At What Point In Time Should Future Lost Profits Be Estimated

Coincident with the current recession, court cases have been coming out that challenge the timing of the estimation of future lost profits.  Primarily, the cases deal with commercial real estate; but they may get extended to other industries as the recession continues.

Obviously, plaintiffs want to forecast future lost profits based on the economic conditions at the date of the breach of contract or other "but for" event.  On the other hand, defendants want to use the economic conditions prevailing at the date of trial. 

In November 2010, the Court found in favor of the defendant in Capitol Justice LLC v. Wachovia Bank N.A.  This decision reduced the plaintiffs claimed losses from $33 million to $6.7 million.  In March 2010, the Court ruled that the forecasted losses should be estimated based on the anticipated conditions at the date of breach (Epicenter Partners LLC v. Northeast Phoenix Partners). 

Traditionally, experts have relied on the economic conditions and outlook that existed at the date of loss, while disregarding subsequent events and conditions.  Although we attempt to focus on what was known or knowable at the date of loss, we must consider whether a particular subsequent event could have been reasonably expected to occur in the future.  Case in point - Consider Hurricane Katrina and its devestating effect on New Orleans.  While it may be reasonable to consider that hurricanes will periodically occur along the Gulf Coast, is it reasonable to include a storm of that magnitude in your assumptions when forecasting future losses?

Off topic bonus heads up - The IRS is not subject to the recent changes to Rule 26(2) of the Federal Rules of Civil Procedure.  Furthermore, U.S. Tax Court has not adopted FRCP 26.  So be careful with report drafts related to income tax issues.

The Ongoing Rage Over Tax Affecting Pass Through Entities

As many of you know, for years there has been an ongoing dialogue over whether pass-through entities should be tax-affected for valuation purposes.  At a recent ASA (American Society of Appraisers)-IRS Symposium, Miles Friedman , Associate Area Counsel in the IRS Office of Chief Counsel, stated definitively that courts and the IRS say no to tax-affecting.  This statement was certain to launch at least a thousand rebuttals.

Intelligent and well-qualified valuation experts hold positions on both sides of this argument.  Personally, I generally tax-affect pass-throughs for valuation purposes.  Many proponents of not tax-affecting point to Gross v. Commissioner as justification.  Like any precedent, care should be taken in applying it.  In Gross, the Court did not reject tax-affecting, it merely said that given a choice between 40% and 0%, 0% was a better choice under the circumstances at hand.  It remains incumbent on the valuation analyst to support his/her position and persuade the Court to accept that tax affecting is justified.

Good data, appropriate analysis, well-reasoned application, and effective communication will generally carry the day.