Estimating Lost Profits for a Self-Employed Business
What are a Self-Employed Person’s Earnings? What are Their Profits?
This article will discuss some of the unique factors relating to assessing lost profits for self-employed operated businesses. As examples, two extremes will be discussed. These extremes provide virtual bookends when assessing a claim of lost profits by a self-employed person. The first addresses a self-employed person who reports his/her income through a Schedule C, Sole Proprietor. The second addresses self-employed individuals that own and operate a subchapter S corporation and file an 1120S for that business.
Financial experts will often be asked to estimate the lost earnings or lost earning capacity for an injured self-employed person. This type of analysis often begs the question, “For the self-employed, what are lost earnings and what are lost profits?” In an injury matter, it is the individual (the self-employed person) who is seeking recovery of lost wages. In a lost profits matter, the entity seeking recovery of the lost profits is the business itself. As the owner of the business, the self-employed person will, more than likely, be the representative of the business, but it is the business that has been injured and the business that will receive payment for the loss of profits. This is why the analysis for lost profits for a business owned by a self-employed person turns the analysis for a self-employed person’s lost earnings on its head.
Estimating Lost Profits for a Self-Employed Businesses
Analyzing the economic damages for the self-employed is a unique situation. In most cases, financial experts are asked to estimate an injured self-employed person’s lost earnings or earning capacity. I have written articles for NACVA’s QuickRead and The Value Examiner addressing the potential complications which may come with such an assignment.
Occasionally, we find a self-employed person claiming lost profits based on the alleged wrongful behavior of a person or business. This situation creates its own complications to consider.
This article will discuss some of the unique factors relating to assessing lost profits for self-employed operated businesses. As examples, two extremes will be discussed. These extremes provide virtual bookends when assessing a claim of lost profits by a self-employed person. The first addresses a self-employed person who reports his/her income through a Schedule C, Sole Proprietor. The second addresses self-employed individuals that own and operate a subchapter S corporation and file an 1120S for that business.
Definition of Self-Employed
It is important to define, “What is a self-employed person?” The term self-employed covers a broad range of individuals. Their businesses run from one person operations to large businesses with numerous employees. The Internal Revenue Service has provided the following definitions:
- You carry on a trade or business as a sole proprietor or an independent contractor.
- You are a member of a partnership that carries on a trade or business.
- You are otherwise in business for yourself (including a part-time business).[1]
Many self-employed people “own their own job.” That is, they work in a trade (electrician, plumber, etc.) that allows them flexibility to serve customers but not work for an employer that pays them W-2 wages and directs their work. These self-employed individuals generally work as independent contractors and may become subcontractors working for larger general contractors. They may also provide services directly to end users, like homeowners. The net income from their business is their personal income that is shown on their 1040 income tax return.
Sometimes these self-employed businesses are larger than the smaller businesses. Many of these entities have multiple employees, invested capital that is used to generate products and/or services, a trained sales force, and markets which may be regional, national, or global in size. In these businesses, the self-employed owner is the overseer, manager, or chief executive directing the business but not the main generator of the work that produces the profits for the business.
What Are a Self-Employed Person’s Earnings and What Are Their Profits?
This question has been answered in court decisions regarding self-employed individuals’ lost earnings. “If a plaintiff is engaged in a business and suffers personal injury because of another’s negligence. It is unquestioned that the plaintiff may recover his/her lost earnings. But most courts hold that a plaintiff may not recover lost profits, as such. Most modern cases have held, however, that evidence of lost profits of a business can be admitted as evidence of lost earnings in a proper case. The standard set down is that plaintiff’s personal efforts must be the predominant factor in producing business profits, not invested capital or the labor of employees. The admissibility of evidence of lost profits to prove lost earnings appears least open to question when the plaintiff is a sole proprietor and self-employed.”[2]
“It is a generally accepted proposition that evidence of the profits of a business in which the injured party in a personal damage suit is interested, which depend for the most part upon the employment of capital, the labor of others, and similar variable factors, is inadmissible in such a suit and cannot be considered for the purpose of establishing the pecuniary value of lost time or diminution of earning capacity, for the reasons that a loss of such profits are uncertain and speculative. In such circumstances, loss of profits cannot be considered either as an element or measure of damages. In such a case, the measure of damages is the loss of value of the injured person’s services in the business. ‘Profits’ and ‘earnings’ are not synonymous. Loss of personal earnings is properly considered as an element of damages. [Citations omitted] However, where the business is small and the income which it produces is principally due to the personal services and attention of the owner, the earnings of the business may afford a reasonable criterion to the owner’s earning power.”[3]
Lost Profits
Courts have followed a similar path when laying out how to assess the lost profits for a business owned by a self-employed person. When addressing a sole proprietor who files a Schedule C with their 1040 income tax returns, an expert will generally find that the lost earnings and lost profits are the same. For these self-employed individuals, their income is the difference between their firm’s revenue and the costs related to generating that revenue. The difference after subtracting expenses from the revenue is shown as net income which is then shown on the individual tax returns.
