The billion dollar bite: everything went wrong with Times' tax gamble.

HOURS after Tribune Co. lost its $1 billion bet in U.S. Tax Court over a 7-year-old sale it didn't even have any role in, Chairman and Chief Executive Dennis FitzSimons gamely tried to offer assurances that the company would appeal and that it had the resources to pay the bill.

"We have always realized that our best opportunity for winning this case would be on appeal," FitzSimons wrote in an e-mail to employees.

What he wouldn't say was far more tantalizing: How could executives of the Chicago-based publishing giant and parent of the Los Angeles Times let the years-long tax dispute get this far?

"Why management did not settle this years ago is anybody's guess," Douglas Arthur, an analyst at Morgan Stanley, wrote in a research note. "The cost to investors and therefore the company's cost of equity capital from the looming anxiety of this outcome has been incalculable."

Not everyone on Wall Street is convinced that the Tax Court ruling was so dire, though Tribune's stock fell to a four-year low and Standard & Poor's said it may cut the company's long-term corporate credit rating. Tribune executives are counting on the decision by U.S. Tax Court Judge Mary Ann Cohen being reversed.

Still, the dispute with the Internal Revenue Service is a cautionary tale for executives and corporations that use complex tax shelters to avoid paying corporate income taxes. It also underscores the hazards of buying into a company with a huge tax liability that was generally minimized (to the point where Tribune tamed down a chance to settle three years ago for $551 million).

Losing big

The case centers on a 1998 deal in which Times Mirror Co. sold its Matthew Bender legal publishing subsidiary to Reed-Elsevier in what was supposed to be a tax-free transaction. Times Mirror, at the time led by Chairman and Chief Executive Mark Willes, later structured a similar deal to dispose of a health-publishing subsidiary.

Tribune purchased Times Mirror in 2000. In 2001, the IRS issued an opinion contending that the deals were taxable sales--and not restructurings, as Times Mirror had claimed. Now Tribune is required to pay up to $1 billion in back taxes on the transaction.

"They lost big," said Charlotte Crane, a tax expert and professor at Northwestern University School Law School. "They obviously had a lot of high-profile professionals vouching that this would work, so maybe they're counting on some type of indemnification."

In July, FitzSimons had told analysts that Tribune was ready to appeal.

In a conference call last week, he said that the company was weighing its options on whether to sell off stakes in separate units, such as the Food Network. "At this point," he said, "we would not make any short-term decisions."

Asked whether staff reductions at the Times or any other Tribune property were on the table, a Tribune spokesman referred back to the conference call, in which executives emphasized that no immediate moves were planned.

As to whether the acquisition of Times Mirror is looking like such a good deal, FitzSimons said, "It takes five or six years for an acquisition to cover its cost of capital. We're still analyzing it at this point."

When it bought Times Mirror five years ago for $6.4 billion, Tribune received $180 million that Times Mirror had set aside as a reserve. Tribune began adding to that reserve in the past year and recently sold $850 million in short-term notes to cover its obligations. An appeal will take 18 months.

Complex transactions aimed at eliminating tax bills were common in the late 1990s, when Times Mirror's Chief Financial Officer Thomas Unterman structured the Matthew Bender sale.

"They had opinions from two major accounting firms and two major law firms," said Renee LeBran, a partner at Rustic Canyon Group, the venture capital firm headed by Unterman. "At some point you can only rely on people advising you, and I don't know that I would say it was bad advice."

Calls to Daniel Shefter, the financial advisor at Goldman Sachs who worked on the 1998 transactions, were not returned. Unterman was said to be traveling in Italy last week and could not be reached for comment.

In a Tax Court hearing in December, Unterman denied that the deals were structured to avoid taxes.

Inherited litigation 

A large number of companies have inherited lawsuits and also chose the same route as Tribune--litigating n court instead of settling. An example is the asbestos industry.

Only after years of litigation and threats of bankruptcy did Halliburton Inc. and Pfizer Inc., which both faced hundreds of thousands of inherited asbestos claims, agree to a settlement.

Last year, Halliburton agreed to pay $5.1 billion to settle asbestos-related claims stemming from its $7.7 billion acquisition of Dresser Industries Inc. in 1998. Halliburton has collected more than $1 billion from various insurance carriers.

Pfizer has paid roughly $1.1 billion to resolve hundreds of thousands of asbestos personal injury claims filed against Quigley Corp., a subsidiary it bought in 1968 that sold products containing asbestos. Quigley filed for Chapter 11 bankruptcy protection in March and is setting up a trust to settle remaining claims.

Tribune's case is somewhat different, since it involved inherited litigation against the IRS rather than individual or class-action claims filed against the company by personal injury lawyers.

Chris Edwards, director of tax policy studies at the Cato Institute, said many companies are willing to litigate in tax court because "there is a fairly high chance of winning against the government because they lose a lot of tax cases."

The U.S. Tax Court does not collect statistics on how often the government wins cases. Yet it's clear that the environment for these types of deal structures has changed.

"The U.S has for some time now been fighting the good fight back at aggressive transactions of all different kinds," said Brace Kayle, chairman of the tax department at Milbank Tweed Hadley & McCloy LLP. "I would chalk this up to one more in the plus column for the IRS, and not really a sea change in the landscape for aggressive tax transactions."

Still, companies will always try to minimize taxes in every way they can, said Edwards. "But in pushing the edge, you get into very gray and uncertain territory about whether something breaks the letter of the law."

The 135-page Tribune ruling details the board meetings, merger discussions and the strategic objectives of Times Mirror that prompted the sale of Matthew Bender to Reed Elsevier Group for $1.6 billion, and health publications group Mosby Inc. to Harcourt General Inc. for $415 million.

A company is allowed to complete a stock-for-stock transaction, tax-free, as long as it retains a continuing interest in the business. "It's absolutely crystal clear that the tax law is supposed to let corporations transfer stock in exchange for other stock and not have it be taxable," said Crane.

The Times Mirror deal gets complicated because the company received cash, not stock, from the Bender sale, and Times Mirror wanted to get out of the legal publishing business altogether.

"From any perspective, the "true economic effect" of the Bender transaction was a sale," Cohen wrote. "Because the consideration paid by the buyer, to wit, unfettered control over $1.375 billion in cash passed to the seller from the buyer, the Bender transaction does not qualify as a reorganization, which requires that the exchange be solely for stock."

Staff reporter Deborah Crowe contributed to this story.