“In conception, it was brilliant,” said Robert Willens, a longtime tax analyst who now runs his own firm, Robert Willens L.L.C. “It would have been probably the greatest tax avoidance structure ever devised, had they earned income.”

Instead, the strategy has now backfired on the Tribune Company, the publisher of The Chicago Tribune and The Los Angeles Times, among other publications. The company seems likely to have to pay hundreds of millions of dollars in taxes that it would never have owed had it not tried to be so clever.

In a way, this latest disaster is an indictment of a corporate tax law that allows companies — even encourages them — to play games to minimize their tax bills.

Without the expected tax savings, the numbers probably would not have worked when Samuel Zell, the real estate billionaire, was putting together his 2007 takeover of Tribune. Perhaps he would have dropped the deal, or perhaps he would have been unable to finance it. In either case, everyone involved would have been better off.

As it is, Tribune has come out of bankruptcy and now faces a big tax bill that it had not budgeted for. It says it thinks the Internal Revenue Service is wrong, but Mr. Willens says the I.R.S. has tax court precedents on its side and is likely to prevail.

If so, that will be one more — and perhaps the final — indignity to Tribune caused by Mr. Zell. He is long gone from the company, but his legacy lives on.

Here is how the clever strategy was supposed to work: For his leveraged takeover of Tribune, Mr. Zell set up a corporate structure the likes of which I have never seen in a large company.

The new Tribune had only one shareholder, an employee stock ownership plan, or ESOP. Mr. Zell had no shares, but he did have a warrant to buy a lot of shares for virtually nothing. We’ll get to that later.

Normal corporations are called C corporations in the tax law. They pay taxes — at least theoretically, given all the loopholes and strategies that many of them have found or developed — and then pay dividends out of after-tax income. Those dividends in turn are taxable to investors, unless those investors are exempt from paying taxes.

But there is another kind of company, an S corporation. It pays no income taxes, but its shareholders are personally liable for taxes on the company’s profits, whether they were paid any dividends or not. It is popular with small-business owners and is limited to companies with fewer than 100 shareholders.

Mr. Zell first converted the company to an S corporation. No matter how much it made, it would never have to pay a dime in federal income taxes.

But wouldn’t its shareholders be on the hook?

Not in this case. Russell Long, the senator from Louisiana and longtime chairman of the Senate Finance Committee, viewed ESOPs as a way to provide the benefits of capitalism to workers. “It is only fair and right that those who work to make this economy succeed should have an opportunity to share in that success,” he said in 1983, as he pushed through Congress the Employee Stock Ownership Act, which contained numerous tax breaks for such plans. “It is a matter of simple common sense and basic equity.”

As a result of Senator Long’s affection for such plans, ESOPs that own stock in S corporations are exempt from taxes on the profits.

The result was that, presto, Tribune’s profits would no longer be taxable. It had become a tax-exempt organization, in reality if not in name.

Mr. Willens says that would have worked if Tribune had ever had any profits after the takeover. Mr. Zell presumably would not have exercised his warrant until he was ready to cash out. Then he would have either sold the warrant to someone, or exercised it and immediately sold the stock.

There is one catch to the taxation of S corporations. A company that converts from C to S status may still be subject to capital gains taxes if it sells assets within 10 years after the conversion. If that happens, it owes taxes on the gain in value that accrued before the company converted.

Article source: http://www.nytimes.com/2013/06/21/business/tribunes-clever-tax-strategy-now-spells-trouble.html?partner=rss&emc=rss