For a sole proprietorship, most cases have found the lost profits for the business identical to the self-employed person’s lost wages. Courts have sided with the self-employed person when it can be shown that the self-employed person was responsible for generating the company’s profits.
“In Landreth v. Barnard & Kinney, Inc., supra.,[4] the court held that plaintiff was not required to deduct the value of his services in computing his damages for a breach of a construction contract. The court viewed the contract as one for personal services, and permitted plaintiff to recover the contract price less other compensation he had been able to earn in mitigation of his damages. The lesson of the case is that it is inappropriate to deduct the value of the proprietor’s services when the contract is one for services. This would leave the injured plaintiff with no damages.”[5]
The matter with subchapter S corporations is different. In these situations, the self-employed is a shareholder or sole owner of the corporation. He/she may be the one who generates the profits or the manager who directs employees in completing tasks which generate the profits for the business.
Self-employed individuals usually receive their income from the subchapter S corporation in two ways. He/she will receive wages which are reflected in their W-2. The self-employed person will also receive a K-1 showing his/her share of the profits produced by the business. This income is not taxed at the business level but passes through the business to the self-employed person. This K-1 income is reflected on the person’s 1040 tax return.
For these pass-through entities, court decisions on earnings and profits have been mixed. In Karl v. Carefree Lifestyles, Inc.,[6] the calculation of lost profits damages awarded in action for breach of covenant not to compete must deduct salaries paid to officers.[7] Others have allowed for the compensation for an owner’s time shall not be deducted in calculating lost profits.[8] An expert assigned a lost profits calculation for a self-employed person’s business should discuss the local standards for assessing these losses with the hiring attorney.
Should it be determined the self-employed person’s wages need to be deducted, the expert should review the annual wages the self-employed person has been receiving and then research the average wages paid for manager/chief executives for businesses of comparable size and in that industry or sector.
As the owner or partial owner of a business, the self-employed person controls how much is paid to him/her in wages and in profit. It is common to see self-employed individuals that pay themselves below market wages but take larger amounts of business income distributions. This saves the individual on FICA (Medicare and Social Security) taxes. While the self-employed person who operates a subchapter S corporation pays income taxes on both W-2 wages and K-1 income, the self-employed only pays FICA taxes on the wages portion.
An expert needs to review the wages being paid to the self-employed and adjust those earnings for the industry standard. This adjustment may increase or decrease the projected profits that could been achieved “but for” the alleged wrongful act. Without this adjustment or normalizing of the owner’s wages, the expert will have opened himself/herself to criticism of inflating the profits (if the wages are below market averages for a comparable sized firm).
Another adjustment an expert should consider is related to employer-provided fringe benefits. In a sole proprietorship situation, the self-employed seldom deducts the cost of fringe benefits. This is because the benefits are paid out of the owner’s profits from the business. The costs for those benefits should be added to the net income amount to reflect the total income earned by the self-employed person. This income adjustment shows that some of the business income is reflected in the net income. While a part of the business income was spent on the self-employed person’s benefits. This expenditure was the owner’s choice or a reallocation of a portion of the business income for his/her benefit.
