Practice Tip: Determining Damages to Entrepreneurs

According to Census Bureau figures, the United States is home to some 20 million sole proprietorships, so chances are good that an active trial attorney will eventually be confronted with a case involving a small-business owner. Determining the lost future income of a self-employed entrepreneur or sole proprietor
is not a simple task. My colleagues and I have analyzed damages to entrepreneurs in a multitude of varying scenarios and find that claims very often rely on inappropriate evidence. Moreover, they tend to confuse business loss with the individual's lost earning capacity. Here are some common problems encountered in determining damages to entrepreneurs.

Are Tax Returns Reliable?

One of the most common problems in determining lost income of entrepreneurs for litigation purposes is that earning capacity for litigation purposes may bear little resemblance to earnings listed in the individual's tax returns.

A claimant's or decedent's Schedule C may include 'business expenses' that might include a portion of the business owner's personal living expenses, which for tax purposes reduce taxable income but for litigation purposes should be removed to develop the economic earnings. Are the 'travel meals and entertainment' expenses all truly business related? Do the car and truck expenses really reflect business necessity, or are some personal transportation costs included? Do the declared 'dues and publications' expenses go to professional journals and associations, or to membership at a golf club?

Economists at the Center for Forensic Economic Studies were faced with an extreme example of this situation some years ago in a wrongful death action brought by the family of the proprietor of a scrap metal and demolition business. The decedent's tax returns showed that he had declared an average annual income of about $25,000. However, it was apparent from his lifestyle that he enjoyed access to significantly more income than his tax returns implied. He owned racehorses and collectible automobiles. He traveled extensively and owned a luxury home and a vacation property. Establishing his actual earnings for litigation purposes became an exercise in more of the art of economics than the science.

While trying to establish what similarly situated demolition and scrap metal business owners might expect to make, our economists interviewed another sole proprietor involved in demolition. This business owner was extremely helpful ' he regularly sent his new employees to observe the decedent's operations in order to learn the business. In fact, he said, he gladly would have hired the decedent for $80,000 a year or more. He was willing to testify to this, and we were able to use his testimony as the basis of our damages report. Where tax records may be suspect, discovery takes on a new level of importance, and in many cases, 'creative' discovery can prove invaluable.

What Does the Plaintiff Really Do?

Another problem area when determining lost income of small business owners involves identifying the claimant's actual role in the business. In one case, involving a plumber whose business grossed between $400,000 and $600,000 annually, the plaintiff's economic expert, a Certified Public Accountant, testified that the plumber was totally disabled and would have worked to age 65 absent his injury. The expert further testified that lost future earnings were between $50,000 and $60,000 annually, based on the average earnings of plumbers.

Ignoring the fact that a CPA is probably not qualified to testify as to the plaintiff's degree of disability, this claim was puzzling: Was the plaintiff really a plumber? Did the business gross what it did due to the plaintiff's skill with wrenches and plungers, or was the success of the business due to his acumen and skill as a manager? My colleagues presented a damages report taking these apparent skills into consideration.

Labor or Capital?

Another issue that frequently arises in determining loss to an entrepreneur is the distinction between income resulting from return on labor and income resulting from a return on capital: Is the lost income the result of labor, or is it simply a return on an investment? Passive income that does not derive directly from the claimant's or decedent's efforts normally cannot be claimed as lost income damages.

This issue presented itself in a wrongful-death case where the decedent owned an auto dealership. The sole proprietor took away $300,000 annually from his business. The estate claimed the $300,000 as lost earning capacity. The defense attorney in the case, however, compelled discovery of the estate tax return, which included a valuation of the business. The valuation projected future revenue minus costs. One of the costs listed on the return was the salary of a manager for the business. That salary was put at $80,000 annually. The defense was able to argue, successfully, that the decedent's earning capacity was replacement cost of the manager and not the net income of the firm.

Who Is the Claimant?

Often, claims made by entrepreneur plaintiffs confuse personal lost income with loss to the business. This occurred in a matter involving a proprietor of a photo finishing business who allegedly suffered carbon monoxide poisoning. The photo finishing business showed erratic revenues over its 10 years of existence, reporting taxable income in only two years and posting significant losses after losing a key customer. Highest-year revenue was $583,000; the lowest year gross was $126,000. The plaintiff's compensation as an officer of the corporation varied from year to year with no consistent pattern, averaging $25,000.

