When calculating income losses for individuals due to catastrophic loss, personal injury, wrongful death, or discrimination claim, a forensic accounting expert needs to consider numerous components, including the concept of earning capacity, applicable case law, worklife probabilities, and expert opinions, among others. Earning capacity is arguably the most important component for an income loss calculation, and it can be very challenging when it comes to business owners.
In cases involving business owners, earning capacity is trickier to determine because their income may include salary as well as business profits, but the profits may be impacted by more than just one individual’s work efforts. The application of the lost profits methodology – evaluating proximate cause (Is the injury or event the primary reason for a decrease in sales/profits/earnings?), foreseeability (Were the sales/profits/earnings foreseeable given the economic/business climate?), and reasonable certainty (Would it be reasonably certain that the business/individual would attain that level of income?) – combined with the concept of earning capacity (based on individual characteristics, work history, some theoretical components, and other factors) can be used. Knowing how to separate these concepts when evaluating a claim for an economic loss and projecting future earning capacity losses starts by understanding relevant Pennsylvania case law.
Relevant Case Law
There are several cases in Pennsylvania that discuss earning capacity related to business owners, including Offensend v. Atlantic Ref. Co. (322 Pa. 399) and Sherin v. Dushac (404 Pa 496). According to the Offensend case, “The general rule is that profits derived from a business are not to be considered as earnings and cannot be admitted as a measure of loss of earning power, but where they are almost entirely the direct result of personal management and endeavor, they are an accurate measure of earning capacity and admissible.” The Sherin case reaffirmed Offensend: “The pertinent rules are that profits realized from a business with invested capital or which employs the labor and skill of several individuals may not be shown to establish loss of the owner’s earning power ... The reason, of course, is that profits are generally speculative, may come from sources other than the owner, and are usually dependent on other factors, such as the condition of the market, the value of labor, the availability of credit, and the like. In such cases, the measure of loss of earning power is the value of the owner’s services in the business.” These cases stress the importance of understanding the business owners’ income structure as well as the business structure.
As referenced in Offensend and Sherin, business profits are impacted by the owner’s work efforts, the efforts of employees, invested capital, the supply and demand conditions of the market, and competition, among other elements. An expert must consider all of these components when evaluating the earning capacity of a business owner as well as whether or not the individual incurred a loss of earnings. For example, assume an owner of an air-conditioning business with 10 employees gets injured and can no longer work. His reported annual income for the past few years totaled $150,000, comprised of $50,000 in W-2 wages and $100,000 in net profits. What is the owner’s earning capacity? Is it $50,000, which is limited to wages only? Or $150,000, which includes his wages and all the profits earned by him and others?
Discovery Is Key
In most cases involving lost earning capacity of an individual, the expert will request documents such as tax returns, employment records, deposition testimony, disability records, and expert reports (such as medical reports and vocational reports). This is sufficient information for a calculation most of the time. However, in cases involving the lost earning capacity of a business owner, the expert should request additional documents, including payroll records, business bank statements, calendars, contracts, sales reports, business tax returns, and other records designed to provide more information about what makes the business tick and how the owner is directly involved. The additional records will help better determine the individual’s earning capacity since a business owner’s reported earnings are influenced by their own work efforts, business factors, and industry factors. The greater the information gathered, the more light is shed on the following critical factors.
Proximate cause (linking the event to the owner’s reduced income) – How involved the business owner has been in developing sales, performing the work, and generating profits before and after the event is critical in determining a loss of earnings. For example, a small construction firm (one to three persons) whose owner was involved in every aspect of the business, from generating sales to performing the work, is lost due to an injury. The accounting and tax records show a related decline in revenues and profits, then it is more straightforward to link the injury to reduced sales or profits. But consider the previously referenced air-conditioning company with 10 employees: here, the owner is more of a manager/supervisor and is not primarily involved with performance of the company’s work. However, sales decreased during the period of loss, resulting in lower profits to the owner. Does the owner have a compensable loss? It depends.
First, you need to link the absence of the owner due to injury or other issue (relying on medical, vocational reports, testimony, and other documents) with the decline in sales or increases in expenses. To answer this question, the expert may need additional discovery documents from the business, such as timesheets, sales reports, calendars, contracts, and other related documents. Many experts fail to specifically address this issue, assuming that any decrease in the owner’s income is directly related to the injury and failing to dig into the company records to see how the owner’s periodic absence in the business directly resulted in lower sales or profits. Sometimes there is little or no connection to a sales decrease; other times there may be a blended connection because a company’s sales are dependent on several factors, including competition, pricing, contracts, supporting labor force, and the economy, all of which could move sales up or down in a given year. Each one of these elements should be analyzed to try to determine if the owner’s injury was the primary cause of the decrease in profits or income to the owner.
Production records/business tax returns (determining the “life blood” of revenues) – Consider a medical doctor who was injured in a slip-and-fall and alleges that she can no longer operate as quickly on patients as a result of her injuries, resulting in reduced earnings. If only considering the doctor’s actual reported earnings, it may appear that her loss of earnings occurred as a result of the incident. But the doctor was one of several physicians in the medical practice. If the expert requested tax returns of the practice and the production reports for each physician, showing the number of surgeries, office visits, and other services per month over several years, the documents would show that the number of patients treated by each physician, including the plaintiff, had decreased during the relevant period of time, and the decline of the plaintiff’s production was in line with her colleagues. These records would have shown that the physician performed fewer surgeries as claimed, but only for about two months; and during those two months, she performed more office visits, partially mitigating the claimed loss. Income for medical practices are also impacted by government/insurance reimbursement rates that need to be evaluated for changes. As you can see, the reported income of a physician may appear related to a slip-and-fall incident, but when considering other business factors the variation in income was not the result of the injury or absence.
