Practice Tip: The Earning Capacity of Business Owners

The Small Business Administration reports that in 2005 more than 26 million small businesses were operating in the United States. Chances are that sooner or later any attorney practicing in the personal-injury arena will encounter a matter involving a small business proprietor or co-owner of a business. Personal-injury claims involving lost income to sole proprietors, small business owners, and other self-employed plaintiffs can be perplexing, since there is a tendency to confuse lost profits with lost earning capacity.

Recently, I was asked to analyze a damages claim in a product liability matter brought by the 50% shareholder of a family owned photo-imaging business. The plaintiff alleged that a defective heater in his home exposed him to carbon monoxide poisoning, leading to injuries that allegedly affected his ability to manage and operate his business effectively, which allegedly led to the demise of his photo business.

The plaintiff's damage claim was based on his adjusted (accounting fiction) historical business financial records, which turned actual net losses into net income, then projected the newly found net income into the future. Total damages sought were based on net-income projections for the business of $75,000 per year through 2010, claiming these are the profits the business would have made had he been able to manage it actively. Because he could not manage the business, he tacitly claimed, he lost the future income stream of the business.

This approach may at first glance appear reasonable, but, like many lost-income claims brought by business owners of small corporations or limited liability companies, it was based on a significant misunderstanding of the concept of lost earning capacity.

Here, the plaintiff confused damages to his business with damages to himself. The claimant in a personal-injury action is the plaintiff as an individual, not the business. While it is true that the plaintiff might have experienced loss of earning capacity and lost income as a result of his injury, the proper method of determining the loss is to focus on what the plaintiff himself has actually lost. Here, the proper measure of damages would be the replacement cost of hiring a manager to replace the injured plaintiff ' in this case, about $18,000 per year, as opposed to loss of all business profits, since the business itself continued to be viable. (For a discussion of the cost of hiring a substitute as an element of damages see Corbett v. Seamons, 904 P.2d 229 (1995)).

Lost earnings are determined by subtracting earning capacity after the injury from earning capacity prior to the injury. Earning capacity has been defined as:

The capability of a worker to sell his labor or services in any market reasonably accessible to him, taking into consideration his general physical functional impairment resulting from his accident, any previous disability, his occupation, age at the time of injury, nature of injury and his wages prior to and after the injury. Sims v. Industrial Commission, 10 Ariz.App. 574, 560 P.2 1003, 1006. Term does not necessarily mean the actual earnings … at the time the injuries were sustained, but refers to that which, by virtue of the training, the experience, and the business acumen possessed, an individual is capable of earning. Black's Law Dictionary, 5th Edition.

While the measure of damages is, technically, earning capacity, as a practical matter, actual earnings have a strong influence on the trier of fact. For example, a trained surgeon who has spent 20 years working as a missionary would, for purposes of damages assessment, be regarded as a missionary, notwithstanding his ability to perform surgery.

Earning capacity is expected income taking into consideration such factors as age, education, personal attributes, health, labor-market conditions, and actual earnings.

In determining the lost earning capacity of small-business owners, problems often arise where the plaintiff's role in the business is poorly defined, or perhaps misrepresented. (When I use the term 'business owner,' I am referring to a shareholder of a corporation or a member of an L.L.C. For a sole proprietor who reports his/her income on a Schedule C, lost earning capacity is equivalent to a loss to the business because the sole proprietor himself is 'the business.') In another case in which my firm was asked to analyze a damage claim to a sole proprietor, the claimant was a plumber who operated a successful plumbing business. The business grossed between $600,000 and $1 million annually. The plumber was injured and claimed to be unable to work as a plumber. His damages expert, a Certified Public Accountant, measured his earning-capacity damages in terms of the plaintiff's ability to do the physical work of plumbing ' installing pipes, replacing fixtures, and other demanding physical work. The expert assumed that the plaintiff would have worked to age 65, that his earning capacity as a plumber was what plumbers were making in the area ' $50,000 to $60,000 annually, through age 65. However, it was clear that the 'plumber' was somewhat mischaracterized by his damages expert. His earning capacity was clearly greater than the average earnings of a plumber. Was the plumber's ability to run a business grossing in excess of $600,000 each year due to his skill at installing toilets or due to his business acumen? The proper question to ask ' and the one not addressed by the expert ' was whether or not the plumber's ability to manage his business was affected by his injury. If not, damages might best be calculated by determining the plumber's actual physical work for the business if, indeed, he did any physical work, in addition to managing the business, and whether the 'plumber's' ability to manage the business was in any way impaired. If that were the case, the measure of damages would be the cost to hire a new manager. If he could continue in his role as manager, damages might be calculated as the loss of the value of his physical work.

