& Valuation. GHP Horwath, P.C. Member Crowe Horwath International

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1 March/April 2012 & Valation Litigation BRIEFING Owner salaries and how they affect lost profits When divorce enters the pictre A qalified valation expert can make a hge difference Boltar illstrates the dangers of expert advocacy What s the vale of intellectal property? GHP Horwath, P.C. Member Crowe Horwath International Acconting, Conslting, Financial Planning, Investment Advisory, and Financial Staffing Services 1670 Broadway, Site 3000 Denver, Colorado (303) Fax (303) GHP Horwath, P.C. Member Crowe Horwath International GHP Horwath, P.C., provides financial advisory, bsiness valation, and dispte resoltion services to attorneys, insrance professionals, and bsiness owners on a regional and national basis. Or team of Certified Pblic Accontants, Accredited Bsiness Valators, Certified Valation Analysts, and Certified Forensic Examiners has extensive experience in the areas of civil and criminal litigation, domestic relations disptes, bsiness valation, bankrptcy, frad, and general bsiness conslting.

2 Owner salaries and how they affect lost profits On paper, a company s profits may bear little relationship to its actal financial performance. Closely held C corporations often distribte all or most of their income as owner salaries to avoid doble taxation, leaving the corporation with little profit. S corporations, on the other hand, aren t sbject to doble taxation, so they often pay low owner salaries to minimize payroll taxes and distribte profits as dividends. So, does a company s strctre affect its ability to recover lost profits damages? The answer depends on which state the company resides in. Nothing bt net Generally, lost profits damages are measred by estimating the net profits a plaintiff wold have earned bt for the defendant s miscondct. That reqires sbtracting the plaintiff s variable expenses from its projected revene stream. Why? Becase an injry that deprives a plaintiff of revene also cases it to avoid the variable expenses it wold have incrred to generate that revene. Generally, lost profits damages are measred by estimating the net profits a plaintiff wold have earned bt for the defendant s miscondct. In a breach of contract case, for example, a typical measre of damages is the contract price less contractrelated expenses avoided by the nonbreaching party. Treatment of salaries Typically, when a wrongfl act obviates the plaintiff s need to compensate employees, those salaries are considered saved expenses that shold be dedcted when calclating lost profits. Bt what if the plaintiff pays ot most of its earnings as owner salaries? In some cases, this leads to seemingly anomalos reslts. Consider Anesthesiologists Associates of Ogden v. St. Benedict s Hospital, in which a professional corporation owned by six anesthesiologists sed a hospital for breach of contract. They soght damages of more than $1 million in lost profits, inclding anticipated salaries the shareholders wold have received over the remaining contract term. The trial cort awarded jst nder $15,000 in damages, representing the corporation s lost income mins the shareholders salaries and other saved expenses. The appellate cort reversed the award, finding that, when shareholders and employees are virtally the same persons, npaid salaries shold be inclded in lost profits. The Utah Spreme Cort disagreed, however, and reinstated the trial cort s damages award. 2

3 The plaintiffs arged that dedcting salaries from lost profits wold prevent professional corporations from ever recovering the real lost benefits of their bargains. Bt the high cort observed that the doctors cold have protected their interests by, for example, strctring their practice as a partnership or entering into employment contracts that reqired the corporation to pay their salaries regardless of whether the practice was profitable. Instead, the cort explained, they decided to do bsiness as a professional corporation and to take salaries contingent on income. In so doing, they assmed all the attendant advantages as well as the disadvantages of the corporate form. One disadvantage, the cort said, was that the corporation coldn t recover losses sffered by its shareholders. Notably, the shareholders weren t parties to the lawsit, thogh the cort sggested that woldn t have made a difference becase the hospital hadn t contracted with the individal doctors. Other corts reached a different conclsion. In Bettis & Sanderson, P.C. v. National Union Fire Insrance Co., the U.S. Cort of Appeals for the Forth Circit rled that a law firm organized as a professional corporation was entitled to inclde shareholder salaries in its lost profits claim. If we were to treat a professional corporation s net income as its net profit for the prpose of proving loss of profits, the cort explained, it wold rarely, if ever, show a profit even when its shareholders were earning large incomes. Conslt state law Depending on applicable law, owner salaries can have an enormos impact on the availability of lost profits damages. In states that exclde these salaries from profits, attorneys shold consider alternative avenes of recovery. When divorce enters the pictre A qalified valation expert can make a hge difference When a married cople parts ways and one or both sposes own an interest in a bsiness, it s critical that they retain valation experts or perhaps a joint expert to vale not only the bsiness interests, bt also other marital assets. Withot sch information, the monied spose may end p losing too mch or the nonmonied spose may not get what he or she deserves. Different approaches Along with valing private bsiness interests (and other marital assets), valators help divorcing sposes by providing expert witness testimony on bsiness valations. 3

