March/April 2012
Valuation
Litigation
&
BRIEFING
Owner salaries and
how they affect lost profits
When divorce enters the picture
A qualified valuation expert can
make a huge difference
Boltar illustrates the
dangers of expert advocacy
What’s the value of
intellectual property?
GHP Horwath, P.C.
Member Crowe Horwath International
Accounting, Consulting, Financial Planning, Investment Advisory, and Financial Staffing Services
1670 Broadway, Suite 3000 • Denver, Colorado 80202
(303) 831-5000 • Fax (303) 831-5032 • www.GHPHorwath.com
GHP Horwath, P.C.
Member Crowe Horwath International
GHP Horwath, P.C., provides financial advisory, business valuation, and dispute resolution services to attorneys, insurance
professionals, and business owners on a regional and national basis. Our team of Certified Public Accountants, Accredited Business Valuators, Certified
Valuation Analysts, and Certified Forensic Examiners has extensive experience in the areas of civil and criminal litigation, domestic relations disputes,
business valuation, bankruptcy, fraud, and general business consulting.
Owner salaries and
how they affect lost profits
O
n paper, a company’s profits may bear little
relationship to its actual financial performance.
Closely held C corporations often distribute all or most
of their income as owner salaries to avoid double taxation, leaving the corporation with little profit. S corporations, on the other hand, aren’t subject to double
taxation, so they often pay low owner salaries to minimize payroll taxes and distribute profits as dividends.
So, does a company’s structure affect its ability to
recover lost profits damages? The answer depends on
which state the company resides in.
Nothing but net
Generally, lost profits damages are measured by estimating the net profits a plaintiff would have earned
but for the defendant’s misconduct. That requires
subtracting the plaintiff’s variable expenses from its
projected revenue stream. Why? Because an injury
that deprives a plaintiff of revenue also causes it to
avoid the variable expenses it would have incurred to
generate that revenue.
Generally, lost profits damages
are measured by estimating the net
profits a plaintiff would have earned
but for the defendant’s misconduct.
In a breach of contract case, for example, a typical
measure of damages is the contract price less contractrelated expenses avoided by the nonbreaching party.
Treatment of salaries
Typically, when a wrongful act obviates the plaintiff’s
need to compensate employees, those salaries are considered saved expenses that should be deducted when
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calculating lost profits. But what if the plaintiff pays
out most of its earnings as owner salaries? In some
cases, this leads to seemingly anomalous results.
Consider Anesthesiologists Associates of Ogden v. St.
Benedict’s Hospital, in which a professional corporation owned by six anesthesiologists sued a hospital
for breach of contract. They sought damages of more
than $1 million in lost profits, including anticipated
salaries the shareholders would have received over
the remaining contract term. The trial court awarded
just under $15,000 in damages, representing the
corporation’s lost income minus the shareholders’
salaries and other saved expenses.
The appellate court reversed the award, finding that,
when “shareholders and employees are virtually the
same persons,” unpaid salaries should be included in
lost profits. The Utah Supreme Court disagreed, however, and reinstated the trial court’s damages award.
The plaintiffs argued that deducting salaries from lost
profits would “prevent professional corporations from
ever recovering the real lost benefits of their bargains.” But the high court observed that the doctors
could have protected their interests by, for example,
structuring their practice as a partnership or entering
into employment contracts that required the corporation to pay their salaries regardless of whether the
practice was profitable.
Instead, the court explained, they “decided to do
business as a professional corporation and to take
salaries contingent on income. In so doing, they
assumed all the attendant advantages as well as the
disadvantages of the corporate form.”
One disadvantage, the court said, was that the corporation couldn’t recover losses suffered by its shareholders. Notably, the shareholders weren’t parties to
the lawsuit, though the court suggested that wouldn’t
have made a difference because the hospital hadn’t
contracted with the individual doctors.
Other courts reached a different conclusion. In Bettius
& Sanderson, P.C. v. National Union Fire Insurance Co.,
the U.S. Court of Appeals for the Fourth Circuit ruled
that a law firm organized as a professional corporation was entitled to include shareholder salaries in its
lost profits claim. “If we were to treat a professional
corporation’s net income as its net profit for the purpose of proving loss of profits,” the court explained,
“it would rarely, if ever, show a profit even when its
shareholders were earning large incomes.”