The plaintiff's damages expert, a business valuation specialist, calculated the plaintiff's economic loss on the basis of the value of the loss to the business. Our analysis was premised on the fact that the business was not the claimant. The business, in fact, was owned by both the plaintiff and a partner. Any diminution of the value of the business would fall on each of them, but lost business value really has no bearing on the plaintiff's loss of earning capacity. Economic losses to the plaintiff had little or nothing to do with lost business value. The business continued to operate after the alleged injury. Any loss stemming from the alleged injury would be the cost of a replacement manager, not any loss in business value.

Conclusion

Tax returns are not developed for litigation. Taxable (accounting) earnings are not the same as economic earnings. Often, through our tax system, sole proprietors are allowed to pass through certain quasi-professional expenses as full business expenses, usually pursuant to sophisticated tax planning reducing taxable income. The taxable-income line on the return does not always reflect economic earnings. Tax returns must be carefully examined to determine the true economic earnings of the individual.

The lawyer must look beyond what the claimant states as lost earnings and conduct good discovery. Just because the claimant claims to have earned $300,000 does not mean the attorney should accept this statement at face value as a measure of earning capacity. If the claimant received distributions of earnings, are there other shareholders or partners who reduce the pot of earnings? Is there a distribution agreement limiting distributions? Given the injury, is the claimant still able to receive distributions?

Who really suffered the loss? Was it the individual claimant, or that individual's business? Often, if the claimant operates as a sole proprietor and files a Schedule C, the business has suffered a loss. However, if the claimant is a shareholder or partner in a partnership, corporation, or limited-liability company, there is a distinction between the claimant and the business entity. In the latter business formations, injuries suffered by a claimant are not recoverable by the business as lost profits, and the measure of damages relates only to the claimant as lost earning capacity.

Chad L. Staller, Esq., MBA, MAC, is a Senior Consultant at the Center for Forensic Economic Studies, a Philadelphia-based national firm providing economic and statistical analysis of issues arising in litigation, including damages in injury, commercial, and employment matters. He can be contacted at [email protected] or at 800-966-6099.

According to Census Bureau figures, the United States is home to some 20 million sole proprietorships, so chances are good that an active trial attorney will eventually be confronted with a case involving a small-business owner. Determining the lost future income of a self-employed entrepreneur or sole proprietor
is not a simple task. My colleagues and I have analyzed damages to entrepreneurs in a multitude of varying scenarios and find that claims very often rely on inappropriate evidence. Moreover, they tend to confuse business loss with the individual's lost earning capacity. Here are some common problems encountered in determining damages to entrepreneurs.

Are Tax Returns Reliable?

One of the most common problems in determining lost income of entrepreneurs for litigation purposes is that earning capacity for litigation purposes may bear little resemblance to earnings listed in the individual's tax returns.

A claimant's or decedent's Schedule C may include 'business expenses' that might include a portion of the business owner's personal living expenses, which for tax purposes reduce taxable income but for litigation purposes should be removed to develop the economic earnings. Are the 'travel meals and entertainment' expenses all truly business related? Do the car and truck expenses really reflect business necessity, or are some personal transportation costs included? Do the declared 'dues and publications' expenses go to professional journals and associations, or to membership at a golf club?

Economists at the Center for Forensic Economic Studies were faced with an extreme example of this situation some years ago in a wrongful death action brought by the family of the proprietor of a scrap metal and demolition business. The decedent's tax returns showed that he had declared an average annual income of about $25,000. However, it was apparent from his lifestyle that he enjoyed access to significantly more income than his tax returns implied. He owned racehorses and collectible automobiles. He traveled extensively and owned a luxury home and a vacation property. Establishing his actual earnings for litigation purposes became an exercise in more of the art of economics than the science.

While trying to establish what similarly situated demolition and scrap metal business owners might expect to make, our economists interviewed another sole proprietor involved in demolition. This business owner was extremely helpful ' he regularly sent his new employees to observe the decedent's operations in order to learn the business. In fact, he said, he gladly would have hired the decedent for $80,000 a year or more. He was willing to testify to this, and we were able to use his testimony as the basis of our damages report. Where tax records may be suspect, discovery takes on a new level of importance, and in many cases, 'creative' discovery can prove invaluable.

