Lost Profits
Questions from the NACVA Conference Regarding Discounting Lost Earnings for Self-Employed Individuals
In June 2021, the author of this article made a virtual presentation at the NACVA and the CTI’s Business Valuation & Financial Litigation Hybrid & Virtual Super Conference. The presentation was “Estimating Economic Loss of the Self-Employed: Lost Profits or Lost Earning Capacity”. One of the attendees asked a very good question regarding discounting future losses to present value, which is the main focus of this article.
In June 2021, I presented a virtual session at the NACVA and the CTI’s Business Valuation & Financial Litigation Hybrid & Virtual Super Conference. My presentation was “Estimating Economic Loss of the Self-Employed: Lost Profits or Lost Earning Capacity”. One of the attendees asked a very good question regarding discounting future losses to present value, which I would like to further discuss in this article.
Defining Self-Employed
A broad definition of self-employed is a situation in which a person works for himself or herself instead of working for an employer that pays a salary or wage. Self-employed individuals earn their income through conducting profitable operations from a trade or business that they operate directly. These operations may be reported as sole proprietorships, partnerships, or S chapter corporations.
For most self-employed individuals, the income from their business is their earnings. For a sole proprietorship, the net income found at the bottom of a Schedule C shows the self-employed person’s income. For partnerships, the K-1 provides information of draws and income for each partner. And S corporation owners may be paid in two ways: one by W-2 and the other by K-1. The combination of these two documents will provide the total non-passive income generated by the self-employed person.
While an injured self-employed person may claim the profits from his or her business as personal earnings, the courts have set limitations on such claims. “It is a generally accepted proposition that evidence of the profits of a business in which the injured party in a personal damage suit is interested, which depend for the most part upon the employment of capital, labor of others, and similar variable factors, is inadmissible in such suit and cannot be considered for purpose of establishing the pecuniary value of lost time or diminution of earning capacity, for the reasons that a loss of such profits is not the necessary consequence of the injury and such profits are uncertain and speculative.
However, where the business is small and the income which it produces is principally due to the personal services and attention of the owner, the earnings of the business may afford a reasonable criterion to the owner’s earning power.”[1]
The question being discussed in this article was directed at calculations for estimating an injured self-employed person’s lost earnings based on his or her business’ lost profits. These calculations assume the business’ income was principally due to the personal services and attention of the owner.
Discounting Future Losses to Present Value
Assessing the lost earnings of a self-employed person brings together methodologies used for calculating lost profits and lost earning capacity. But calculating the present value of future lost earnings is strictly a personal damages calculation. This is because the plaintiff is either the self-employed person or the injured party’s family. The business does not have standing and cannot claim lost profits.
This means, that in most states, the lost future earnings must be discounted by a risk-free rate.[2] This was confirmed by the U.S. Supreme Court as early as 1916. “We do not mean to say the discount rate should be at what is commonly called the -legal rate- of interest, that is the rate limited by law, beyond which interest is prohibited. … This, however, is a matter that ordinarily may be adjusted by scaling the rate of interest to be adopted for computing the present value of the future benefits; it being a matter of common knowledge that, as a rule, the best and safest investments, and those which require least care, yield only a moderate return.”[3] The Supreme Court affirmed this position in 1983. “The discount rate shall be based on the rate of interest that would be earned on the ‘best and safest investments.’” [Citations Omitted][4]
As most states have followed the Supreme Court’s decisions, a self-employed person’s lost future earnings that have been calculated from the profits of his or her business must be discounted by the yield on U.S. Government securities or AAA rated, general obligation tax-exempt bonds.
Question from Attendee
As we moved through this section of my presentation, an attendee asked, “If we are calculating the self-employed person’s lost earnings by using his or her business’ lost profits, why can’t we add risk factors to the discount rate? In this way we can apply a discount rate to the lost earnings that reflects the risks for generating these future lost profits.”
My response was that because this is a personal damages claim, we have to follow the standards set by the courts for discounting future losses for personal injuries. Those standards require discounting with a risk-free rate.
The person asked a follow-up question. “Then how do we address the risks associated with generating those future profits?”
My response was this: The expert should not simply project the future profits based on historical performance or some form of the self-employed person’s projections, but model the future losses as discussed by Dunn and Harry.[5]
My Full Answer
In their article, Modeling and Discounting Future Damages, Dunn and Harry said, “Some CPA experts project the plaintiff’s hope-for income stream, modify those losses to a realistic expectation by factoring in future risks and then discount the adjusted future losses to present value at a risk-reduced, relatively low discount rate. Other experts project the hoped-for-but-lost amounts and then apply a higher discount rate that already incorporates risk or uncertainty to determine the present value.”[6]
This first approach discussed by Dunn and Harry is called modeling. This is the approach I recommended for those calculating the lost earnings of a self-employed person whose losses are also his or her business’ lost profits.