Consult state law
Depending on applicable law, owner salaries can
have an enormous impact on the availability of lost
profits damages. In states that exclude these salaries
from profits, attorneys should consider alternative
avenues of recovery. u
When divorce enters the picture
A qualified valuation expert can make a huge difference
W
hen a married couple parts ways and one or
both spouses own an interest in a business, it’s
critical that they retain valuation experts — or perhaps a joint expert — to value not only the business
interests, but also other marital assets. Without such
information, the monied spouse may end up losing
too much or the nonmonied spouse may not get what
he or she deserves.
Different approaches
Along with valuing private business interests (and
other marital assets), valuators help divorcing
spouses by providing expert witness testimony on
business valuations.
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Indeed, valuations in divorce differ from other types
of valuations. For instance, family courts may prefer
the market approach for its perceived objectivity. Many
courts also embrace the excess earnings method — a
hybrid of the cost and income approaches — especially
for small professional practices.
table. When parties can’t settle their differences out
of court, valuators can address complex financial
matters by helping attorneys draft technical questions
for deposition and trial. They can also assist with jury
instructions or critique the opposing expert’s report.
Divorce cases often require valuators to reconcile the
income approach with these preferred methods as
well as with other, nontechnical value indicators, such
as rules of thumb, purchase offers, loan applications,
insured values and buy-sell agreements.
When hiring a valuation professional, an attorney
faces a tough question: Does he or she need an
expert or a consultant? Failure to understand the differences between these types of services can compromise a valuator’s perceived objectivity — both in and
out of court. (See “Boltar illustrates the dangers of
expert advocacy” on page 5.)
Goodwill
Valuators must separate goodwill from both the company’s tangible value and other identifiable intangible assets, such as patents, brand names, client lists
or proprietary software. Many jurisdictions require
appraisers to split goodwill into two components:
1) personal goodwill, which can’t be separated from
the practitioner, and 2) business goodwill, which is
salable to a third party.
In many states, personal goodwill isn’t part of the
marital estate. Rather, it’s considered part of the monied spouse’s future earnings capacity. When assessing
goodwill in marital dissolution cases, valuators will
review applicable state statutes and case law.
Forensic accounting
A marital estate need not include a private business
interest to benefit from an appraiser’s expertise. Typically, his or her duties include determining whether
certain assets are marital or nonmarital, as state statutes can vary in the treatment of each type of asset.
For example, some unscrupulous monied spouses
hide assets and income, employ unorthodox accounting techniques or intentionally deplete business
values. Many valuators are qualified to conduct fraud
investigations if foul play is suspected.
During settlement talks, valuators are often the voice
of reason, keeping parties focused on financial matters and pinpointing key differences. They also can
evaluate proposed settlement options — and consider
the possible tax consequences, with the assistance of
tax experts — while the parties sit at the negotiating
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Big guns
During settlement talks, valuators
are often the voice of reason, keeping
parties focused on financial matters
and pinpointing key differences.
For example, experts provide unbiased opinions on
technical matters. In a divorce case, an expert might
appraise a private business interest or an intangible
asset, such as a patent, copyright or professional license.
Consultants, on the other hand, act as advocates
for their clients, but behind the scenes rather than
in court. Most jurisdictions don’t require disclosure
of consultants’ identities. Accordingly, a consultant’s
work product is generally not discoverable.
Once you’ve determined whether you want a consultant or an expert to join your team, carefully prepare
the engagement letter to be certain it clearly explains
the tasks you expect of him or her. For example, do
you want the person to develop case strategy and draft
cross-examination scripts for the opposing expert? If
so, be sure to include those tasks in the letter.
The final say
In divorce cases, there are no winners or losers —
just two people who desire to get on with their lives.
A competent valuation expert can help remove much
of the sting from a divorce by adding a dose of common sense to the situation. u
Boltar illustrates the dangers
of expert advocacy
I
n litigation, it’s critical for valuators and other expert
witnesses to be objective, unbiased and reasonable.
Experts who act as advocates for a party — and attorneys who urge them to do so — are asking for trouble.
Boltar, LLC v. Commissioner illustrates the danger.
In this case, the U.S. Tax Court excluded an expert
report as unreliable and irrelevant under Federal Rule
of Evidence 702 and the Daubert standard.
A $3 million gap
The dangers of expert advocacy are especially great
when there’s a large difference between the parties’
respective valuation positions. In this case, Boltar
granted a conservation easement on a portion of
undeveloped land it owned. It valued the easement at
$3.27 million and claimed a charitable deduction of
$3,245,000 on its next tax return (reducing the value
by $25,000 to reflect a claimed enhancement in the
value of adjacent parcels that Boltar owned).
