Friday, September 18, 2009
Sarah Lawsky (George Washington) shares her thoughts on the tax savings driving the sale of the Chicago Cubs:
Yesterday, Paul linked to an article about the acquisition of the Chicago Cubs. The article said "tax breaks" would allow Tribune Company (the seller) and Tom Ricketts (the buyer) to "save hundreds of millions of dollars." It mentioned in particular that Tribune was smart to retain 5% of the team and take a lower purchase price, instead of taking more cash outright. As the article put it, this structure would give the company a "shrewd tax break," because "by accepting the lower purchase price in exchange for retaining a portion of team ownership, Tribune will save about $400 million in capital gains taxes." So what is this shrewd deal? Let's say that the higher offer was $1 billion (a number mentioned in the article). The blended federal and state corporate rate is about 40%. The claim appears to be that Tribune will pay no taxes at all (i.e., will save 40% of $1 billion, or $400 million) because of the current deal structure. What's going on?
I think, based on a quick perusal of the deal documents and some helpful guidance from the TaxProf mailing list, that the deal is structured as a "leveraged partnership." Tribune has used this structure before, when it sold Newsday. Here's how a leveraged partnership works (somewhat simplified): Tribune drops the Cubs business into a limited-liability company, or LLC, which taxed as a partnership, and Buyer drops in some cash. The LLC borrows a large amount of additional cash (essentially, the purchase price) and distributes that cash to Tribune. As a result, Buyer has a 95% interest in the LLC, and Tribune has a 5% interest and a lot of cash.
But wait, you may be saying. Yes, it's true that assets can be contributed tax-free to an LLC that's taxed as a partnership, and it's true that distributions from such an LLC are tax-free to the extent of basis. But surely the claim cannot be that Tribune did not sell the assets, but simply made a tax-free contribution to an LLC of assets worth $844 million and then received a tax-free distribution from the LLC of roughly that amount of cash. If it's that easy, every sale would be tax-free! Also, Tribune should have a basis in the LLC that's equal to its basis in the assets it dropped in. Surely the assets Tribune dropped into the LLC weren't even close to their fair market value, so even if we treat the transaction as a distribution from the LLC, wouldn't there be gain to the extent the distribution exceeds Tribune's basis in the LLC?
Well, there's a twist. Yes, there's a rule that says that you can't just drop assets into an LLC and get cash out and claim it's not a sale. But there is also an exception to that rule: under Treas. Reg. 1.707-5(b)(1), if the debt is allocable to Tribune (the member who got the cash), the transaction won't be considered a sale, because the cash distribution is traceable to the debt. The idea is that Tribune would have been allowed to borrow against the assets anyway, so we shouldn't prevent it from borrowing against the assets just because the assets are now in an LLC. So here's the clever move: Tribune guarantees the debt. Then all of the debt is allocable to Tribune, and the whole deal falls under this exception. And the guarantee means that Tribune's basis in the LLC is increased by the amount of the debt, which gives Tribune plenty of basis to receive the cash distribution tax-free. (Indeed, the Tax Matters Agreement states that Tribune's receipt of cash is meant to be a tax-free distribution, and in fact explicitly cites Treas. Reg. 1.707-5.)
Of course, even if this meets the letter of the law, it still looks like a sale, particularly since Tribune was looking to sell the Cubs and ended up doing this deal instead. Can the IRS do anything? Robert Willens, a master of deal tax analysis, didn't think so when he looked at the Newsday deal. He thought for that deal, at least (which was similar in many ways to this deal), the most the IRS could do would be to challenge it under the general partnership antiabuse provisions, but such a challenge would probably not succeed. (The IRS has also attacked a leveraged partnership structure by disregarding a guarantee, on the grounds that the guaranteeing party was so undercapitalized that it would not really have been able to pay off the loan, but Tribune probably holds enough assets to avoid this sort of attack.)
(A footnote on the basis question for partnership-tax types: the article also claimed the Cubs franchise could be depreciated over 15 years, which would fully offset the Cubs' earnings. If the deal is respected as structured, the assets will have a very low basis inside the LLC, precisely because this was a contribution and not a sale. However, the LLC Operating Agreement calls for the remedial method of allocation with respect to the Cubs assets. This gives Ricketts his full depreciation. Tribune has to be allocated extra income to offset Ricketts's deductions, but this extra income will probably be offset by the deductions for interest payments on the loan, which should be allocated to Tribune as the loan guarantor.)
You can read more about leveraged partnerships in, among other sources, Louis S. Freeman et al., The Partnership Union: Opportunities for Joint Ventures and Divestitures, 863 PLI/Tax 9 (2009). The Robert Willens article that suggests that the Newsday deal would probably be respected is Robert Willens, Newsday Postmortem, 120 Tax Notes 1211 (Sept. 22, 2008). The TaxProf mailing list, in particular Linda Galler, Ted Seto, and especially Adam Rosenzweig, helped me understand this transaction. You can look at the deal documents yourself: the LLC Formation Agreement, the Definitions Exhibit, the LLC Operating Agreement, the Tax Matters Agreement, and the debt guarantees. For a full set of deal documents (including the ones I've listed here), see Docket Number 2004 of Tribune Company's bankruptcy filing (click "Images").
Update: Sarah has more here.