When discussing the two approaches for calculating the present value of future lost profits, Dunn and Harry discussed why they preferred the first approach, “modeling,” to the second approach for arriving at the present value of future losses. “The first approach—‘modeling’ (examining the interactive components of a financial outcome) and analyzing various input factors (sensitivity analysis)—does this more accurately.”[7]
They go on to say, “If the expert believes the damages model represents the lost income stream with a high degree of certainty, he or she may elect to use only a safe rate of discounting.”[8]
By modeling future lost profits, an expert can reduce the concern over many, if not all, of the risks related to generating the projected profits. By reducing the risks related to these lost profits, the discount rate can be adjusted downward. Some would argue the discount rate can be reduced to the risk-free rate. Therefore, modeling allows an expert to justify applying a risk-free discount rate to the lost profits a self-employed person’s business when those lost profits are being shown as his or her lost personal income.
The use of a risk-free or reduced discount rate when discounting lost profits is not a new idea. Numerous states have court decisions allowing for lost profits to be discounted by a risk-free rate. To do so, an expert must provide lost profit results that reasonably approximate the most likely or expected but-for outcome. By applying modeling to the projected lost profits of an injured self-employed person, an expert may have greater confidence in providing results that meet both the personal damages and commercial damages standards.
When addressing the discount of lost profits to present value, federal and state courts have concluded the appropriate discount rate is a question of fact. In the oft quoted Energy Capital case, the appellant court expanded on this position.
“Energy Capital argues that the sole purpose in discounting is to account for the time value of money. Again, we disagree when calculating the value of an anticipated cash flow stream pursuant to the discounted cash flow (DCF) method, the discount rate performs two functions:
- It accounts for the time value of money, and
- It adjusts the value of the cash flow to account for risk.
We do not hold that in every case a risk-adjusted discount rate is required, rather, we merely hold that the appropriate discount rate in question is a question of fact.”[9]
Conclusion
Questions from attendees at NACVA and CTI conferences provide great insight into what the concerns or interests in the presenters’ topics are. One of the attendees at my session on calculating the lost income of self-employed persons posed a question which deserved a longer answer. This article has been a response to that question.
Many experts argue applying a risk-free rate for discounting a self-employed person’s future lost income fails to consider the risks related to generating the lost profits, which are the self-employed person’s lost income. I agree there is some degree of risk in generating any profit stream for a business. But the dilemma is most venues require future losses in personal damages cases be discounted by a risk-free rate.
To assist an expert arrive at the most reasonably accurate projection of lost profits and therefore, lost income for the self-employed person, modeling should be used. By adjusting the projected revenue, expenses, and profits of a self-employed person’s business, the results provide a better focused picture of the self-employed person’s lost income. This is because the expert has examined the interactive components of the financial outcome and performed a sensitivity analysis. By modeling the lost profits before discounting the results as lost personal income, an expert may argue he or she has taken commonly used steps to provide results which fulfil the reasonable certainty standard set by the courts and have considered the risks necessary for generating the lost income.
[1] Smith v Corsat, supra., 260 N.C. at 96, 131 S.E.2d at 897-98 (1963).
[2] Pennsylvania requires personal damages future losses be discounted by total offset, unless a medical malpractice suit. Other states have a statutory rate that is used for discounting.
[3] Chesapeake & O.R. v Kelly, 241 U.S. 485 (1916).
[4] Jones & Laughlin Steel Corp. v Pfeifer, 462 U.S. 523 (1983).
[5] Modeling and Discounting Future Damages, Robert Dunn, Everett Harry, Journal of Accountancy Online, January 2002.
[6] Ibid.
[7] Ibid.
[8] Ibid.
[9] Energy Capital Corp. v U.S., 302 F.3d 1314, (2002).
Allyn Needham, PhD, CEA, is a partner at Shipp Needham Economic Analysis, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp Needham Economic Analysis, he was in the banking, finance, and insurance industries for over twenty years. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy, and business valuation. Dr. Needham has published articles in the area of financial and forensic economics and provided continuing education presentations at professional economic, vocational rehabilitation, and bar association meetings. Dr. Needham is a member of NACVA’s QuickRead Editorial Board.
Dr. Needham can be contacted at (817) 348-0213, or by e-mail to aneedham@shippneedham.com.