For the owner of a subchapter S corporation, fringe benefits may be provided to all the business’ employees, including the owner. These benefits are also a part of the employee’s compensation. These benefits may not factor into the wages versus profits calculation but should be reviewed to ensure that the self-employed person is not receiving a benefit available only for corporate officers. An example could be life insurance coverage payable to his/her family on the self-employed person’s death. This “key man” type policy would not be available to the rank-and-file employees and should be considered as a part of the self-employed person’s compensation. An adjustment for such a “special benefit” could lead to a reduction in the estimated lost profits.
After these considerations, the remainder of the calculations analysis should be like those performed in other lost profit cases; considering other proximate causes, loss period, opportunity to mitigate the loss through pursuing other options, appropriate discount rate, and present value estimate for future losses.
Conclusion
Financial experts will often be asked to estimate the lost earnings or lost earning capacity for an injured self-employed person. This type of analysis often begs the question, “For the self-employed, what are lost earnings and what are lost profits?” In an injury matter, it is the individual (the self-employed person) who is seeking recovery of lost wages.
In a lost profits matter, the entity seeking recovery of the lost profits is the business itself. As the owner of the business, the self-employed person will, more than likely, be the representative of the business, but it is the business that has been injured and the business that will receive payment for the loss of profits. This is why the analysis for lost profits for a business owned by a self-employed person turns the analysis for a self-employed person’s lost earnings on its head.
For self-employed individuals reporting their business income on a Schedule C, the answer most often is that their earnings and profits are the same. These sole proprietors are the ones generating the profits for their business through the services they provide. They may have employees or contract labor that assists them, but the services provided by their business come directly from the self-employed. So, in an assessment of lost profits for the sole proprietorship’s business, the profits and earnings would be the same. The net income of the business is the wages and profit for the owner and any reduction caused by an alleged wrongful act would create lost profits.
For self-employed individuals whose businesses report their income through a subchapter S corporation, owner’s wages and profits are shown through W-2 sand K-1s. Because in these businesses, the self-employed owner may be a manager or overseer of the operations where the employment of capital and the labor of others may be part of producing the profits generated by the business. In these situations, the wages and profits must be separated for lost profits estimates.
Because court decisions have been mixed on whether to include a self-employed person’s wages as a part of lost profits, a financial expert accepting a lost profits assignment for a self-employed person’s business should discuss the precedent in the jurisdiction relating to the assignment.
By recognizing the unusual factors to be considered when assessing the lost profits for a self-employed business, an expert can avoid potential pitfalls and provide a report that is defensible at the time of trial.
[1] “Who is Self-Employed,” Self Employed Individual Tax Center, Internal Revenue Service, updated May 28, 2021.
[2] Robert Dunn, Recovery of Damages for Lost Profits, 6th ed., vol. 1 (Westport, CT: Lawpress Corp., 2005), 247.
[3] Smith v. Corsat, 260 N.C. 92,96, 131 S.E.2d, 894, 897-98, (N.C. 1963).
[4] Landreth v. Barnard & Kinney, Inc., 277 Or. 703, 561 P.2d 631 (1977).
[5] Robert Dunn, Recovery of Damages for Lost Profits, 6th ed., vol 1, (Westport, CT, Lawpress, 2005), 519.
[6] Karl v. Carefree Lifestyles, Inc., 95 So. 3d 289 (Fla. App. 2012).
[7] Robert Dunn, Recovery of Damages for Lost Profits, 6th ed., Supplemental September, 2023, Editors Sharon Rutberg, Wendy Malkin, (Tiburn, CA, Lawpress, 2023), 463.
[8] Indianapolis City Market Corp. v. MAV, Inc., 915 N.E.2d 1013 (Ind. App. 2009), America’s Directories Inc. v. Stellhorn One Hour Photo, Inc., 833 N.E.2d 1059, (Ind. App. 2005).
Allyn Needham, PhD, CEA, is a partner at Shipp Needham Economic Analysis, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp Needham Economic Analysis, he was in the banking, finance, and insurance industries for over 20 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 areas of financial and forensic economics, and provided continuing education presentations at professional economic, vocational rehabilitation, and bar association meetings. In 2021, Dr. Needham received a NACVA Outstanding Member Award. He is also a member of NACVA’s QuickRead Editorial Board.
Dr. Needham can be contacted at (817) 348-0213 or by e-mail to aneedham@shippneedham.com.