4 Indeed, valations in divorce differ from other types of valations. For instance, family corts may prefer the market approach for its perceived objectivity. Many corts also embrace the excess earnings method a hybrid of the cost and income approaches especially for small professional practices. Divorce cases often reqire valators to reconcile the income approach with these preferred methods as well as with other, nontechnical vale indicators, sch as rles of thmb, prchase offers, loan applications, insred vales and by-sell agreements. Goodwill Valators mst separate goodwill from both the company s tangible vale and other identifiable intangible assets, sch as patents, brand names, client lists or proprietary software. Many jrisdictions reqire appraisers to split goodwill into two components: 1) personal goodwill, which can t be separated from the practitioner, and 2) bsiness 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 spose s ftre earnings capacity. When assessing goodwill in marital dissoltion cases, valators will review applicable state stattes and case law. Forensic acconting A marital estate need not inclde a private bsiness interest to benefit from an appraiser s expertise. Typically, his or her dties inclde determining whether certain assets are marital or nonmarital, as state stattes can vary in the treatment of each type of asset. For example, some nscrplos monied sposes hide assets and income, employ northodox acconting techniqes or intentionally deplete bsiness vales. Many valators are qalified to condct frad investigations if fol play is sspected. Dring settlement talks, valators are often the voice of reason, keeping parties focsed on financial matters and pinpointing key differences. They also can evalate proposed settlement options and consider the possible tax conseqences, with the assistance of tax experts while the parties sit at the negotiating table. When parties can t settle their differences ot of cort, valators can address complex financial matters by helping attorneys draft technical qestions for deposition and trial. They can also assist with jry instrctions or critiqe the opposing expert s report. Big gns When hiring a valation professional, an attorney faces a togh qestion: Does he or she need an expert or a consltant? Failre to nderstand the differences between these types of services can compromise a valator s perceived objectivity both in and ot of cort. (See Boltar illstrates the dangers of expert advocacy on page 5.) Dring settlement talks, valators are often the voice of reason, keeping parties focsed on financial matters and pinpointing key differences. For example, experts provide nbiased opinions on technical matters. In a divorce case, an expert might appraise a private bsiness interest or an intangible asset, sch as a patent, copyright or professional license. Consltants, on the other hand, act as advocates for their clients, bt behind the scenes rather than in cort. Most jrisdictions don t reqire disclosre of consltants identities. Accordingly, a consltant s work prodct is generally not discoverable. Once yo ve determined whether yo want a consltant or an expert to join yor team, careflly prepare the engagement letter to be certain it clearly explains the tasks yo expect of him or her. For example, do yo want the person to develop case strategy and draft cross-examination scripts for the opposing expert? If so, be sre to inclde those tasks in the letter. The final say In divorce cases, there are no winners or losers jst two people who desire to get on with their lives. A competent valation expert can help remove mch of the sting from a divorce by adding a dose of common sense to the sitation. 4

