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, the media magnates (L.A. Times and Newsday) 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 out of the newspaper business and to end their battles with Tribune's Chicago-based managers. The Chandler family paying taxes is like the sun rising in the west—an unnatural event. The family pioneered in tax avoidance when it controlled the old Times Mirror Co., which Tribune bought in 2000. The Chandlers specialized in convoluted transactions designed to give themselves (or Times Mirror) the economic benefits of selling assets without triggering capital-gains tax. (The IRS got two of these deals ruled illegal, forcing Tribune, which is appealing, to fork over $1 billion.)
But it's Zell who's breaking new tax ground here. Zell, Tribune and the Chandlers all declined to comment. But public records indicate that Zell is using a provision 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 LLP. He said 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—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 holders 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. It's about a $13 billion deal if you include fees and Tribune's existing debt. Zell will lend the post-buyout company—which we'll call New Tribune—$225 million. He'll pay it an additional $90 million for the right to buy 40 percent of it at a fixed price.
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 ESOP, 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. Zell has a warrant to buy 40 percent of New Tribune for 15 years for $500 million to $600 million. But he won't actually own the stock, and hence won't owe tax on his 40 percent of New Tribune's income. (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.)
Is this deal what Congress had in mind when it let S corps and ESOPs combine in 1996? Not according to former senator John Breaux, who sponsored the legislation, 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 played the ESOP-S corp game, for a variety of technical reasons. But there's nothing to stop Wall Street from assembling groups of fewer than 100 individuals and mimicking Zell's deal.
So it's goodbye to the Chandlers, such a rich tax topic for so long. And hi 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.