A similar situation arose in a matter involving wrongful-death damages to a car dealer. The dealer was the only shareholder of the dealership and, according to tax records, received $300,000 annually from the business via S-Corporation distributions. His representative in the survival action claimed that lost earning capacity was what the decedent took from the business ' $300,000 annually through retirement age.

However, the business had to be valued for estate-tax purposes. The business valuation was based on a projection of future business revenue minus the costs of doing business, including the salary of a manager for the dealership. The manager's salary was put at $80,000 annually. The defense successfully argued that lost-earnings damage were $80,000 annually, not the $300,000 claimed.

In cases involving business owners, the line between earning capacity and lost profits to the business oftentimes becomes blurred. When dealing with a claim involving a business owner, it is critical to ask four questions: 1) In what type of business entity does the plaintiff have an interest? 2) Who is the claimant ' the business or the injured person? 3) What is the cost to replace the injured person in the workplace? (e.g., Can a replacement manager be hired or who will maintain the business?) and 4) What portion of the injured person's earnings are attributable to his or her labor and what portion is return on capital (investment income)? The owner of a business can claim as lost earning capacity in a personal-injury action only the working time lost due to injuries and harm to future earning capacity, not the business' alleged profits in perpetuity.

Chad L. Staller is a senior consultant at the Center for Forensic Economic Studies, a Philadelphia-based national firm providing economic and statistical analysis and litigation support, including the analysis of damages and liability in product liability matters. He can be contacted at 800-966-6099 or at [email protected].

The Small Business Administration reports that in 2005 more than 26 million small businesses were operating in the United States. Chances are that sooner or later any attorney practicing in the personal-injury arena will encounter a matter involving a small business proprietor or co-owner of a business. Personal-injury claims involving lost income to sole proprietors, small business owners, and other self-employed plaintiffs can be perplexing, since there is a tendency to confuse lost profits with lost earning capacity.

Recently, I was asked to analyze a damages claim in a product liability matter brought by the 50% shareholder of a family owned photo-imaging business. The plaintiff alleged that a defective heater in his home exposed him to carbon monoxide poisoning, leading to injuries that allegedly affected his ability to manage and operate his business effectively, which allegedly led to the demise of his photo business.

The plaintiff's damage claim was based on his adjusted (accounting fiction) historical business financial records, which turned actual net losses into net income, then projected the newly found net income into the future. Total damages sought were based on net-income projections for the business of $75,000 per year through 2010, claiming these are the profits the business would have made had he been able to manage it actively. Because he could not manage the business, he tacitly claimed, he lost the future income stream of the business.

This approach may at first glance appear reasonable, but, like many lost-income claims brought by business owners of small corporations or limited liability companies, it was based on a significant misunderstanding of the concept of lost earning capacity.

Here, the plaintiff confused damages to his business with damages to himself. The claimant in a personal-injury action is the plaintiff as an individual, not the business. While it is true that the plaintiff might have experienced loss of earning capacity and lost income as a result of his injury, the proper method of determining the loss is to focus on what the plaintiff himself has actually lost. Here, the proper measure of damages would be the replacement cost of hiring a manager to replace the injured plaintiff ' in this case, about $18,000 per year, as opposed to loss of all business profits, since the business itself continued to be viable. (For a discussion of the cost of hiring a substitute as an element of damages see Corbett v. Seamons , 904 P.2d 229 (1995)).

