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June 2017 Tip of the Month

Measuring Damages-Lost Profits vs. Lost Business Value

But a day after the April tax filing deadline, we started to fulfill requests to educate anxious audiences at five different forums:

  • New Jersey Hispanic Bar Association’s conference in Cartagena Colombia (not bad, eh?) entitled “Tax Aspects of Damage Awards”
  • New Jersey State Bar Association in Edison, NJ entitled “IRS Audit Guide Targeting Attorneys Attorneys”
  • Association for Justice in Atlantic City entitled “”
  • Blume Forte Fried Zerres & Molinari in Morristown, NJ entitled “What Lawyers Must Know About Taxes on Damage Awards”
  • NJ Society of Enrolled Agents in Mt. Laurel, NJ entitled “Business Succession Planning-How Tax Practitioners Can Help (and what’s that business really worth)”

Want a copy of the handouts?  Just give us a shout. In fact, Marty Abo's and Joe Cipolla's professional resumes can be retrieved from our website and are easily available on request. Please feel free to pass them along to those you feel would so find of interest. We thank you and we believe they will thank you, as well.

Since Abo Cipolla Financial Forensics is often brought in by attorneys, the Courts or other third parties to evaluate and quantify damages, we thought some of the key takeaways from that particular training session would be of interest to our friends and colleagues.

•           Business damages are calculated by two common damage measurement concepts- lost profits and lost business value.

•           In either of these two approaches we want to put the plaintiff, the injured party, in an economically equivalent position.  In both a tort matter and a contract matter, we, as damage experts, have to get direction from the lawyer and consider liability, proximate causation, and reasonable certainty.  If solely in the contract arena, we also need to consider forseeability (i.e. explicit or implicit expectation of damages).

•           One 10th Circuit case we read stated it quite well: “Numerous jurisdictions hold to the view that when the loss of business is alleged to be caused by the wrongful acts of another, damages are measured by one of two alternative methods:  (1) the going concern value; or (2) lost future profits. The courts allow a plaintiff to recover either the present value of lost future earnings or the present market value of the lost business, but not both.   The “going concern value” is the price a willing buyer would pay and a willing seller would accept in a free marketplace for the business in question.  It measures damages by awarding the difference between.  The award of lost profit damages in addition to this amount, however, was an improper double recovery.”

•           Courts thus will often see the real purpose of compensatory damages for lost business value to place an injured party in the same position as it would have been had there been no injury.  Thus, the decrease in value will be measured by the value prior to and subsequent to the defendant’s misconduct. This should be the same as compensatory damages for lost profits or the amount required to make the injured party whole and put it in the same position it would have been but for the defendant’s action.

•           When determining lost value as well as computing lost profits, the use of estimates and projections are required, thus throwing more variables into the mix.  Corroborating the underlying assumptions of any such projections is a critical component and we need to effectively focus in on the accuracy of such calculations and their underlying assumptions. 

•           “Lost profits” damages are generally considered taxable income to the Plaintiff (As an aside, there may be exceptions when damage measurement by use of “lost profits” is used in a personal injury or wrongful death action.  See Abo’s separate handout on this).  As a result, Courts will typically not reduce the gross award from the Defendant. Doing such would certainly not leave the Plaintiff whole ”but for” the alleged wrong resulting in incurring an effective double tax.  In addition, public policy is considered better served by the defendants having to pay the full amount of the damages they caused. The Plaintiff company would receive the award pre-tax, then pay applicable taxes and would presumably be left in the same after-tax position it would have been “but for” the alleged wrong.  Such is why we experts would, in most cases, compute the benefits stream for a “lost profits” calculation before income taxes.

•           Conversely, in valuing a company in a lost business computation, an appraiser will often apply income taxes to the benefit stream being used in the income approach of valuation.  A shareholder will also typically receive cash flow after-tax and, thus, any lost value from the appraisal is based on after-tax earnings.

•           In lost profits damage calculations we generally use a specific time period computing what the enterprise would have earned during the limited period of loss rather than the actual loss suffered. Losses into the future are discounted to present value at an applicable discount rate, risk adjusted or court determined, generally to the date of trial. If the business is totally destroyed than, in a business appraisal, the “but for” income is computed into perpetuity rather than a specific time period as under the lost profits methodology.  An appraiser may reconcile how this lost income translates to the lost value of the business. Desirous of assessing “economic certainty” in the matter, Courts are obviously hesitant to grant lost profits damages for long periods where such projections become more and more imprecise too far into the future.

Confused?  Getting from us copies of the full handouts may help but, still, that’s okay.  We only wanted to give you a “taste” of what we do besides Quickbooks, accounting, tax returns and business planning.