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Analyzing Lost Earning Capacity for the Self-Employed

Income of Partners and Owners of Pass-through Entities (Part II of II)

This is the second part of a two-part article where the author discusses the methodology for assessing the lost earning capacity of a self-employed person. This article provides an overview for analyzing the lost earning capacity of the self-employed and discusses why this category of work provides unique assessment situations. In this second part, the author discusses how to address fringe benefits, worklife, mitigation, the value of a business.

lost-earningsFringe Benefits

Fringe benefits are generally not included in a self-employed individual’s lost earnings calculations.  The tax code does not allow the deduction of payments made for the self-employed person’s fringe benefits on a Schedule C.[1]  Therefore, the reported income is the self-employed person’s earnings prior to paying for health insurance or putting money into a retirement account.

Worklife

One of the most puzzling questions an expert must address when calculating a self-employed person’s lost earning capacity is, “How long would they have worked?”

Lawrence Spizman noted, “The self-employed are different from wage and salary workers in several aspects.  First, the self-employed tend to work continuously throughout their careers and do not exit and enter the labor force with the same frequency as wage and salary workers.  Secondly, the self-employed do not go from full-time employment to full-time retirement, but instead reduce the number of hours they work as they age, thus postponing retirement.  Third, the self-employed are less likely to have pension plans than wage and salary workers.”[2]

Because self-employed covers such a broad category of jobs (painters, mechanics, accountants, attorneys, retail store owners), there are no worklife expectancy tables to consult.  The more physically demanding jobs may have earlier retirement ages than the indoor more sedentary ones.  In addition, a self-employed person may turn the physically demanding tasks over to others while continuing to manage the business.  Therefore, any projected retirement age should reflect the facts of the case being analyzed.

Retirement ages of 65 or 70 may be considered.  Age 65 is when the self-employed person would qualify for Medicare coverage.  Age 70 is the age at which a person must begin receiving Social Security retirement income.[3]

Each self-employed person may have in mind an age at which to sell or close his or her business.  In addition, a transition plan may have been discussed prior to the injury.  A key employee or family member may have agreed to take over the running of the business at a certain time.  The self-employed person may have agreed to remain as a co-owner or employee during the transition to allow for the continuing of the business.

An expert should discuss the self-employed’s plans for retirement prior to his or her injuries.  Transition plans and/or potential sales of the business should be discussed.  It is from this information that the expert should be able to determine the appropriate retirement age.

Spizman’s article recommends the expert provide the court with a range of loss based on varying retirement ages.  This allows the loss calculations to take into account the differences noted in his article and let the expert mold the calculations to information received from the client.

Mitigation

Injured individuals have an obligation to seek post injury income to offset the loss of pre-injury income.  Some injured persons will be able to return to their previous work or find alternative employment.  Others will be unable to return to work due to their injuries.  This is also true with the self-employed.

A vocational expert should be able to assess the transferable skills possessed by the injured self-employed person, what additional vocational training may be needed, and the opportunities available in the job market.  This analysis is similar to the one performed on wage and salary employees, and the offsetting income would, more than likely, reflect the self-employed becoming an employee of another employer.

The issue of mitigation may become more complicated if the self-employed person returns to work as owner/operator of their own business.  The injury may cause the self-employed to give up certain physically demanding jobs to take on more sedentary, office related jobs.  This may require the hiring of additional workers to perform the work formerly handled by the self-employed.

As an example, a self-employed painter may no longer be able to climb a ladder or squat down to paint floor trim or reach above his shoulders to paint a ceiling.  He, therefore, hires a person to do that work.  Now free from some or all painting duties, he is able to meet with more potential clients and bid on more work.  In some cases, he is better able to handle work coordination and manage personnel because he is in the office.  I have seen cases where the revenue and income of the business has increased due to this change in work responsibility.  However, the increase in revenue or even income does not address the fact the self-employed painter enjoyed being a painter, not an office manager.  Most times, he would be willing to give up the additional revenue to be able to paint.

In situations where the self-employed has returned to work in his or her business, an expert could consider reviewing the out-of-pocket expenses created by the hiring of additional worker(s) to take on job responsibilities the self-employed can no longer perform.  The money paid to these employees is money out of the pocket of the self-employed owner.  Because he can no longer perform these tasks, he had to hire these employees to maintain his business.  Therefore, these out-of-pocket expenses have reduced the income that would have gone to the self-employed had he been able to do the work.[4]

Under most circumstances, a calculation for out-of-pocket expenses would preclude the calculation of lost earning capacity.  To argue both would result in double counting of the loss.  This is because the lost earning capacity amount includes the out-of-pocket expenses.  The post-injury income would be used as mitigation to offset the pre-injury income loss.  The self-employed person’s post-injury income would be net of all expenses including the cost for the additional employees.  Unless the cost for the additional employees is added back in and then shown as a separate loss, it has already been included in the lost earning capacity calculations.

Discount Rate

Estimating the lost earning capacity of a self-employed person is a personal damages calculation (personal injury, wrongful death).  Most courts and jurisdictions have been specific that future losses of this nature should be discounted by using a risk free rate.[5]  The U.S. Supreme Court addressed the interest rate to be used in discounting future lost earnings as early as 1916.

