Determining a person’s earning capacity is crucial when establishing damages as part of a personal injury or wrongful death lawsuit. However, quantifying earning capacity can be more complicated than one might think. Typically, the starting point is reported income (i.e. the income reported on a tax return), but certain factors may exist that could render reported income an inaccurate measure. In these cases, it may be necessary to calculate earning capacity using different methods, or by adjusting reported income. Even for the same individual in the same year, the calculations of reported income and earning capacity can result in much different conclusions, as you will see below.
Mr. Tomlin was quite elderly and, on paper, not a rich man — showing only $12,000 or so of annual income from his small general contracting business, located in Toronto. So, when he was struck and killed by a motor vehicle, the value of his lost income looked quite meager.
Consequently, the vehicle driver’s insurance company pressed for a minimal settlement for damages. However, when we were retained to review the case on behalf of Mr. Tomlin’s family, we found some inconsistencies. The property tax bill on his house alone soaked-up almost half of the income reported on his tax return. Furthermore, his vehicle use, vacations and financial support for family members indicated a lifestyle that was well beyond the means of anyone earning only $12,000 per year.
Perhaps Mr. Tomlin was living off his savings or a significant inheritance? Further analysis revealed that while he had a substantial nest-egg, it was not due to inherited wealth, and he had barely touched it to fund his lifestyle anyhow. It appeared quite likely that he had been hiding substantial income from the tax authorities. We determined that his spending patterns hinted at an earning capacity that was greater than his reported income. If we could support this, it would allow Mr. Tomlin’s family to claim higher damages than would be expected from an elderly man whose earnings were less than a typical minimum wage-earner.
Our efforts were initially stymied by a lack of a paper trail regarding his actual income. More specifically, it appeared that a lot of Mr. Tomlin’s income was collected in cash and did not include invoices or receipts. As a result, we elected to pursue the investigation in reverse by assembling a picture of his spending patterns to indicate his income level. We estimated his spending on property taxes, household expenses, gifts to family members, vacations, vehicle costs and other items, based on the supporting documentation that we obtained. We also determined how much he had drawn from his savings and financed with debt or credit cards. Finally, we reviewed his credit card statements and accounting records to assess the business nature of his expenses.
Our analysis ultimately revealed that Mr. Tomlin’s real income was substantially more than what he had reported on his tax returns. With the resulting picture, our well-supported analysis led to a negotiated settlement that was much higher than the initial offer presented by the insurance company.
Determining earning capacity for a self-employed individual or small business owner could be a challenging exercise. However, if it is done properly and with care, the results can yield a significantly more accurate outcome for a client.
Tom Strezos, CPA, CA, CBV, CFE, ASA
Valuations and Litigation Support
Direct: (905) 747-5162
Claudio Martellacci, CPA, CA, CBV
Valuations and Litigation Support
Direct: (905) 479-1700, ext. 4006