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Business Valuations: Owner salaries and how they affect lost profits

February 21, 2012

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On 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.

In a breach of contract case, for example, a typical measure of damages is the contract price less contract-related 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 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.

Anesthesiologists Associates of Ogden v. St. Benedict’s Hospital, 884 P.2d 1226, 1238, 1994 (Supreme Court of Utah)
Bettius & Sanderson, P.C. v. National Union Fire Insurance Co., Nos. 87-3036, 87-3043, Feb. 17, 1988 (4th Cir.)

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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