KPMG LLP can remain MCI Inc.'s auditor and does not have to return $146 million in fees, a federal bankruptcy judge ruled yesterday.

Fourteen states, led by Massachusetts, wanted KPMG fired for designing a strategy that helped the company, then known as WorldCom Inc., avoid hundreds of millions of dollars in taxes between 1998 and 2001. The states said MCI, the second-biggest U.S. long-distance phone company behind AT&T Corp., should also consider suing KPMG.

The states said an outside firm should replace KPMG to review the accountant's tax strategy. Former U.S. attorney general Richard Thornburgh, appointed to review WorldCom matters, said in a January report that KPMG's strategy for minimizing WorldCom's state taxes was flawed.

"The court finds no appearance of impropriety," U.S. Bankruptcy Judge Arthur J. Gonzalez said in denying the states' request. "KPMG does not have an interest adverse to the interests of MCI, its creditors or equity holders."

The judge noted that MCI has supported keeping KPMG as its auditor. KPMG audited MCI's 2002 and 2003 financial results.

"We're obviously disappointed in the judge's decision, and we're still reviewing it to see whether or not we want to appeal," said Joan Grourke, a spokeswoman for the Massachusetts Department of Revenue. "The main issue is whether the commonwealth is owed money. We'll continue to pursue our claims as part of the bankruptcy proceedings."

Massachusetts has said MCI owes it $90 million in taxes.

"We are very pleased that Judge Gonzalez has denied the states' motion for disqualification, which we always believed was without merit," KPMG spokesman Tom Fitzgerald said.

MCI spokesman Peter Lucht declined to comment.

WorldCom subsidiaries paid more than $20 billion in royalties for services to a separate company unit, according to Thornburgh's report, which was commissioned by the bankruptcy court. The subsidiaries deducted the royalty expenses for state-tax purposes and the parent company was lightly taxed on them, the report said.

"KPMG provided the basis for the tax evasion strategy by which WorldCom generated the invalid deductions" under the royalty plan, the states said in court papers. Both KPMG and MCI have said the strategies were appropriate.

KPMG replaced Arthur Andersen LLP as Ashburn-based WorldCom's auditor in May 2002. Andersen stopped auditing public companies after its conviction for obstructing a government investigation into the collapse of Enron Corp.

WorldCom filed the largest bankruptcy in U.S. history in July 2002 after disclosing financial misstatements that were part of a $10.6 billion accounting fraud. The company exited bankruptcy as MCI in April.