Of the claimed $3,245,000 deduction, the IRS
allowed only $42,400, taking issue with Boltar’s
valuation methods.
Boltar’s experts determined that the “highest and
best use” of the subject property was development
of 174 condominiums pursuant to a Planned Unit
Development (PUD). They determined the value of
the easement as the difference between the claimed
forgone development opportunity ($3.34 million)
and the value of the “raw, vacant and developable”
land ($68,000).
The IRS moved to exclude Boltar’s experts’ report as
unreliable and irrelevant because the report:
1.Failed to value the easement using the traditional
“before and after” method, which examines the
land’s fair market value immediately before and
after the easement is granted,
2.Failed to consider the easement’s impact on the
value of Boltar’s contiguous parcels, and
3.Relied on a highest and best use of the property
that was not physically possible because the land
was too small for the planned development and
wasn’t zoned as a PUD.
The IRS’s expert valued the easement at
$31,280 — a before-easement property
value of $100,600 less an after-easement
value of $69,320. In reaching this conclusion, the expert found that the land’s highest and best use was for development of
detached, single-family homes, but not until
the surrounding properties were developed, because the subject property was
landlocked.
An unreasonable position
The Tax Court acknowledged that the
experts in this case were qualified. But
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it frowned upon “their willingness to use their
resumes and their skills to advocate the position
of the party who employs them without regard to
objective and relevant facts, contrary to their professional obligations.”
In excluding the taxpayer’s experts’ report, the court
rejected Boltar’s argument that Daubert applies only
in jury trials. Although, in a bench trial, a court can
simply receive evidence and give it no weight, the Tax
Court said there were benefits to excluding expert
testimony, including increasing the efficiency of trials
and discouraging the “cottage industry of experts who
function primarily in the market for tax benefits....”
In excluding the taxpayer’s
experts’ report, the court rejected
Boltar’s argument that Daubert
applies only in jury trials.
Boltar’s experts’ report was “so far beyond the realm
of usefulness that admission is inappropriate and
exclusion serves salutary purposes.” Among other
things, the experts:
uDeparted from the before-and-after approach
without offering persuasive reason for doing so,
uFailed to address the errors and unsupportable
assumptions raised by the IRS expert, maintaining
their appraisal was “supportable and appropriate,”
uFailed to determine the highest and best use of
the property after the easement was granted, even
though development for single-family residential
use remained feasible, and
This was fatal to their case, because the court
was “not inclined to guess at how their valuation
should be reduced by reason of their erroneous factual assumptions.”
The court noted that comparable land in the area was
selling for around $12,000 per acre. Boltar’s experts
assigned a value of around $400,000 per acre, a position,
the court said, that “defies reason and common sense.”
The court accepted the IRS expert’s valuation, observing that “an expert loses usefulness to the court and
loses credibility when giving testimony tainted by
overzealous advocacy.” (See “Object lessons” below
for tips on maintaining expert objectivity.)
Be reasonable
As Boltar demonstrates, you have little to gain and
a lot to lose by failing to ensure that your experts
remain objective — and reasonable. The best way to
ensure reasonableness is to work with experienced,
reputable professionals and to encourage them to
provide unbiased opinions. u
Object lessons
Using an expert who’s biased — or is perceived to
be so — can ruin your case. Here are some ways to
ensure a valuation expert’s objectivity:
uDiscourage experts from acting as advocates for
your client’s position.
uAsk experts to correct any mistakes revealed at
trial and adjust their valuations accordingly.
uBe sure experts follow accepted valuation
methodologies — unless your client is willing to
be a “test case.”
uConsider using separate valuation and rebuttal
experts.
uFailed to evaluate prospects for rezoning to allow
the condominium development to go forward.
The court was troubled that Boltar’s experts didn’t
offer to adjust or correct their calculations, instead
persisting in asserting an “unreasonable position.”
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uHave your trial expert’s valuation reviewed by an
independent consulting expert.
uEncourage experts to act as advocates only for
their own (objective) position.
What’s the value of
intellectual property?
V
aluations can’t be performed in a vacuum. Regardless of the type of property involved, a valuator’s
conclusions depend on many factors, including the
scope and context of the engagement, the standard
and premise of value, the type of ownership interest,
and applicable law.
