace nor generational status confer advantages or disadvantages which relate directly to educational or occupational attainment.” This finding is supported by the work of Pineo and Porter, who found that the opportunity of the second generation is not impeded, as members of this group, born and raised in Canada, did as well as any.

We subscribe to the view that factors related to their foreign parentage may benefit the children of immigrants, on the one hand, and hamper them on the other. Since the positive effects tend to overwhelm, or at the very least offset, the negative effects, however, it would be misleading to assume that the children of immigrants are at an earning disadvantage, by virtue of their parentage.

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From 1996 through February 1998, Therese Brown was a consultant at Economica.

Economic and Employment Prospects of the Disabled

Posted on By economica

by Therese Brown

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

Most research concerning the effects of disability on earnings and employment uses cross-sectional data — that is, data which are collected for a large group of individuals at one time. The impact which an injury incurred this year will have in ten years time is inferred by comparing the status of individuals who have recently been injured with the equivalent status of those who incurred their injuries ten years ago.

This approach suffers from two serious drawbacks. First,
those who are injured today may differ in many significant ways from those who were injured ten years ago. Second, it is difficult to use cross-sectional data to determine the “life courses” of individuals. For example, assume that it has been observed that the unemployment rate of those who suffered a particular type of injury in the past is consistently 20 percent regardless of how many intervening years have passed. Does that mean that 20 percent of those with that type of injury have been unemployed for 100 percent of the time? That
100 percent of the individuals have each been unemployed for 20 percent of each year? Or some position in between?

One possible way of dealing with these problems would be to rely on panel data — that is, data from studies
which “follow” individuals for a number of years. For example, some of the issues identified above could be resolved if disabled individuals could be followed for a number of years after their accidents had occurred.

One study which uses this type of data (from the United States) is “Employment and Economic Well-Being Following the Onset of a Disability” by Richard Burkhauser and Mary Daly. In the interests of providing an all-encompassing perspective, the authors define disability in a broad sense, allowing them to include individuals who have been integrated into the workforce. Further, their analysis considers only those who report a physical or nervous condition that has limited their work capability for at least two consecutive years.

The authors estimate the prevalence of disability among individuals between the ages of 25 and 61 — prime working ages — to be 9.2 percent for males and 10.6 percent for females. Results from their multi-period analysis of these individuals suggest that the onset of disability is not accompanied by a dramatic reduction in economic well-being
(especially once government income is included) — a considerably different finding from that reported by other studies utilising cross-sectional data.

Particularly interesting for our purposes are their estimations of the cumulative risk that disabled persons will experience particular events. Their sample population is aggregated into a younger group of 25 to 50 year olds and an older group of 51 to 61 year olds. Their results indicate that
15 percent of the younger group and 24 percent of the older group had stopped working for at least one full year, one year after experiencing the disabling condition. After five years,
44 percent and 53 percent of the younger and older group, respectively, had experienced at least one year of no work. For those in the younger group who stopped working for a year, many subsequently returned to work. After one year, 28 percent of this group had returned to work, and by five years the majority
(61 percent) had returned to work. Fewer of the older group had resumed employment, with only 14 percent after one year and 28 percent after five years. In terms of economic well-being, in both the younger and older groups, 46 percent earned an income that was at least equivalent to their pre-accident income after one year, with the majority reaching their pre-disability income after 2 years. At a five-year point following the onset of the disability, 84 percent in the younger group and 75 percent in the older group had returned to a level of household income that was at least equivalent to their pre-onset income.

The authors point out that poverty is not unknown to many people who report disabling experiences, as within a five year period 22 percent of this population had fallen into poverty for at least one year. They suggest, however, that the loss of income experienced by disabled individuals is less notable on average than might be expected. Their analysis also suggests that older workers are likely to be more negatively affected by their disabling condition than are their younger counterparts, in terms of reintegration into the workforce and restoration to their pre-onset economic position. The authors indicate that government transfer payments have a larger role in the income recovery of disabled individuals than does the recovery of their health, as the experience of health recovery is relatively rare. They also conclude that there is a longer time period than was previously expected between the time that an individual becomes disabled and the time they exit from the labour market or enter the disability or retirement rolls.

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From 1996 through February 1998, Therese Brown was a consultant at Economica.