“We do not mean to say that the discount should be at what is commonly called the ‘legal rate’ of interest, that is, the rate limited by law, beyond which interest is prohibited.  It may be such rates are not obtainable upon investments on safe securities, at least, without the exercise of financial experience and skill in the administration of the fund; and it is evident that the compensation should be awarded upon a basis that does not call upon the beneficiaries to exercise such skill, for where this is necessarily employed, the interest return is in part earned by the investor rather than by the investment.  This, however, is a matter that ordinarily may be adjusted by scaling the rate of interest to be adopted in computing the present value of the future benefits; it being a matter of common knowledge that, as a rule, the best and safest investments, and those which require the least care, yield only a moderate return.”[6]

The U.S. Supreme Court confirmed its position in 1983 in the Pfeifer decision.  “It has been settled since our decision in Chesapeake & O.R. Co. v. Kelly [cite omitted], that in all cases where it is reasonable to suppose that interest may safely be earned upon the amount that is awarded, the ascertained future benefits ought to be discounted in the making up of the award.”[7]

“The discount rate should be based on the rate of interest that would be earned on ‘the best and safest investments’ [cite omitted].  Once it is assumed that the injured worker would definitely have worked for a specific term of years, he is entitled to a risk-free stream of future income to replace his lost wages; therefore, the discount rate should not reflect the market’s premium for investors who are willing to accept some risk of default.”[8]

Even though the self-employed person’s lost earning capacity is based on the profits generated by his or her business, it is still a personal damages calculation.  And, being an assessment of a person’s lost earning capacity, a risk-free rate should be applied for the discounting of the lost future earnings (unless local statutes or standards require a specific discounting method).

Value of Business

Self-employed businesses range in size from one employee (the owner) to numerous employees.  In situations where the self-employed person owned and operated a business with value beyond the self-employed person’s earnings, additional thought may be given to the damages incurred.

As an example, the self-employed person owned and operated a restaurant.  The restaurant had assets: tables, fixtures, kitchen equipment, food inventory, dishes, silverware, computers, and software for bookkeeping.  It also had liabilities: a working capital loan, utilities, lease, and supplier payments, payroll, and payroll tax responsibilities.  The restaurant was well known and had consistent revenue and income.  Because of the injury, the self-employed owner will have to sell the business (or its assets).

The question, “If held until the retirement date projected in the lost earning capacity calculations, would the restaurant have a greater selling price than the one being achieved?”

The appraisal of the business is no different from most appraisals performed in a litigation situation, except the terminal value of the business (i.e., the sales value) is a future value.  The appraiser will need to determine the sales value that coincides with the projected date of retirement for the self-employed.  Then, the future value needs to be discounted to present value.  Finally, the amount the self-employed is receiving for selling the business at the current time must be subtracted from the discounted future value as an offset (just like mitigation income).

This could be a laborious process to determine a very small, if any, projected loss.  It could however, provide a significant loss; especially if the current transaction was a rushed sale of assets.

This is not a calculation for an inexperienced expert.  Should an expert believe this calculation should be made, the hiring attorney should be consulted.  It is possible a business valuation expert may be needed.  Ultimately, consideration of the loss of business value should not be made to increase the loss amount, but to accurately measure and reflect the overall damage to this self-employed person and his or her estate.

Conclusion

Estimating the lost earning capacity of the self-employed uses the same methodologies as those used for estimating lost earning capacity for standard wage and salary employees.  But, assessing the lost earning capacity of a self-employed person provides unique challenges.  Income data does not just come from a W-2.  Schedule C’s, K-1’s, and W-2’s may provide income information.  The self-employed person takes on a number of responsibilities while running his or her business.  The injured person may return to work after recovery, return to work giving up some responsibilities but taking on others, or be unable to return and close the business.

Worklife and retirement considerations are different because the self-employed do not leave and re-enter the workforce as often wage and salary employees and do not usually go from full-time work to full-time retirement.  Therefore, transition or work reduction plans may have to be considered as a part of assessing the damages.

And, the business itself may be damaged or destroyed by the injury to the self-employed.  This compounds the self-employed’s loss.  Not only did the self-employed person lose earnings but all or a portion of the business’ value as well.

These are some of the issues an expert must consider when assessing a self-employed person’s lost earning capacity.  This article has provided a review of the general issues relating to analyzing the lost earning capacity of a self-employed person.  Determining a self-employed person’s earning capacity may not be difficult, but may require additional time to insure the loss figures relate to the facts of the case.  By keeping in mind the factors discussed in this article, an expert can work toward providing a result that is relevant and reliable in assessing the lost earning capacity of the self-employed.

[1] Schedule C Instructions, 2015, www.irs.gov

[2] Work-Life Expectancy for the Self-Employed, Lawrence Spizman, The Earnings Analyst, Vol. 1, 1998, page 87.

[3] Retirement Benefits, Social Security Administration, www.ssa.gov

[4] This example assumes 100% ownership of the business by the injured self-employed person.

[5] Some states mandate the interest rate or methodology to be applied in discounting lost earnings to present value.  An expert should consult with the hiring attorney to determine if a particular case falls under such standards or local rules.

[6] Chesapeake & O.R. Co. v. Kelly, 241 U.S. 485, 490-491 (1916).

[7] Jones Laughlin Steel Corp. v. Pfeifer, 462 U.S. 523, 537 (1983).

[8] Ibid.

Allyn Needham, PhD, CEA, is a partner at Shipp, Needham & Durham, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp, Needham & Durham, he was in the banking, finance, and insurance industries for over twenty years. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy, and business valuation. Dr. Needham has published articles in the area of financial economics and forensic economics and provided continuing education presentations at professional economic, vocational rehabilitation and bar association meetings.

Dr. Needham can be reached at (817) 348-0213, or by e-mail to aneedham@shippneedham.com.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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