Lost earnings are determined by subtracting earning capacity after the injury from earning capacity prior to the injury. Earning capacity has been defined as:

The capability of a worker to sell his labor or services in any market reasonably accessible to him, taking into consideration his general physical functional impairment resulting from his accident, any previous disability, his occupation, age at the time of injury, nature of injury and his wages prior to and after the injury. Sims v. Industrial Commission , 10 Ariz.App. 574, 560 P.2 1003, 1006. Term does not necessarily mean the actual earnings … at the time the injuries were sustained, but refers to that which, by virtue of the training, the experience, and the business acumen possessed, an individual is capable of earning. Black's Law Dictionary, 5th Edition.

While the measure of damages is, technically, earning capacity, as a practical matter, actual earnings have a strong influence on the trier of fact. For example, a trained surgeon who has spent 20 years working as a missionary would, for purposes of damages assessment, be regarded as a missionary, notwithstanding his ability to perform surgery.

Earning capacity is expected income taking into consideration such factors as age, education, personal attributes, health, labor-market conditions, and actual earnings.

In determining the lost earning capacity of small-business owners, problems often arise where the plaintiff's role in the business is poorly defined, or perhaps misrepresented. (When I use the term 'business owner,' I am referring to a shareholder of a corporation or a member of an L.L.C. For a sole proprietor who reports his/her income on a Schedule C, lost earning capacity is equivalent to a loss to the business because the sole proprietor himself is 'the business.') In another case in which my firm was asked to analyze a damage claim to a sole proprietor, the claimant was a plumber who operated a successful plumbing business. The business grossed between $600,000 and $1 million annually. The plumber was injured and claimed to be unable to work as a plumber. His damages expert, a Certified Public Accountant, measured his earning-capacity damages in terms of the plaintiff's ability to do the physical work of plumbing ' installing pipes, replacing fixtures, and other demanding physical work. The expert assumed that the plaintiff would have worked to age 65, that his earning capacity as a plumber was what plumbers were making in the area ' $50,000 to $60,000 annually, through age 65. However, it was clear that the 'plumber' was somewhat mischaracterized by his damages expert. His earning capacity was clearly greater than the average earnings of a plumber. Was the plumber's ability to run a business grossing in excess of $600,000 each year due to his skill at installing toilets or due to his business acumen? The proper question to ask ' and the one not addressed by the expert ' was whether or not the plumber's ability to manage his business was affected by his injury. If not, damages might best be calculated by determining the plumber's actual physical work for the business if, indeed, he did any physical work, in addition to managing the business, and whether the 'plumber's' ability to manage the business was in any way impaired. If that were the case, the measure of damages would be the cost to hire a new manager. If he could continue in his role as manager, damages might be calculated as the loss of the value of his physical work.

A similar situation arose in a matter involving wrongful-death damages to a car dealer. The dealer was the only shareholder of the dealership and, according to tax records, received $300,000 annually from the business via S-Corporation distributions. His representative in the survival action claimed that lost earning capacity was what the decedent took from the business ' $300,000 annually through retirement age.

However, the business had to be valued for estate-tax purposes. The business valuation was based on a projection of future business revenue minus the costs of doing business, including the salary of a manager for the dealership. The manager's salary was put at $80,000 annually. The defense successfully argued that lost-earnings damage were $80,000 annually, not the $300,000 claimed.

In cases involving business owners, the line between earning capacity and lost profits to the business oftentimes becomes blurred. When dealing with a claim involving a business owner, it is critical to ask four questions: 1) In what type of business entity does the plaintiff have an interest? 2) Who is the claimant ' the business or the injured person? 3) What is the cost to replace the injured person in the workplace? (e.g., Can a replacement manager be hired or who will maintain the business?) and 4) What portion of the injured person's earnings are attributable to his or her labor and what portion is return on capital (investment income)? The owner of a business can claim as lost earning capacity in a personal-injury action only the working time lost due to injuries and harm to future earning capacity, not the business' alleged profits in perpetuity.

Chad L. Staller is a senior consultant at the Center for Forensic Economic Studies, a Philadelphia-based national firm providing economic and statistical analysis and litigation support, including the analysis of damages and liability in product liability matters. He can be contacted at 800-966-6099 or at [email protected].