Tribune’s Bankruptcy May Trigger Tax Complications

The private media company could be in danger of losing its favorable tax status if creditors make a grab for its stock.
Marie LeoneDecember 9, 2008

Of the many issues that surfaced after Tribune Co. filed for Chapter 11 protection yesterday, tax consequences were among the least discussed. But tax effects may be extremely cumbersome to deal with as the company works its way through bankruptcy, especially if Tribune loses its tax status as a so-called S corporation, says a new client advisory from Robert Willens LLC.

An S corporation — named so because it is subject to the tax code’s subchapter S provision — meets the Internal Revenue definition of a small business, has fewer than 100 shareholders, and is structured as a corporation but taxed like a partnership. As a result, income and the attendant taxes pass through the corporation directly to the shareholders, who pay taxes on the profits. So, with the exception of “built-in gains,” an S corporation is not subject to tax on its income.

Currently, all of Tribune’s outstanding stock is owned by an Employee Stock Ownership Plan (ESOP), established when owner Sam Zell orchestrated the LBO. However, the number of shareholders may grow precipitously if the company is forced through a bankruptcy restructuring to pay-off its creditors in stock. That’s a problem, notes tax expert Willens in his company’s advisory.

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Citing the classic tax tome Federal Income Taxation of Corporations and Shareholders, Willens says that handing out stock to creditors in lieu of cash payments could force Tribune to exceed its 100 shareholder limit, and as a result, lose its S corporation status. What’s more, its S corporation tax treatment will disappear if an “impermissible” shareholder is awarded stock. The persona non gratis, according to the tax code, is a person (other than an estate, certain trusts, or certain qualified retirement plans) who is not an individual or a U.S. citizen. Further, Tribune’s S corporation structure would break down if a second class of stock is created — because an S corporation may not have more than one class of stock

Less onerous, but still important, is that Tribune also faces tax issues with regard to how it treats creditors’ debt that has been exchanged for stock in a bankruptcy restructuring. Under the tax code, specifically Section 108(e)(8), the debt is treated as having been paid off with cash that is equal to the fair market value of the transferred stock, notes Willens. But if the adjusted issue price of the retired debt exceeds of the debt’s repurchase price, the excess is considered cancellation of indebtedness (COD) income.

The tax code exempts COD income involved in a Chapter 11 filing from current taxation, but it requires compensating reductions in tax benefits from the debtor. In short, the tax rules mandate that tax benefits of a bankrupt company be reduced — in a specified order — so the COD income is excluded from gross income.

In most cases, the COD income is not permanently excluded, notes the advisory, but rather is deferred for later recognition. Usually the rule slashes the value of net operating loss carryovers, capital loss carryovers, and tax credit carryovers. However, S corporations rarely have those types of tax breaks. What affects S corporations the most in this situation is the shrinking of its asset base, says Willens.

S corporations filing for bankruptcy likely will face tax issues tied to built-in gains, as well. Built-in gains are generated from the sell-off of assets during a 10-year recognition period. The decade-long period usually begins the first day of the first taxable year a company becomes an S corporation. For Tribune, the period begins Jan. 1, 2008, when it was bought out by Zell.

In some cases a company can get around the effective date if it can establish that the asset was not owned on the first day of the taxable year, or the value of the asset exceeds its adjusted basis on the first day of the year, explains the advisory.

The mere filing of a bankruptcy petition does not trigger the recognition of built-in gains, asserts Willens. By the same token, if a company sells off assets during the recognition period, it is not automatically exempt. What happens is that the “net recognized built-in gain” that is subject to tax cannot exceed the S corporation’s taxable income for the year. If it does, the excess gain is carried over to the next taxable year, and the corporation must pay the corresponding levy.