By Allan Sloan
Tuesday, May 1, 2007
Whenever you see a deal involving Los Angeles's Chandler family, you usually see a tax dodge. And sure enough, the pending sale of Tribune Co., the big media firm in which the Chandlers are the largest shareholders, exploits a loophole so gaping that we taxpayers can only pray that someone closes it quickly. But it's not the Chandlers, media magnates (L.A. Times, Newsday, the Baltimore Sun), whose shenanigans I've tracked for 15 years, who are dodging taxes here. It's Sam Zell, the Chicago real-estate mogul who's buying control of Tribune.
As best I can tell, the Chandlers are willing to pay taxes on their $1.7 billion of sale proceeds just to be able to exit the newspaper business and end their ties to Tribune's Chicago-based managers, with whom their relationship is so venomous that one adviser calls it "Sunni versus Shiite."
The Chandler family paying taxes is like the sun rising in the west. Before the Chandlers sold the old Times Mirror Co. to Tribune in 2000, they engaged in groundbreaking tax avoidance deals, including the first "monetizing Morris Trust" (which is too complicated for me to explain briefly) and various convoluted transactions designed to give themselves or Times Mirror (or both) the economic benefit of selling assets without triggering the capital gains tax. (The IRS challenged two of those deals and prevailed in court, forcing Tribune, which by then owned Times Mirror, to fork over $1 billion. Tribune is appealing.)
But it's Zell, not the Chandlers, who's breaking new tax ground here. Neither he nor Tribune nor the Chandlers would comment, but public records indicate that Zell is using a provision that was stuck into a minimum-wage-increase bill in 1996 at the behest of the owner of a small Minnesota company who wanted to sell a stake to his workers via an employee stock-ownership plan. "We were instrumental in drafting that language," said Stephen Smith of the Indianapolis law firm of Krieg DeVault. His client, David Copham of Liberty Enterprises, which prints checks for credit unions, couldn't set up an ESOP because Liberty was a so-called S corporation rather than a C corporation. (Please don't ask why S corps couldn't set up ESOPs -- trust me, you don't want to know.) An S corp, generally a small business, can't have more than 100 shareholders, and its income is taxed directly to its shareholders. By contrast, C corps like Tribune and other big companies pay tax directly, and their shareholders owe tax only on whatever dividends the corporation distributes to them.
Still with me? All right! The $34-a-share, $8.2 billion buyout of Tribune is being run through an ESOP, using borrowed money. (Including Tribune's existing debt, the transaction totals roughly $13 billion.) Now, watch: Zell is lending the post-buyout company -- which we'll call New Tribune -- $225 million. He'll pay it an additional $90 million for a warrant that gives him the right to buy 40 percent of it for prices ranging from $500 million to $600 million.
After all the papers are shuffled, Tribune, currently a C corporation, will convert to an S corporation. New Tribune's only shareholder will be the employee stock ownership plan, which -- like all ESOPs and other employee-benefit plans -- is tax-exempt. So New Tribune will be a tax-free company (with a few minor exceptions we won't go into here).
The tax exemption substantially increased New Tribune's borrowing power, making it possible to finance a $34-a-share deal. We're talking major tax bucks. Last year, Tribune racked up $1 billion in pretax profit. If you adjust for the (tax-deductible) interest on New Tribune's added debt, it would still have had $527 million in pretax profit and a $167 million tax bill, according to a recent filing. Taxes under the ESOP structure: zippo.
How will Zell and Tribune's management avoid taxes on their pieces of New Tribune (40 percent and 8 percent, respectively)? Easy. Management will have "phantom stock," not real stock. It'll get the economic benefit of ownership but not actual ownership and thus won't be liable for taxes on New Tribune's income. Zell's warrant gives him the right to buy 40 percent of New Tribune, but he won't owe tax on his 40 percent of New Tribune's income because he won't own any of its stock. (An aside: Zell will probably take his profit, if any, by selling his warrant in a tax-efficient way, not by holding New Tribune stock.)
The Tribune deal bears no resemblance to what Copham did 11 years ago. Copham, who stressed that he knows nothing about Zell's deal, said that he "believed in participation and ownership" and wanted to help his employees. Which he did. By the time he sold the company for $160 million two years ago, Copham says, the 800 or so employees owned 20 percent of it.
Is a deal like Tribune's what Congress had in mind when it let S corps and ESOPs combine in 1996? Not according to former senator John Breaux (D-La.), who sponsored the provision, which was subsequently tweaked twice. "I wanted to encourage employee ownership," Breaux told me. "I wasn't trying to encourage tax avoidance."
Hedge funds and buyout houses haven't been able to play the ESOP-S-corp game for technical reasons that I'm not sure I quite grasp (and that I know I can't explain). But there's nothing to stop Wall Street from assembling groups of fewer than 100 people and mimicking Zell's deal. It will be interesting to see if the dealmakers strike before Washington's loophole closers can do their job.
Meanwhile, it's goodbye to the Chandlers, such a rich tax topic for so long. And hello to Sam Zell. He calls himself the Grave Dancer for reviving properties others considered dead. But he now rates a new name: the Artful Dodger.
Sloan is Newsweek's Wall Street editor. His e-mail address email@example.com.