Page 66 - Calculating Lost Profits

Chapter 10

Taxes

Overview

As a general matter and as discussed previously, a lost profits damages calculation financially attempts
to put an injured party into the position in which that party would have been absent the alleged harmful
act (assuming liability) or, when that exact position is not possible, a position that is equally well off.
For example, if as a result of the alleged wrongful acts, a business has been forced to forgo a stream of
cash flows from a period prior to trial and into the future, a lost profits calculation is often made to pro-
vide the business the present value of the lost past and future income. This is done because it is impossi-
ble to go back in time and provide the business the lost income as of the time when it would have been
earned and the cash flow streams received. One complication related to this difference arises in the case
of future lost profits, when the company will no longer earn or receive these incomes or cash flow
streams. Assuming the injured party successfully litigates its case, the past and future lost profits (as-
suming both are awarded) would typically be paid in a lump sum as of the judgment date instead of over
the period of time during which they would have been received. By changing the timing of when profits
would be received, the injured party will pay taxes on the lump-sum award in one period instead of pay-
ing the taxes over time as would have been the case had the profits been earned over multiple periods.

Taxes are often ignored in a lost profits calculation because a plaintiff who receives a judgment will
have to pay income taxes on that judgment, and the profits lost would have been taxed had they been
earned by the plaintiff in the but-for world. In theory, this seemingly comports with the typical goal of
awarding lost profits damages — to make the injured party whole. Of course, theory and reality do not
always perfectly align, and it may be appropriate in a properly constructed lost profits calculation for
practitioners to consider tax effects in the effort to ensure that the injured party receives an award that
places the party in an economic position that is no better or worse than would have been experienced
but-for the wrongful act.

"In Lieu of" and "Origin of the Claim"

In a typical litigation, whether the plaintiff is awarded damages by the court or agrees to and receives a
settlement, the tax treatment of the plaintiff’s money received is evaluated under the Raytheon “in lieu
of” rule. Conversely, a payment of money by the defendant to the plaintiff is analyzed under the Gil-
more “origin of the claim” doctrine. fn 1

Raytheon and the “In Lieu of” Test

When analyzing the appropriate tax treatment for the plaintiff, the question is “In lieu of what were the
damages awarded?” In the Raytheon dispute, Raytheon, as plaintiff, settled its antitrust suit against Ra-
dio Corporation of America (RCA). Raytheon excluded from income $350,000 of the total $410,000 set-

fn 1 Although the tax treatment by a defendant of amounts it pays related to a litigation is not directly relevant to the plaintiff's tax
treatment, this issue is discussed herein to see the other side of the payment.

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