Accounting for Personal Business Expenses in Calculation of Base Year Income: Preventing Downward Bias
Speicher, Brian, Journal of Legal Economics
For some occupations, the correct forensic economic measure of lost earnings is not an individual's gross income from labor effort, but gross income after subtraction of non-reimbursed employee business expenses. For most occupations, no such subtraction is necessary, but for occupations in which individuals must bear unusual personal expenses to provide labor services, such reductions are appropriate. This is true of many union jobs, railroad workers, truckers, and other occupations where travel is important, but this issue may arise in other occupations as well. In most cases, the appropriate way to make this determination is to examine the worker's federal tax form 1040 to see if the worker has made a claim for non-reimbursed employee business expenses. If the worker has recorded non-reimbursed employee business expenses, then the economist should subtract these from any calculations of base year income. However, there are several figures on a form 1040 that a forensic economist might use and adjustments might need to be made to those figures. Because the method selected may make a difference of thousands of dollars in the base income used to project future damages, the method selected can make tens of thousands of dollars of difference in the final estimation of lost earnings damages. To the best of this author's knowledge, no paper in the journals of forensic economics have explained how this can best be done. This short paper is an attempt to fill that void.
II. Economic Theory
Theory is clear that a person's wage or salary is usually not the figure used when compensating a person or estate for injury or loss. Personal business expenses are expenses that are incurred in the pursuit of, or enabling completion of a job. There can be many implicit and explicit expenses - the primary implicit cost is the opportunity cost of a person's time. This should be captured by attempting to measure residual earning capacity and is important but has been addressed in more detail elsewhere. Explicit costs include professional or union dues, job specific equipment like cell phone or vehicle, travel and clothes among others.1 To fairly compensate an injured person, the personal business expenses that are not reimbursed by the employer should be subtracted from the wage or salary to calculate the base year income.
III. Information Available to Forensic Economists
Interviews with the injured party by the forensic economist are rare and can be questionable as to how well a person can provide unbiased estimates of their own expenses. Instead, most information is taken from the tax returns. If the person has itemized his or her deductions then they will have a Schedule A form.2 The Schedule A form for 2008 (see Figure 1) records personal business expenses on line 21. Lines 22 and 23 include other miscellaneous expenses that are not related (normally) to a person being able to function at their job and should not be included. The total that is given in line 27, however, first subtracts 2% of the person's adjusted gross income. While the IRS does not allow a person to deduct personal business expenses unless they exceed 2% of adjusted gross income, there is no compelling economic reason for this reduction. In addition to a Schedule A, a Form 2106 should be attached to tax returns where there are personal business expenses. Form 2106 (see Figure 2) breaks down business expenses into two broad categories: food/entertainment and everything else. The only reason for them to be recorded separately (food/entertainment is column B, everything else is column A) is because the IRS only allows a portion of the food/entertainment to be deducted as a business expense. Line 6 records the total expenses, then line 7 is reimbursement from the company. The unreimbursed amount of food/entertainment is multiplied by .50 (.80 for certain DOT workers). This modifier is representing the fact that a person is deriving benefit from the food/entertainment. …