What Does the Plaintiff Really Do?

Another problem area when determining lost income of small business owners involves identifying the claimant's actual role in the business. In one case, involving a plumber whose business grossed between $400,000 and $600,000 annually, the plaintiff's economic expert, a Certified Public Accountant, testified that the plumber was totally disabled and would have worked to age 65 absent his injury. The expert further testified that lost future earnings were between $50,000 and $60,000 annually, based on the average earnings of plumbers.

Ignoring the fact that a CPA is probably not qualified to testify as to the plaintiff's degree of disability, this claim was puzzling: Was the plaintiff really a plumber? Did the business gross what it did due to the plaintiff's skill with wrenches and plungers, or was the success of the business due to his acumen and skill as a manager? My colleagues presented a damages report taking these apparent skills into consideration.

Labor or Capital?

Another issue that frequently arises in determining loss to an entrepreneur is the distinction between income resulting from return on labor and income resulting from a return on capital: Is the lost income the result of labor, or is it simply a return on an investment? Passive income that does not derive directly from the claimant's or decedent's efforts normally cannot be claimed as lost income damages.

This issue presented itself in a wrongful-death case where the decedent owned an auto dealership. The sole proprietor took away $300,000 annually from his business. The estate claimed the $300,000 as lost earning capacity. The defense attorney in the case, however, compelled discovery of the estate tax return, which included a valuation of the business. The valuation projected future revenue minus costs. One of the costs listed on the return was the salary of a manager for the business. That salary was put at $80,000 annually. The defense was able to argue, successfully, that the decedent's earning capacity was replacement cost of the manager and not the net income of the firm.

Who Is the Claimant?

Often, claims made by entrepreneur plaintiffs confuse personal lost income with loss to the business. This occurred in a matter involving a proprietor of a photo finishing business who allegedly suffered carbon monoxide poisoning. The photo finishing business showed erratic revenues over its 10 years of existence, reporting taxable income in only two years and posting significant losses after losing a key customer. Highest-year revenue was $583,000; the lowest year gross was $126,000. The plaintiff's compensation as an officer of the corporation varied from year to year with no consistent pattern, averaging $25,000.

The plaintiff's damages expert, a business valuation specialist, calculated the plaintiff's economic loss on the basis of the value of the loss to the business. Our analysis was premised on the fact that the business was not the claimant. The business, in fact, was owned by both the plaintiff and a partner. Any diminution of the value of the business would fall on each of them, but lost business value really has no bearing on the plaintiff's loss of earning capacity. Economic losses to the plaintiff had little or nothing to do with lost business value. The business continued to operate after the alleged injury. Any loss stemming from the alleged injury would be the cost of a replacement manager, not any loss in business value.

Conclusion

Tax returns are not developed for litigation. Taxable (accounting) earnings are not the same as economic earnings. Often, through our tax system, sole proprietors are allowed to pass through certain quasi-professional expenses as full business expenses, usually pursuant to sophisticated tax planning reducing taxable income. The taxable-income line on the return does not always reflect economic earnings. Tax returns must be carefully examined to determine the true economic earnings of the individual.

The lawyer must look beyond what the claimant states as lost earnings and conduct good discovery. Just because the claimant claims to have earned $300,000 does not mean the attorney should accept this statement at face value as a measure of earning capacity. If the claimant received distributions of earnings, are there other shareholders or partners who reduce the pot of earnings? Is there a distribution agreement limiting distributions? Given the injury, is the claimant still able to receive distributions?

Who really suffered the loss? Was it the individual claimant, or that individual's business? Often, if the claimant operates as a sole proprietor and files a Schedule C, the business has suffered a loss. However, if the claimant is a shareholder or partner in a partnership, corporation, or limited-liability company, there is a distinction between the claimant and the business entity. In the latter business formations, injuries suffered by a claimant are not recoverable by the business as lost profits, and the measure of damages relates only to the claimant as lost earning capacity.

Chad L. Staller, Esq., MBA, MAC, is a Senior Consultant at the Center for Forensic Economic Studies, a Philadelphia-based national firm providing economic and statistical analysis of issues arising in litigation, including damages in injury, commercial, and employment matters. He can be contacted at [email protected] or at 800-966-6099.