Corroboration of records with asserted claims – Some people underreport business income on their personal or business tax returns in an effort to dodge paying taxes. Surprisingly, this lower level of reported income does not dissuade some plaintiffs from making a claim for what they truly believe they lost. These plaintiffs may talk about earning “$50,000 to $100,000” a year, but their personal or business tax returns show only a fraction of these amounts reported as income.
Business and personal bank statements can be critical documents when evaluating economic claims of business owners because they can corroborate information reported on the business’s tax returns and the accuracy of reported revenues and expenses, as well as verify statements made in deposition. An expert should specifically request bank statements in instances where the business or business owner regularly reports losses or low levels of income, specifically levels that would be considered too low to pay for necessary living expenses. Consider a plaintiff who operates a daycare business and reports income of less than $20,000 annually on his Schedule C. In the deposition, he indicated that he took a salary; however, he reported no wages on his tax return, only the net profits of the business. A review of the business’s bank statements indicate mortgage payments and personal expenses. A comparison of the bank statements with the tax returns indicate that these expenses should not have been reported as business expenses, which were used to reduce taxable income. After adding back all the nonbusiness-related expenses, the plaintiff earned close to $40,000 a year. No loss of earnings occurred due to the injury because he continued to draw the same compensation, and the gross revenues of the business decreased due to the loss of a contract that was unrelated to the temporary absence of the business owner.
Research and social media – In addition to documents provided by counsel or the client, an expert needs to perform research into publicly available resources too, including social media. This will help identify more about the business owner personally, as well as the business and its industry.
Say a hairdresser alleges she has been forced to close her salon and could no longer perform the physical labor of being a hairdresser as a result of an incident. Research of publicly available records and social media might reveal that the plaintiff’s daughter had opened a hair salon, despite not being a hairdresser herself. The plaintiff, as evidenced through pictures and videos on social media as well as business reviews referencing the plaintiff, was performing services for her daughter’s business. This research would directly refute the plaintiff’s claims as well as assumptions made by the other experts.
In other cases, one might find through social media a plaintiff’s financial interest in other businesses separate from the business they were seeking a loss, changes in competition in the marketplace of the plaintiff that impacted their revenues, and the renewal of professional licenses that contradict claims of disability, among other influencing factors.
Multiple Claims on Multiple Businesses
Linking the cause of action – or proximate cause of a person who has several businesses – to the decline of income derived from several businesses requires more detailed and thorough discovery. For example, suppose a business owner is part doctor, author, speaker, and television/radio personality – all with streams of income that are not foreseeable or certain. Individuals who generate income from publishing books, making television and radio appearances, and making speeches have a different income cycle than a typical wage earner. The expert cannot use one or two years of earnings, or average the two, and project it out for the next 25 years. Say this entrepreneur was injured in a car accident. She alleges that she had a reduction in earning capacity as a result of the accident, and reported business income losses. A detailed review of her daily calendar entries would show that she performed a greater amount of business activities after the motor vehicle accident than she had the year prior to the accident. Key documents should be requested for each of her business segments that generate revenues and where she spent time performing activities, such as publishing, medical practice, and media appearances. Each business has its own life cycle of revenues, and are temporary in nature. This individual worked on publishing another book after the car accident; therefore, it may be determined that she had reallocated her time and efforts from immediate income-producing activities, such as treating patients, to writing activities that do not generate income immediately. By analyzing her calendars, the expert would see her work hours and efforts were the same as prior to the injury period even though her income was lower because of the choices she made regarding which business segment to focus on.
Revenues and profits are not guaranteed for business owners, so merely taking an average of one or two years in the past and projecting it forward is a flawed approach.
Many business owners who are injured for a period of time, or permanently, perform both management and labor activities for the business in varying degrees, depending on the size of the company. A plaintiff may cease performing labor activities after an accident and have to incur extra labor costs to replace his prior labor activities. The business may incur additional labor costs, but it may also generate additional revenues as a result of the owner reallocating working time and efforts to performing managerial activities for the business, such as providing estimates and scheduling future jobs. An expert must consider the overall value to a business of hiring additional workers that result in additional revenues, and must not look solely at the claimed extra costs or reduced salary to the owner. Often, business owners may earn greater compensation after an incident because they have reallocated their time within the business. If the owner is putting the same number of hours into the business after the accident as before the accident, there may be a limited basis to calculate economic loss.
Discovery is the key to obtaining the right type of documents to properly evaluate the key aspects of the plaintiff’s business and to understand and correlate the injury of the owner to the financial results of the business and, ultimately, changes in earnings to the owner, if any. Many factors affect business revenues, and the impact of the owner’s physical efforts is only one of several influences that need to be considered.
Calculating business income losses for individuals can be challenging, but if an expert focuses on understanding the applicable case law and the details of the business, as well as the business owner’s income and efforts, then they will be able to determine reasonable estimates.
James A. Stavros, CPA, CFF, is a managing director at Forensic Resolutions Inc., headquartered in Westmont, N.J., with offices in Philadelphia. He is a member of the PICPA Forensic and Litigation Services Committee and the
Pennsylvania CPA Journal Editorial Board. He can be reached at email@example.com.
Jessica Vrooman, CPA, is a senior associate at Forensic Resolutions Inc. She can be reached at firstname.lastname@example.org.