5 Boltar illstrates the dangers of expert advocacy In litigation, it s critical for valators and other expert witnesses to be objective, nbiased and reasonable. Experts who act as advocates for a party and attorneys who rge them to do so are asking for troble. Boltar, LLC v. Commissioner illstrates the danger. In this case, the U.S. Tax Cort exclded an expert report as nreliable and irrelevant nder Federal Rle of Evidence 702 and the Dabert standard. A $3 million gap The dangers of expert advocacy are especially great when there s a large difference between the parties respective valation positions. In this case, Boltar granted a conservation easement on a portion of ndeveloped land it owned. It valed the easement at $3.27 million and claimed a charitable dedction of $3,245,000 on its next tax retrn (redcing the vale by $25,000 to reflect a claimed enhancement in the vale of adjacent parcels that Boltar owned). Of the claimed $3,245,000 dedction, the IRS allowed only $42,400, taking isse with Boltar s valation methods. Boltar s experts determined that the highest and best se of the sbject property was development of 174 condominims prsant to a Planned Unit Development (PUD). They determined the vale of the easement as the difference between the claimed forgone development opportnity ($3.34 million) and the vale of the raw, vacant and developable land ($68,000). The IRS moved to exclde Boltar s experts report as nreliable and irrelevant becase the report: 1. Failed to vale the easement sing the traditional before and after method, which examines the land s fair market vale immediately before and after the easement is granted, 2. Failed to consider the easement s impact on the vale of Boltar s contigos parcels, and 3. Relied on a highest and best se of the property that was not physically possible becase the land was too small for the planned development and wasn t zoned as a PUD. The IRS s expert valed the easement at $31,280 a before-easement property vale of $100,600 less an after-easement vale of $69,320. In reaching this conclsion, the expert fond that the land s highest and best se was for development of detached, single-family homes, bt not ntil the srronding properties were developed, becase the sbject property was landlocked. An nreasonable position The Tax Cort acknowledged that the experts in this case were qalified. Bt 5

6 it frowned pon their willingness to se their resmes and their skills to advocate the position of the party who employs them withot regard to objective and relevant facts, contrary to their professional obligations. In exclding the taxpayer s experts report, the cort rejected Boltar s argment that Dabert applies only in jry trials. Althogh, in a bench trial, a cort can simply receive evidence and give it no weight, the Tax Cort said there were benefits to exclding expert testimony, inclding increasing the efficiency of trials and discoraging the cottage indstry of experts who fnction primarily in the market for tax benefits... In exclding the taxpayer s experts report, the cort rejected Boltar s argment that Dabert applies only in jry trials. This was fatal to their case, becase the cort was not inclined to gess at how their valation shold be redced by reason of their erroneos factal assmptions. The cort noted that comparable land in the area was selling for arond $12,000 per acre. Boltar s experts assigned a vale of arond $400,000 per acre, a position, the cort said, that defies reason and common sense. The cort accepted the IRS expert s valation, observing that an expert loses seflness to the cort and loses credibility when giving testimony tainted by overzealos advocacy. (See Object lessons below for tips on maintaining expert objectivity.) Be reasonable As Boltar demonstrates, yo have little to gain and a lot to lose by failing to ensre that yor experts remain objective and reasonable. The best way to ensre reasonableness is to work with experienced, reptable professionals and to encorage them to provide nbiased opinions. Boltar s experts report was so far beyond the realm of seflness that admission is inappropriate and exclsion serves saltary prposes. Among other things, the experts: Departed from the before-and-after approach withot offering persasive reason for doing so, Failed to address the errors and nspportable assmptions raised by the IRS expert, maintaining their appraisal was spportable and appropriate, Failed to determine the highest and best se of the property after the easement was granted, even thogh development for single-family residential se remained feasible, and Failed to evalate prospects for rezoning to allow the condominim development to go forward. The cort was trobled that Boltar s experts didn t offer to adjst or correct their calclations, instead persisting in asserting an nreasonable position. Object lessons Using an expert who s biased or is perceived to be so can rin yor case. Here are some ways to ensre a valation expert s objectivity: Discorage experts from acting as advocates for yor client s position. Ask experts to correct any mistakes revealed at trial and adjst their valations accordingly. Be sre experts follow accepted valation methodologies nless yor client is willing to be a test case. Consider sing separate valation and rebttal experts. Have yor trial expert s valation reviewed by an independent conslting expert. Encorage experts to act as advocates only for their own (objective) position. 6