Implications of Duncan v. Baddeley

Posted on By economica

by Christopher Bruce

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

The recent decision in Duncan v. Baddeley (Alberta Appeal #9503-0408-AC), provides important direction for both fatal accident and “lost years” claims. In this article, I review a number of the implications of this decision for the assessment of tort damages. The first part of the article deals with fatal accident claims. The remainder discusses “lost years” claims.

Fatal Accident Claims

Justice Kerans ruled that, regardless of whether the deceased had any dependants,

. . . in Alberta a claim for loss of future earnings does survive the death of the victim. And, with two important qualifications, that claim should be assessed as would any claim for loss of future earnings (Duncan, at 2).

The two qualifications to which he referred are that deductions are to be made from the deceased’s projected annual income for (i) income taxes and (ii) the “cost of personal living expenses.”

The purpose of this section is to assess the impact of the Duncan decision on the calculation of damages in fatal accident cases. This assessment is conducted in three parts. In the first of these, I review the calculation of the two deductions. In the second, I consider the arguments concerning a “tax gross up” in calculations based on Duncan. Finally, in the third, I identify whether there are any cases in which dependants, who are eligible to sue under the Fatal Accidents Act, might find it advantageous to base their claim on Duncan (that is, on the Survival of Actions Act).

Method of Calculation

Justice Kerans ruled that the income taxes which would have been paid by the deceased must be deducted from gross income when calculating the loss to the estate. Although he appears to believe that the deceased would have paid “. . . taxes in the area of 30 to 40 percent of his income,” Statistics Canada data suggest that the average Canadian household pays only 20 percent of its income as income taxes — with a range from about 10 percent to 30 percent.

Second, an amount is to be deducted from after-tax income for the “costs of personal living expenses.” After canvassing a number of alternative methods for calculating this deduction, Justice Kerans settled on an approach which he attributed to Constance Taylor, the plaintiff’s counsel. This method, which Justice Kerans refers to as the “available surplus” approach, was first enunciated in the U.K. Court of Appeal in Harris v. Empress Motors (1983) 3 All E.R. 561 and later adopted in one of the first Canadian cases concerning the “lost years deduction,” Semenoff v. Kokan (1991) 84 D.L.R. (4th) 76. In the latter case, the court concluded that the “conventional deduction” was 33 percent of income.

Kemp and Kemp on the Quantum of Damages explains how the available surplus approach is to be applied, using an example similar to the following: assume that a deceased male would have married and had two children. Of the family’s after-tax income, approximately 22 percent would have been spent on items which benefitted the deceased alone. In addition, approximately 40 percent of family income would have benefitted all members of the family equally. Thus, if one-fourth of that portion of income, or 10 percent, is allocated to the deceased, the total fraction of family income which would have benefitted the deceased is approximately 32 percent.

Two points need to be made with respect to the available surplus approach. First, it should be noted that if this approach was to be applied to an individual who had no reasonable prospect of being married over the period of her or his loss, the value of the damages which would be calculated would equal those calculated using the “lost savings” approach. That is, as all of a non-married individual’s expenditures are spent on him or herself, once personal expenditures have been deducted from after-tax income it is only savings which will remain. As Justice Kerans was highly critical of the lost savings approach, it appears that the available surplus approach may not stand up to scrutiny. Indeed, although Justice Kerans indicated that it was the plaintiffs who had argued for the available surplus approach in Duncan, a review of their submissions suggests that it is the “conventional approach” which they preferred. (See the discussion of “lost years,” below.)

Further, as Scott Beesley argued in “Shortened Life Expectancy: The ‘Lost Years’ Calculation” (Vol. 1(1) of The Expert Witness), it is difficult to argue that wealthy individuals spend as much as 32 percent of their incomes on the “costs of personal living expenses.” Rather, as incomes rise, an increasing portion of expenditures is devoted to items which could only be categorized as “luxury”. Thus, at least for high income earners, one would assume that the appropriate deduction would be less than 32 percent — and for low income earners it would be greater than 32 percent.

Income Tax “Gross Up”

Whereas an income tax “gross up” is allowed in most fatal accident cases, it is not allowed in personal injury claims for lost earnings. The usual rationale which is offered for this is that the effect of basing (personal injury) damages on gross (before-tax) income is to produce an award which is approximately equal to that which would have been obtained by “grossing up” a lump sum award based on after-tax income.