These factors are particularly complex for intellectual
property (IP) valuations. Why? Because an appraisal
of IP assets may be required in a variety of contexts
and involve different bundles of rights. And the value
of IP can depend on applicable statutory law, which
defines its useful life and establishes the owner’s
rights to commercialize the property.
Purpose of the valuation
Value varies dramatically depending on a valuation’s
purpose. An IP asset’s fair market value, for example,
may be lower than its strategic value to a specific
buyer who has the ability to maximize the asset’s
earnings potential. And its fair value for purposes of
Generally Accepted Accounting Principles (GAAP)
may diverge widely from its value for transfer pricing
purposes or in a litigation context.
Interest being valued
The bundle of legal rights that make up an IP asset
can be divided in different ways, so it’s important for
an appraiser to know what type of interest is being
valued. Is it the entire “fee simple” interest? An
interest in the entire bundle of rights for a
limited time period? Or a license to use
the IP? Is the license exclusive or nonexclusive, or is it limited to a particular
use or geographic area? Is there an
established market for similar IP assets?
The valuator should also know whether
an IP asset is being valued on a stand-alone
basis or as part of an aggregation of assets. For
example, a patent may be valued together with other,
related IP assets or with tangible assets, such as engineering drawings or specifications. Keep in mind that
it may not be feasible to segregate IP assets and value
them separately from a company’s other assets.
Asset’s useful and legal life
An IP asset’s value is heavily influenced by its remaining useful life, which is defined by statute and is different from its legal life. A patent’s term, for example,
may be 20 years from the date it’s filed but, in many
cases, its useful life will be much shorter. Factors that
can diminish an IP asset’s lifespan include shrinking
demand for related products or technological advances
that render it obsolete.
Get on the same page
These are just a few factors that can affect
IP valuations. To arrive at an accurate,
useful value, work closely with your valuator to be sure you’re on the same page
and that you receive the type of valuation
opinion you need. u
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional
advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. ©2012 VLBma12
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THE SERVICE
The professionals of GHP Horwath are dedicated to providing expert witness testimony, business and intangible asset valuations,
and consulting services for attorneys, insurance professionals, and business owners.
Our areas of expertise include:
u
Alter Ego
u
Construction Claims
u
Marital Dissolution
u
Bankruptcy & Corporate Recovery
u
Economic Damages
u
Mergers & Acquisitions
u
Business Interruption/ Destruction
u
Employee Stock Ownership Plans
u
P
ersonal Injury/
u
Buy/Sell Agreements
u
Estate & Gift Taxes
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Capital Procurement/Financing
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Dissenting Shareholder Matters
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Professional Liability
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Class Action & Claims Administration
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Employment/Wrongful Termination
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Securities Litigation
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C
ommercial/Contract Disputes
Wrongful Death
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Financial Reporting
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Shareholder Disputes
Computer Forensic & Electronic
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Succession Planning
Discovery
Insurance Claims
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I ntellectual Property Damages,
Valuation & Licensing Consulting
THE TEAM
Lisa A. Meer,
CPA/ABV/CVA
Mark W. Pedigo,
CPA/ABV/CVA
Ms. Meer has over 24 years of experience
in providing forensic accounting, financial
and economic analysis, valuation, and
business advisory services in commercial
and shareholder litigation, bankruptcy,
marital dissolution, and transaction
matters. She regularly teaches continuing
legal education and training courses and
writes articles on economic damage,
valuation, and corporate finance
concepts, approaches, and techniques.
Mr. Pedigo has over 30 years of experience
in economic damages analysis, valuation,
strategic consulting, auditing, due diligence,
and financial analysis. Mr. Pedigo provides
consulting, valuation and expert testimony
services to Counsel on behalf
of plaintiffs and defendants involved in
commercial disputes. Further, he has
extensive experience with construction litigation and audit-related experience, and
has worked on intellectual property and
other commercial litigation cases involving
numerous other industries.
Adam H. Newman,
CPA/ABV
Mr. Newman has over 16 years of
experience providing technical valuation,
tax and consulting services for closely held
companies in a wide range of industries,
including manufacturing, real estate,
professional practices, and family limited
partnerships.
GHP Horwath, P.C.
Member Crowe Horwath International
1670 Broadway, Suite 3000 • Denver, Colorado 80202 • (303) 831-5000 • www.ghpcpa.com