7 What s the vale of intellectal property? Valations can t be performed in a vacm. Regardless of the type of property involved, a valator s conclsions depend on many factors, inclding the scope and context of the engagement, the standard and premise of vale, the type of ownership interest, and applicable law. These factors are particlarly complex for intellectal property (IP) valations. Why? Becase an appraisal of IP assets may be reqired in a variety of contexts and involve different bndles of rights. And the vale of IP can depend on applicable stattory law, which defines its sefl life and establishes the owner s rights to commercialize the property. Prpose of the valation Vale varies dramatically depending on a valation s prpose. An IP asset s fair market vale, for example, may be lower than its strategic vale to a specific byer who has the ability to maximize the asset s earnings potential. And its fair vale for prposes of Generally Accepted Acconting Principles (GAAP) may diverge widely from its vale for transfer pricing prposes or in a litigation context. Interest being valed The bndle of legal rights that make p an IP asset can be divided in different ways, so it s important for an appraiser to know what type of interest is being valed. Is it the entire fee simple interest? An interest in the entire bndle of rights for a limited time period? Or a license to se the IP? Is the license exclsive or nonexclsive, or is it limited to a particlar se or geographic area? Is there an established market for similar IP assets? The valator shold also know whether an IP asset is being valed on a stand-alone basis or as part of an aggregation of assets. For example, a patent may be valed together with other, related IP assets or with tangible assets, sch as engineering drawings or specifications. Keep in mind that it may not be feasible to segregate IP assets and vale them separately from a company s other assets. Asset s sefl and legal life An IP asset s vale is heavily inflenced by its remaining sefl life, which is defined by statte and is different from its legal life. A patent s term, for example, may be 20 years from the date it s filed bt, in many cases, its sefl life will be mch shorter. Factors that can diminish an IP asset s lifespan inclde shrinking demand for related prodcts or technological advances that render it obsolete. Get on the same page These are jst a few factors that can affect IP valations. To arrive at an accrate, sefl vale, work closely with yor valator to be sre yo re on the same page and that yo receive the type of valation opinion yo need. This pblication is distribted with the nderstanding that the athor, pblisher and distribtor are not rendering legal, acconting or other professional advice or opinions on specific facts or matters, and, accordingly, assme no liability whatsoever in connection with its se VLBma12 7

8 THE SERVICE The professionals of GHP Horwath are dedicated to providing expert witness testimony, bsiness and intangible asset valations, and conslting services for attorneys, insrance professionals, and bsiness owners. Or areas of expertise inclde: Alter Ego Constrction Claims Marital Dissoltion Bankrptcy & Corporate Recovery Economic Damages Mergers & Acqisitions Bsiness Interrption/ Destrction By/Sell Agreements Capital Procrement/Financing Class Action & Claims Administration Commercial/Contract Disptes Compter Forensic & Electronic Discovery Employee Stock Ownership Plans Estate & Gift Taxes Dissenting Shareholder Matters Employment/Wrongfl Termination Financial Reporting Insrance Claims Intellectal Property Damages, Valation & Licensing Conslting Personal Injry/ Wrongfl Death Professional Liability Secrities Litigation Shareholder Disptes Sccession Planning THE TEAM Lisa A. Meer, CPA/ABV/CVA Ms. Meer has over 24 years of experience in providing forensic acconting, financial and economic analysis, valation, and bsiness advisory services in commercial and shareholder litigation, bankrptcy, marital dissoltion, and transaction matters. She reglarly teaches contining legal edcation and training corses and writes articles on economic damage, valation, and corporate finance concepts, approaches, and techniqes. Mark W. Pedigo, CPA/ABV/CVA Mr. Pedigo has over 30 years of experience in economic damages analysis, valation, strategic conslting, aditing, de diligence, and financial analysis. Mr. Pedigo provides conslting, valation and expert testimony services to Consel on behalf of plaintiffs and defendants involved in commercial disptes. Frther, he has extensive experience with constrction litigation and adit-related experience, and has worked on intellectal property and other commercial litigation cases involving nmeros other indstries. Adam H. Newman, CPA/ABV Mr. Newman has over 16 years of experience providing technical valation, tax and conslting services for closely held companies in a wide range of indstries, inclding manfactring, real estate, professional practices, and family limited partnerships. GHP Horwath, P.C. Member Crowe Horwath International 1670 Broadway, Site 3000 Denver, Colorado (303)