In Duncan, even though income tax was deducted, as in other fatal accident cases, no allowance was made for a tax gross up. It is my view that no gross up will be allowed in cases brought under a Duncan type of claim. The reason for this is that the tax gross up is only required if the plaintiff is expected to invest her or his award in order to replace a future stream of lost income. In Duncan claims, however, there is no presumption that the estate will invest the award in such a way as to replace the deceased’s income stream on a year-by-year basis. Hence, it appears that no gross up will be necessary.

Distinction Between the “Fatal Accidents Act” and the “Survival of Actions Act”

It appears from Justice Coté’s concurring decision in Duncan that overlap between Fatal Accidents Act and Survival of Actions Act claims will be possible in only extremely exceptional circumstances. Hence, it will be important to determine which of these Acts will yield the higher award to the plaintiffs in those cases in which they are eligible to select between those two causes of action — that is, in cases in which the plaintiffs are also dependants of the deceased.

It appears that in most circumstances dependants would receive a higher award under the Fatal Accidents Act than under the Survival of Actions Act. There are three reasons for this. First, whereas it is only that portion of family income which the deceased spent directly on him or herself which is deducted in a traditional fatal accident claim, in a Duncan type of claim, it is this amount plus the deceased’s share of common family expenses which is to be deducted. Second, no claim for loss of household services can be made in a Duncan claim. Finally, it appears that no tax gross up will be allowed in the latter claim.

There are, however, two factors which might make it advantageous for dependants to file their claim under the Survival of Actions Act. First, if the Alberta courts should decide that it is the cross dependency approach which is to be employed when calculating losses under the Fatal Accidents Act, a deduction will be made for the portion of the survivors’ incomes which was spent on the deceased. No such deduction was contemplated in Duncan. As this deduction can be very substantial — particularly when the survivors earn more than the deceased — high income survivors may be able to make a larger claim under the Survival of Actions Act than under the Fatal Accidents Act. (It should be noted, however, that many experts recommend use of the sole dependency approach. See, for example, my article, “Calculation of the Dependency Rate in Fatal Accident Actions” [Vol. 1(4) of The Expert Witness].)

Second, damages in fatal accident claims are reduced for the possibility that the surviving spouse may remarry. In cases in which this possibility is very high — usually those involving individuals less than 35 years old — the survivor may find it advantageous to claim under the Survival of Actions Act.

Alternatively, it has recently been suggested to me that it may be possible to add together a “standard” claim under the Fatal Accidents Act and some portions of the deceased’s income which cannot be claimed by dependants under the Fatal Accidents Act but which are permissible under the Survival of Actions Act. One such portion might be the “non-necessary” element of the deceased’s expenditures on him or herself. This portion would be deducted in a standard fatal accident claim but might be claimable under the Survival of Actions Act.

“Lost Years” Actions

Duncan also has important implications for the assessment of damages in “lost years” claims; that is, in personal injury claims in which the plaintiff’s life expectancy has been shortened significantly. In these cases, the courts have ruled that a deduction for the cost of necessities is to be made from the income which the plaintiff would have earned during his/her lost years.

Although Justice Kerans appeared to accept the “available surplus” approach to the calculation of this deduction, this approach necessarily becomes identical to the “lost savings” approach when the deceased could have been expected to remain single — and Justice Kerans had explicitly rejected the latter approach. With respect, I suggest that Justice Kerans’ discussion in Duncan is more consistent with the application of what is known as the “conventional deduction” approach than it is with the “available surplus” approach.

First, Justice Kerans expressed his approval of the B.C. Court of Appeal’s reasoning in Semenoff v. Kokan, in which the court appeared to have had in mind the “conventional deduction” approach. Second, the 20-30 percent deduction recommended by Justice Keran in Duncan was consistent with the 33 percent deduction adopted only two months earlier in the Alberta trial division decision: Brown and Fogh v. University of Alberta Hospital. In that decision, Justice Marceau explicitly adopted the “conventional deduction” approach.

Together, it appears that Semenoff, Brown, and Duncan signal a preference for a conventional deduction of approximately 30 percent in both fatal accident and lost years actions.

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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).

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.