Zell's tax dodge

How did Sam Zell manage to avoid a huge tax bill in the Tribune deal? Newsweek's Allan Sloan found a small provision in minimum-wage legislation in 1996 that helped pave the way. It was tucked into a bill to help out the owner of a small Minnesota company who wanted to use an employee stock-ownership plan. The company couldn't do the ESOP because it was an S corporation (usually small businesses that have income taxed directly to its shareholders) rather than a C corporation (generally large ones). As part of the deal, Zell has the right to buy 40 percent of the New Tribune (parent of the LAT). But doesn't that mean he'll have to pay taxes? Let Sloan take it from here:

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.